Editor's note (China Daily): Standard & Poor's has just released the report "China Banking Outlook 2005", a year-end assessment of Chinese banks and how it sees their rating and future outlook. The following is a summary of the report.

The outlook on China's banking industry is positive. Although the system still faces some major challenges, recent government actions signify that industry reform is taking a major step forward.

While the sector is still characterized by weak asset quality, low profitability and low capitalization, direct and indirect capital injections from the government and banks' continuous reform efforts have helped the sector to improve its financial profile.

In addition, intensifying the supervisory efforts of regulators is slowly shaping the industry. Given time, these efforts are likely to lay a solid foundation for the sector to build on.

However, financial sector reform in China is still very much a work in progress, and any setbacks along the road are only to be expected.

Positive factors

A rapidly growing economy. The country's rapidly growing economy provides lending opportunities to banks, which have taken advantage of such favourable conditions in the past few years.

An increase in productive loans has reduced the proportion of residual problem loans. But the quality of new loans and individual bank's underwriting skills have yet to be fully tested.

High level of commitment. Both regulators and the sector in general are showing a high level of commitment to reform. Intensifying supervisory efforts is likely to push the management of individuals, in turn speeding up reform. Banks in general have a growing level of awareness of the challenges they face.

Government support. The government has shown its commitment to reforming the sector by injecting a sizable amount of capital into three banks and allowing these banks to dispose of large amounts of non-performing loans (NPLs) at favourable prices to a government-owned asset management company.

Negative factors

Improving but high level of problem assets: Recent cases of irregularities involving a sizable amount of funds have highlighted the fact that the sector still has a lot of work to do to strengthen its risk management and build a solid credit culture across individual organizations. These improvements are needed to improve the sector's asset quality.

Growing but insufficient capital: While recent capital injections by the government and fresh capital injected by foreign investors have helped a few Chinese banks to strengthen their capitalization, the banking system's capitalization is still inadequate to support the sector's fast asset growth and cover its inadequate loan loss provisions.

Rising domestic credit to GDP: While regulators are trying to rationalize domestic credit growth, domestic credit continues to grow at a brisk pace. It reached 148 per cent of GDP at the end of 2003 compared with 138 per cent in 2002, 127 per cent in 2001, and only 103 per cent in 1997.

High information risk and high gearing in corporate sector: Banks are facing high information risks because disclosure standards and quality of information in China are still weak, though improving.

Outlook on two pilot State banks

The ratings of two of China's four leading State banks, the Bank of China Ltd (BOC, BBB-/Stable/A-3) and China Construction Bank Corp (CCB,BBB-/Stable/A-3), were raised to investment grade in July 2004 following substantial capital injections and the disposal of sizable amounts of NPLs.

As a result of the equity injections, the two banks are now solvent, with sufficient resources to deal with NPLs and likely losses embedded in their asset books.

The major questions now facing investors, management and regulators alike is whether or not the two banks will remain solvent and profitable and build their respective equity bases in parallel with the growth in their assets and risk profiles.

Clearly the Chinese Government has no appetite for repeated bank bail-outs and together with new equity investors, counterparties and depositors, is hoping that a combination of ongoing reforms and upcoming public listings will lay the ground work for continuing viability on the part of the two banks.

Both BOC and CCB have transformed themselves into government-controlled joint-stock commercial banks. Accordingly, their management structures and reporting lines have also changed.

Judging from the structural changes made, both BOC and CCB have made noticeable efforts to improve their corporate governance standard. They are putting more emphasis on management accountability and increasing levels of central control over branches and other outlets.

These efforts include the centralization of credit authorization functions, and the strengthening of the internal audit functions. While these efforts are yielding some results, there remains room for improvement. Irregularities, including lending irregularities and management override, are still issues that the banks have to address.

Reshaping corporate culture is another key success factor that is being addressed. Experienced staff and an advanced credit culture are perhaps as important or more important than the systems themselves.

The government's view and plan for these banks and senior management's commitment and persistence in implementing these changes will be critical for further reform efforts.

Currently the outlook on the ratings of both BOC and CCB is stable.

The prospects for a change in outlook to positive or a further upgrade in the near term are modest.

While the planned public listing of the two banks will result in a further infusion of equity, the new capital is likely to be quickly consumed by their strongly growing asset bases and is unlikely to radically transform the position of either bank.

Standard & Poor's would prefer to let some time elapse before revisiting the ratings. Any upgrade or revision is likely to depend on the actual impact that the new risk management systems have on behaviour and performance.

Summary of analysis

Agricultural Bank of China (ABC): The public information rating on the bank recognizes the weakness of the bank's financial profile, which is exacerbated by underprovisioning and a high level of NPLs, but there are some signs of improvement.

The bank has made appreciable efforts to improve its performance, asset quality, and management capability in recent years.

However, the challenges it faces remain daunting. It requires external support, such as assistance from the government, to resolve the difficulties.

The government is likely to provide support to speed up the reform process to help ABC to achieve the ambitious targets it has set for the bank.

Industrial and Commercial Bank of China (ICBC): The outlook of the bank is positive on the expectation of likely government support to the bank in the medium term in a manner similar to that on BOC and CCB.

ICBC's market size, with a combined 59 per cent market share in China, and its ownership by the State reflect its importance to the Chinese Government.

The bank's financial profile is improving but still weak. In recent years, it has made noticeable efforts to improve performance, asset quality and management capability. But it needs fresh capital to speed up the resolution of its non-performing asset issue and rebuild its capitalization.

Bank of Communications: The ratings reflect recent improvements in the bank's capital and asset quality. Its capital has been strengthened by 18 billion yuan (US$2.2 billion) of capital infections from the government and an acquisition of a 19.9 per cent interest by HSBC.

Standard & Poor's is continuing to assess the ramifications of the acquisition on the Bank of Communications' credit profile against the backdrop of other anticipated improvements in the bank's financial metrics. Any raising of the rating of the bank will depend on whether such improvements adequately support the bank's credit profile in a manner commensurate with a higher rating level.

China Merchants Bank Co Ltd: The public information rating on the bank reflects its mediocre capitalization. Additional capital is required to support the bank's continuing rapid growth.

The bank's asset quality compares favourably with the asset quality of its domestic peers, but its increasing special mention loans are a concern. The rating also reflects the bank's modest but improving profitability.

China Minsheng Banking Corp Ltd: The bank's capital is insufficient to support its current rapid expansion, but its profitability is better than average and its asset quality is reasonable.

(China Daily)