Chinese banks have so far emerged relatively unscathed as the coronavirus pandemic hit economies around the world — but that could change in the coming months. Rising bad loans are set to squeeze margins and reduce profits, said analysts.

China’s financial regulator warned over the weekend that commercial banks could experience a big jump in bad loans as the world’s second-largest economy slows down.

The International Monetary Fund has predicted that China’s economic growth in 2020 will moderate to 1% from last year’s 6.1%.

The China Banking and Insurance Regulatory Commission said some banks have yet to set aside enough provisions to cover for potential loan losses. Putting aside the minimum amount of buffers would set profits in the banking sector back by more than 350 billion yuan ($50.08 billion), said the regulator.

In China, bad or non-performing loans generally refer to those with overdue repayments exceeding 90 days. But some banks — reportedly urged by the regulator — also consider loans with a shorter overdue period as bad loans.

Analysts said the hit to profits as a result of bad loans could emerge in the coming months, with smaller banks expected to feel the pressure more.

“Due to various COVID-19 relief measures, the Chinese banking sector has not fully accounted for the risks to profitability and asset quality which may begin to materialise in the (second half of 2020) and 2021,” analysts from credit research firm CreditSights wrote in a Wednesday report.

Covid-19 is the formal name of the coronavirus disease, which first emerged in China before spreading globally.

“Small and medium-sized financial institutions remain much more vulnerable than large, state-owned commercial banks with nationwide franchises and will likely bear the brunt of the eventual reckoning,” they added.

A report released this week by Fitch Bohua — a Chinese domestic bond ratings agency wholly owned by Fitch Ratings — projected that city commercial banks would experience a larger jump in bad loans this year compared to their larger peers, which are state-owned lenders and joint-stock banks.

The agency outlined the trajectory of bad loans among the different category of banks under three scenarios.

In its worst scenario, where China’s economic growth slows to 1% this year, the ratio of bad loans among city commercial banks would increase by 3.44 percentage points, Fitch Bohua said. That’s more than the jump of 2.62 percentage points in joint-stock banks and 1.92 percentage points among state-owned lenders, according to the report.

The relative weakness of smaller banks is a reason why the Chinese government has introduced measures targeted at helping them, analysts at CreditSights said. The measures include those aimed at lowering funding costs and support to replenish capital, they said.

Meanwhile, bigger banks have the resources to withstand much larger increases in bad loans, according to the research firm.

Even though profitability will likely be hurt in the near term, interest rates that are inching up and a recovery in demand for loans should support Chinese banks’ margins going forward, according to a Morgan Stanley report over the weekend.

That’s coming on the back of an overall improvement in the Chinese economy. In the quarter ended June 30, China reported a 3.2% year-over-year economic growth — reversing a 6.8% contraction in the previous quarter.  

Morgan Stanley analysts said they expect the market to look beyond the immediate hit to profit growth and focus on future earnings prospects instead.

Shares of Chinese banks have suffered this year, with the FTSE China A 600 Banks Index — which tracks large- and mid-cap banks listed on mainland China exchanges — declining by 10.9% so far this year, according to Refinitiv data.

Morgan Stanley said any near-term weakness in share price would provide investors an entry point into Chinese banks such as China Merchants Bank and Ping An Bank.