Alicia García Herrero (Natixis) | China’s banking sector technically opened up to full foreign competition in late 2019, as an aftermath of the Trump-Xi meeting in Beijing in 2017. The formal announcement has hardly changed the situation of foreign banks operating in China, which have a small and decreasing market share as well as lower profitability than domestic peers.
Lower foreign participation than peers
Despite the further opening, the share of foreign banks’ asset in China has declined from 1.69% in 2018 to 1.25% in Q3 2023. Foreign participation in China’s banking sector is also lower than global peers, such as 14% in the US, 6% in India and Japan, but it also shows there is room to grow further. In this note, we compare the performance of Chinese banks, foreign banks in China and developed markets to analyze the opportunities and challenges.
Existing challenges in profits, funding costs, credit and geopolitical risks
While the market share may be falling, it does not mean foreign banks have not expanded in China. The difference is the assets of foreign banks in China have grown 16% since 2018, but Chinese banks have expanded by 66%. The slow asset growth is accompanied by lower profitability. Annual profit of foreign banks in China have fallen by 22% since 2018, contrasting a growth of 22% in Chinese banks.
It explains the difficulties foreign banks face in China, including a lack of competitive neutrality, tougher regulatory requirements (e.g., cross-border capital control, eased but still special treatment in interest-bearing assets) and more expensive funding costs. Foreign banks also have a higher cost-to-income ratio than Chinese banks due to staffing costs, regardless of China or home markets.
Another problem is on deteriorating asset quality from a higher non-performing loan (NPL) ratio and elevated but slightly declining charge-off rates. The NPL ratio of foreign banks in China surged from 0.56% in 2021 to 0.94% in Q3 2023. It is lower than 1.61% for Chinese banks and 1.45% in developed markets. However, the charge-off rate of foreign banks in China remains higher than that of Chinese peers and their home markets, showing the persisting pressure on profits.
With the Russia-Ukraine war and the persisting US-China strategic competition, geopolitics have also caused more risks that are hard to assess and quantify in recent years. Trade and investment restrictions have increased, which was started between the US and China but is growing for the rest of world.
China’s large market and better profitability should keep foreign banks’ interests
While the prospects look challenging, China is relevant to foreign banks for two reasons. First, China’s large market size is still a growing revenue source. In 2023, China’s banking sector was 62% and 53% bigger than the Eurozone and the US. China is also the second largest source of Fortune 500 companies, only slightly lagging behind the US.
Foreign banks also play an intermediary role in cross-border capital flows. China’s outstanding amount of outbound securities investment has expanded by 75% in bonds to $475 billion and 63% in equities to $606 billion from 2019 to June 2023. The turnover of northbound stock and bond connects have also grown 134% to $3.59 trillion and 279% to $1.43 trillion from 2019 to 2023. That said, foreign banks will likely interact more with Chinese entities in China and the rest of world.
Second, foreign banks in China have lower return on assets (ROA) than local players, but it is still slightly higher than in their home markets. However, the future trend is challenging. With slower economic growth, it seems unavoidable that China’s interest rate environment will head lower, which will pressure ROA.
Extra headwinds?
In the future, the opportunities of foreign banks in China will continue to be weighed by existing challenges and additional concerns about slower growth and geopolitics. The upside is China will be likely to accelerate its financial opening to meet policy goals, such as RMB internationalization and pension reform through private insurance policies. However, the higher credit risk and the worries of an unclear policy path will be the dark cloud hovering over the expansion speed. The divergence versus the rest of Asia can grow wider if China’s growth trajectory further heads south and geopolitical relationships turn more soured, leading to more systemic risks than expected and prompting global banks to rebalance new investment.
