The policy of monetary tightening to combat inflation on the mainland may lead to a surge in credit losses and weaken profitability of the banking industry over the next few years, Standard & Poor's warned on Wednesday.

But the efforts to cool rapid credit expansion could help ward off long-term pain for the sector, the rating company said in a report released the same day.

"The profitability of Chinese banks could slip in the remainder of 2011 and drop further in the next two years, despite the strong rebound in 2010 and no signs of slippage in the first quarter of this year," Qiang Liao, director of financial services ratings at Standard & Poor's, said in the report.

"Non-performing loans (NPLs) have nowhere to go but up," he said.

Non-performing loans by mainland banks could reach 5 percent to 10 percent of total advances in three years if "lending rates rise significantly and the government support for project loans turns out to be negligible," Standard & Poor's reckoned.

Strong credit growth in the past two years and loose standards for projects related to the government's stimulus package unveiled in late 2008 during the global financial crisis had weakened loan quality, it explained.

The central bank, keen to put a lid on inflation, has unveiled a series of tightening measures in recent months, including repeated increases in bank required reserves and interest rates. It has raised interest rates four times since mid-October and also boosted banks' reserve requirement ratio eight times since November, most recently on May 12.

The government has also implemented harsh administrative measures to restrict bank lending to the property market and local investment projects.

Inflation accelerated to a 32-month high of 5.4 percent in March and has exceeded the government's 2011 target of 4 percent every month this year.

Nonetheless, S&P maintains its "stable" outlook for the banking sector, citing that lenders' asset quality, profitability, liquidity and capitalization will continue to support mainland banks' credit profiles.

"We maintain our stable outlook on the Chinese banking sector, barring renewed turmoil in the global economy and international financial markets that could shake the Chinese economy," said the report. "In our base-case stress scenario, we expect credit losses to be manageable such that the overall financial ratios of banks will remain supportive of their stand-alone credit profiles."

Mainland banks are set to post 20 percent growth in profits this year after earnings grew an average 30 percent in the first quarter, according to Credit Suisse Group AG.

Industrial & Commercial Bank of China Ltd, the world's most profitable lender, said last month first-quarter profit rose 29 percent to 53.8 billion yuan as the country's economic growth boosted its lending margin and spurred fee income.

The country's gross domestic product may gain 9.5 percent in 2011, compared with 10.3 percent last year, according to the median estimate of economists surveyed by Bloomberg.

China Daily - Agencies

(HK Edition 05/26/2011 page2)