OREANDA-NEWS. Fitch Ratings expects the pressure on Macao banks' asset quality - indicators which usually lag behind the economy - to intensify, given the agency's forecast of a further decline in Macao's real GDP by 6.5% in 2016 (2015: -20.1%). This was highlighted in the agency's affirmation of Macao sovereign's ratings at 'AA-' with a Stable Outlook on 10 March 2016. Risks to Macao's banks have also risen because their loan books have expanded rapidly while deposit growth has not kept pace.

The increasing divergence between Macao's exceptionally weak economic growth indicators and its banks' loan quality is captured in Fitch's negative sector outlook which was assigned in December 2015. Banks could become more vulnerable to the volatile economy if the current weak environment persists - causing their earnings generation to weaken - if the trend of tighter structural liquidity was to continue, and if the credit enhancement that Chinese banks provide to their Macao operations also declines.

Macao's loan-to-nominal GDP-ratio had jumped to 206% by end-2015 from 156% at end-2014. The large increase was driven by a 16.9% decline in nominal GDP and a 10.3% increase in loans. This structural disconnect stems from Macao's gaming-driven economy, to which the banking system is mainly (indirectly) exposed. As such, the latest spike in this high and volatile systemic indebtedness, which we have been flagging in our Macro Prudential Indicator of '3' since 2012, has remained less of an issue but it points to the concentrated nature of Macao's economy.

Property-related loans increased by 22.3% in 2015, one of the fastest growth rates in Asia-Pacific. About half of these loans are mortgages and the other half are to corporate borrowers. Resident deposits have fallen, while a strong increase in potentially volatile deposits from 'non-residents' kept the system's loan/deposit ratio at 104.4% at end-2015 (2014: 92.6%).

The key structural characteristics of Macao's banking system - concentration on property lending (44% of loans) and large assets/deposits, direct and indirect gaming exposure (1% and 15% of loans, respectively) and dominance by Chinese-owned banks (70% of assets) - highlight its vulnerabilities, but thus far have supported the system's stability (particularly the latter). So have consumption and investment which both continue to grow, albeit at a subdued pace, and unemployment remains under 2%, reflective of a labour force consisting heavily of non-resident workers (45% of total workers) and ongoing casino project expansion. Nevertheless, the risk remains that a prolonged period of anaemic gaming activity could eventually spill over into the domestic economy.

Furthermore, we view Macao's prudential supervision as less onerous compared with other APAC markets, as regulatory exemptions - eg on large exposures - are common, impaired-loan recognition standards are weak (which is often influenced by Chinese bank parents), and industry-wide stress-testing has yet to be established. This is notwithstanding the establishment of macro prudential measures (low loan-to-value-ratio at around 50%) and strengthened anti-money laundering controls and collaboration with other supervisors.

We believe that banks' underlying loan quality will weaken, in particular from gaming-associated sectors, even though the system's reported NPL ratio is likely to remain low, as forecast by Fitch at 0.5% for end-2016. The NPL ratio of SME loans, including the wholesale and retail sectors, deteriorated to 0.55% in 2H15 from 0.3% in 1H15, due to weaker visitor spending.

We also expect deterioration in mainland-related activities (2015: 22% of assets), but again the NPL increase (0.13% at end-1H15) could just be moderate as Chinese banks - in most instances the Macao banks' parents - guarantee 71% of Macao's mainland China exposure.

We expect property loan delinquencies to remain low (end-2015: 0.05%). Property prices decreased by 20% in 2015, which was still 17% higher than in 2012 when the last round of prudential measures came into place.