A bank clerk serves a client at a branch of China Construction Bank Corp in Beijing on Nov 5, 2016. CHEN YEHUA/XINHUA

While short-term borrowings are dearer, interest rates haven't moved much since 2015, piling on pain

China's drive to reduce financial system risks is squeezing the nation's banks. Caught between policymakers' intensifying efforts to raise short-term borrowing costs, and benchmark interest rates that haven't moved since 2015, Chinese lenders have few options but to absorb much of the higher costs.

The gap between the three-month Shanghai Interbank Offered Rate and the one-year lending rate has narrowed to 17 basis points, the narrowest since July 2011. This has exacerbated a trend that started when the People's Bank of China began guiding money rates higher in August to reduce leverage in the financial system, prompting a surge in bond yields.

In late 2015, when China liberalized interest rates, the PBOC said it wouldn't give the lenders free rein. Financial institutions that use high interest rates to attract deposits or disrupt the market will be disciplined, it said.

"As short-term borrowing costs rise, it may be more painful for Chinese banks compared with their global peers," said Li Liuyang, a Shanghai-based market analyst at Bank of Tokyo-Mitsubishi UFJ (China) Ltd.

"They'll have to digest most of the increases in short-term financing costs themselves rather than passing them on through the loan rates, which are largely decided by the PBOC's benchmarks."

The squeeze comes at an especially painful time for China's financial institutions, with profit growth slowing to the weakest in more than a decade amid an increasingly larger pile of bad debt.

The combined net income at listed Chinese banks may rise by just 1.5 percent this year, according to a Bank of Communications Co Ltd estimate.

China's three biggest lenders－Industrial and Commercial Bank of China Ltd, China Construction Bank Corp and Agricultural Bank of China Ltd－trade at a book value of 0.9x on average, about half that of the Shanghai Composite Index, according to data compiled by Bloomberg. The lenders have traded cheap relative to the overall market since at least 2010. Smaller lenders have faced the brunt of the higher borrowing costs.

The five largest Chinese banks, with extensive branch networks, control more than 40 percent of total household and corporate deposits, forcing their smaller peers to resort to more expensive interbank financing.

The share of wholesale funds in small and medium-sized banks' fundraising rose to a record 34 percent on June 30, versus 29 percent at the end of January 2015, according to Moody's Investors Service. The cost of three-month certificates of deposit issued by AAA-rated banks was at 4.40 percent on Feb 9, already exceeding the benchmark one-year lending rate of 4.35 percent. The yield on China Development Bank Corp's 10-year bonds surged to a 22-month high of 4.19 percent on Feb 7. The three-month Shibor has climbed 137 basis points since October to 4.17 percent.

"Chinese banks have been increasingly relying on wholesale funding," said Becky Liu, rates strategist at Standard Chartered Plc in Hong Kong.

"There's a mismatch in their funding rate benchmark and their asset-based interest-rate benchmark, along with a duration mismatch that could bring some stress in the banking system."

The domestic liquidity squeeze will probably continue into 2017 as the government cuts leverage and monetary conditions tighten, a Bloomberg News survey in December showed.

That would drive up the overall financing costs for companies, and lead to more defaults, according to the survey.

"The catch-up play in funding costs will continue in the foreseeable future," said Li Liuyang at the Bank of Tokyo-Mitsubishi UFJ (China).

"The double-track pricing in the banking system indicates that the pains on Chinese lenders will probably last."

Bloomberg