Chinese reforms ‘may force banks to address losses’

Threadneedle’s head of Asian equities Vanessa Donegan has warned that Chinese banks may be forced to recognise losses on bad loans in the near future as the government begins a wide-ranging overhaul of the world’s second-biggest economy.

In an investor update following a visit to China, Ms Donegan said she was “encouraged” by what she had seen following the Third Plenum meeting of China’s leadership in November, which set out the reforms.

She said: “Progress on implementation will be hard to predict, especially given that deregulation in a number of areas will challenge vested interests. While economic growth may slow as the restructuring... proceeds, we believe the reforms will... usher in higher-quality and more sustainable growth.”

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But she added that reform of the financial sector is “perhaps the most pressing and difficult challenge facing the authorities”, due to a “high risk of destabilising China’s economic growth”.

The manager said: “The state-owned enterprises that dominate the economy were the main beneficiaries of Beijing’s stimulus programme following the global financial crisis.

“The worry is that much of this investment was mismanaged and that it is only a matter of time before the banks will have to recognise the impaired nature of the projects they lent to in the form of increased provisions for non-performing loans.”

Ms Donegan added that Chinese authorities face a “fine balancing act” between sustaining economic growth and reining in the credit market “which appears to be spiralling out of control”.

She said: “[The government’s] solution is to ensure that capital is allocated more efficiently, and to coerce the banks to manage their liquidity risk and interest rate risk more prudently.

“The People’s Bank of China [the central bank] is allowing interest rates to rise at precisely the time when they would normally be looking to stimulate the economy. This ongoing liquidity tightening is causing the stock market to de-rate, as investors worry that the risk to economic growth is on the downside as the strength of fixed asset investment growth tails off.

“However, over the medium term, the economy stands to benefit if higher interest rates ensure that capital is allocated more efficiently and projects that are only viable as a result of artificially low borrowing costs no longer go ahead.”

In her £71.4m Threadneedle China Opportunities fund, Ms Donegan is currently significantly underweight in financials relative to the portfolio’s MSCI China index benchmark.

In the £493.4m Threadneedle Asia fund, which she has run since 2002, Ms Donegan is also underweight in financials, but has overweight positions in Chinese and Hong Kong equities.

In 10 years to March 11, the Threadneedle Asia fund gained 179.1 per cent, according to FE Analytics, compared with an average sector return of 174.1 per cent and a 142.4 per cent rise in the MSCI AC Asia Pacific ex Japan index.