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Shanghai: Add another credit indicator to the financial warning signs flashing in China.

The adjusted loan-to-deposit ratio, which includes a range of off-balance sheet items and is an indicator of the banking system’s ability to weather stress, climbed to 80% as of June 30, according to S&P Global Ratings. For some smaller lenders, the ratio has already topped 100%, S&P estimates.

S&P’s adjusted measure is rising much faster than the official loan-to-deposit ratio as banks pile into off-balance sheet lending, sidestepping government efforts to rein in credit. At the current pace, overall credit could surpass deposits on an adjusted basis within a few years -- a level that would give China little leeway to stave off financial turmoil, S&P says.

“The next two to three years is a crucial window for China to rein in the ratio, or we will be in serious trouble," said S&P’s Beijing-based director Liao Qiang. “Reaching 100% doesn’t mean a crisis will ensue immediately, but it shows China’s entire deposit base is used up and any loss of confidence from savers will severely destabilize the banking system."

Even after S&P’s adjustments, the ratio in China remains lower than in many other countries. Yet the country’s rapid loan growth, diminishing return on credit and rising bad debts combine to make deposits a particularly important buffer against future financial distress, according to Liao.

Cap abolished

Deposit-taking has formed a cornerstone of China’s banking system as it expanded in tandem with the economy, providing lenders with a stable, low-cost funding base to fuel credit growth. Chinese households and companies hold $22 trillion of bank deposits, more than anywhere else in the world. That cushion has made lenders less dependent on short-term wholesale funding than banks elsewhere.

For two decades, China imposed a cap that limited loans to a maximum 75% of deposits as part of measures to contain risks. That ceiling was abolished in October 2015, in part because it was seen as a blunt tool that encouraged illicit deposit-hoarding and moving loans off balance sheets. The official loan-to-deposit ratio among Chinese lenders stood at 67% at the end of September, up only slightly from 66 percent when the cap was lifted.

But that measure has become less relevant as Chinese banks—especially small and mid-sized ones—have stepped up shadow lending and sales of savings-like offerings called wealth management products, which don’t get carried on their balance sheets. The shift is captured in S&P’s adjusted ratio, based on the country’s 50 largest banks, which stood at 70% in 2013 and rose by 10 percentage points over the following two years.

Adjusting ratio

S&P came up with its adjusted ratio by treating all loan-like assets and corporate bond investments on banks’ balance sheets, as well as corporate credit made off-balance sheet, as loans. On the other side of the equation, it added wealth management products to deposits.

Jonathan Cornish, Hong Kong-based head of bank ratings for North Asia at Fitch Ratings, said adjusting the loan-to-deposit ratio to capture items like interbank borrowing, wealth management products and other assets can contribute to “a more comprehensive assessment of liquidity across the system and for individual banks." Fitch doesn’t calculate its own adjusted ratio, he said.

A nine-year credit expansion meant to protect economic growth has prompted numerous warnings of impending financial trouble. China’s debt-to-gross domestic ratio reached 247% after expanding at the fastest pace among Group of 20 nations, according to economists Tom Orlik and Fielding Chen at Bloomberg Intelligence; such sharp increases have been known to trigger crises in other countries, they say.

The Bank for International Settlements in September used data comparing credit and GDP to warn of looming risks in China.

“Targeting economic growth and continued heavy reliance on credit to support growth means that economic leverage is unlikely to abate soon," said Cornish. “This will increase the risks for the financial sector."

Wholesale funding

When loans exceed deposits, banks are forced to rely on wholesale funding that can quickly vanish during market dislocations, Cornish said. In such an event, the central bank—which sets benchmark rates for deposits as well as loans—would be forced to raise interest rates to draw in deposits, according to Liao. That, in turn, would make it harder for companies coping with slower economic growth to repay loans, putting further stress on banks, he said.

The fragile nature of interbank funding was revealed in June 2013, when a credit crunch drove the one-day repurchase rate to a record and the central bank was forced to inject cash amid rumors of lenders missing payments. The episode exposed “deficiencies" in commercial banks’ liquidity management, the chairman of the banking regulator said at the time.

Some banks are already pushing into danger territory. Bank of Jinzhou Co.’s adjusted loan-to-deposit ratio stood at 153% at the end of 2015 and the lender got 43% of its funding from interbank borrowings last year, S&P estimates. At mid-sized Industrial Bank Co., the broadly adjusted ratio was 115% while 39% of its funding came from the interbank market, according to S&P.

Industrial Bank declined to comment. A press officer at Bank of Jinzhou didn’t respond to phone calls.

Wang Tao, head of China economics at UBS Group AG, in April compiled her own adjusted loan-to-deposit ratio for China and came up with an estimate closer to 90%. “Once the LDR visibly exceeds 100%, banks may become more vulnerable to credit market sentiment," she wrote in a report at the time. Bloomberg

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