China's banking sector, aided by the nation's entry to the World Trade Organization (WTO), is poised to press on with reforms, Moody's Investors Service notes in a newly published report.

At the same time, strong economic growth and the prevailing controlled interest rate regime make it possible for the banks to generate handsome interest income, especially from new growth areas, such as consumer lending, Moody's said last week in its industry outlook, titled China: Reform Continues To Progress, But Requires Time As Problems Persist.

China's rapid money supply growth has been driven by a strong economy, the large influx in foreign direct investment (FDI) and the presence of a fixed exchange rate.

Moody's said deposits will increase if both GDP and FDI continue to grow rapidly. That, the agency added, will apply pressure on banks to increase lending.

At the same time, banks' desire to quickly expand market share before 2007 encourages rapid growth.

Recent signs of rapid rises in the prices of raw materials and power shortages will squeeze manufacturing companies' profit margins.

To offset losses, such businesses will boost production, which means they will have to borrow more from the banks. As a result, the credit quality of borrowers - with ongoing margin falls - will become questionable, Moody's noted.

Concerned with overheating, the People's Bank of China and the China Banking Regulatory Commission have issued specific directives aimed at curbing loan growth.

Those directives include tighter real estate lending rules and hikes in deposit reserves' rates.

But Moody's noted the efficacy of the directives is questionable, as they conflict with the intrinsic growth operating mindset of most Chinese banks.

Bank managers must perform against a set of operating targets on loan and deposit growth - and the reduction of NPLs (non-performing loans).

"The administrative mandate to reduce NPL levels is actually driving banks to inflate the equation denominator by extending loans to supposedly promising sectors," Moody's said.

"Risk-adjusted returns are not yet a consideration. Consequently, because managers have to meet their performance targets, loan growth will be difficult to slow down."

Moody's suggested initiatives aimed at tightening lending to overheated sectors, reforms of rural credit co-operatives and a gradual loosening of interest rates are intended to divert lending from fixed-asset investments to the small- and medium-sized enterprises (SMEs) - and the rural areas.

However, Moody's believes the effects of such lending will be limited - at least initially.

The recent government-led, US$45-billion recapitalization of two state-owned commercial banks - Bank of China (BOC) and China Construction Bank (CCB) - has, given its scale and speed, accelerated reform and affirmed the government's commitment to providing support for these key institutions.

Moody's also expects additional, and more pervasive reforms, to follow.

(China Daily June 13, 2004)