OREANDA-NEWS. Economic contraction is beginning to take its toll on Taiwanese banks' earnings, and Fitch Ratings expects this to drag on asset quality. Our outlook for the banking sector, however, is stable, supported by ample liquidity in the system, stable unemployment at around 4%, and our expectations that China will avoid a sharp intensification of the slowdown in nominal GDP growth seen in 2015.

Taiwan's GDP has been contracting since 3Q15. Advanced estimates from the Directorate General of Budget, Accounting and Statistics indicate that GDP shrank by 0.8% year-on-year in 1Q16, following a contraction of 0.5% in 4Q15. Reduced external demand, notably from greater China, is a key cause of the contraction, whereas domestic consumption has thus far remained resilient.

We expected banking sector profitability to fall in 2016 after a flat performance in 2015, and results posted by some of the largest private banks for the opening four months of the year are showing this to be the case. Higher loss-provision charges relating to renminbi-related derivatives or Target Redemption Forwards reduced profits, but margins are also being squeezed after three rounds of interest rate cuts since September 2015.

This affects both loan pricing and yields on Taiwanese government bonds. Credit demand in the corporate sector remains weak, reflecting limited capital expenditure, which heightens the risk of a prolonged period of subdued economic growth, if not contraction. The sector had virtually no loan growth in 1Q16, compared with a 3% rise in 1Q15. We expect growth in SME and consumer lending to pick up during the rest of 2016, which may help offset margin compression but overall loan growth will remain depressed because SME and consumer lending is unlikely to offset soft credit demand from large corporates.

Non-performing loans 90 days overdue increased by 10% in 1Q16 from a low base, and we expect an IFRS-based ratio of impaired loans as a percentage of gross loans to rise to 1.4% by end 2016 (end-2015: 1.2%). Key asset-quality risks could arise from SME loans (20%-30% of total sector loans), real estate-related exposures (35%, including retail mortgages) and exposures to China (7% of total sector assets). Positively, risk concentrations to China reduced last year, as banks cut back on cross-border exposures to Chinese banks and direct lending to Taiwanese companies operating in China, in line with the deceleration of economic growth in China.

We expect interest rates to remain low, easing borrowers' debt-servicing costs, and household leverage is not rising. Loss-absorption capacity in the banking sector has been strengthened as banks have built up additional buffers in line with tougher regulatory requirements.

The Stable Outlooks assigned to most Taiwanese bank ratings are sensitive to a protracted economic recession, a sharper-than-expected slowdown of growth in China or a severe correction in real estate prices. These scenarios do not represent our base case. Any signs that banks are significantly increasing risk appetite, for example by loosening underwriting criteria or loosening credit standards, could also affect ratings, but to date we have seen no signs of this behaviour.