China's de-risking is entering the later stage, and the positive financial cycle is still continuing

Overview

This report is a Morgan Stanley summer school-style investor presentation on China’s financial system, focused on the core question of what stage China’s risk and deleveraging cycle is in and why the research team still believes the positive financial development cycle can persist. It covers themes including real estate risk clearance, local government financing platform debt resolution, industrial credit risk, household deleveraging, TSF growth, infrastructure fiscal capacity, bank earnings recovery, household financial-asset reallocation, RMB internationalization, and capital market development.

Core views

The core view is that after years of risk cleanup, most historical risk in the Chinese financial system has been digested and the share of high-risk financial assets has fallen substantially; although credit growth, household leverage, and parts of industrial capital expenditure are still being adjusted, this deceleration helps lift credit quality, improve asset returns, and lower future financial risks. The research team believes that TSF growth of around 6% is more consistent with medium-term sustainability, and that stable financial asset returns, households shifting savings into diversified financial products, payment recovery, and capital market reforms together will support earnings and valuation recovery for Chinese financial institutions such as banks and brokerages.

Analysis framework

The report uses a macro-financial cycle and industry-mapping approach: it first assesses the pace of stock risk digestion in real estate, LGFV, industrials, and households, then analyzes TSF, loan rates, government net interest burden, infrastructure project cash flow, and shifts in household financial-asset allocation, and finally maps these to profitability, ROE, dividend yield, and long-term growth opportunities for banks, brokerages, and the capital-market ecosystem.

Methodology notes

• Financial cycle analysisRisk and deleveraging cycle framework

  Assesses the stage of risk clearance through indicators such as high-risk financial assets, credit expansion, NPL formation, local implicit debt, and household leverage.

  The report treats real estate, LGFV, industrial credit, and household credit as the main risk sources and measures whether their stock risks have been absorbed by the financial system, investors, supply chains, and fiscal system.

• Macroeconomic credit analysisTSF sustainable growth framework

  Uses the gap between TSF growth and GDP growth to evaluate the quality of credit expansion and the room for recovery in financial asset returns.

  The report argues that narrowing the TSF-GDP growth gap is similar to the 2016-2017 period, and that around 6% TSF growth is more conducive to high-quality growth and risk digestion.

• Industry mappingPositive financial development cycle

  Declining risk, stabilizing returns, household asset-allocation migration, and rising capital-market activity mutually reinforce each other.

  The report links asset-return recovery after financial de-risking with households moving from deposits into wealth products, funds, and stocks, payment recovery, and capital-market reforms to infer profitability improvement for banks and brokerages.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• Chinese bank stocks

  primary beneficiaries

  Strengths

  Net interest margins and income pressure are expected to ease, overall asset quality remains stable, provisions are high, and dividend yield is attractive.

  Weaknesses

  Slower loan growth, household deleveraging, and some retail credit risk may still dampen near-term growth.

  Comparison

  The report expects long-term ROE for state-owned large banks to stabilize around 9%, with clear improvement in 1Q26 income growth.

  Risks

  If real estate or household credit risk deteriorates again, or if financial asset returns fail to stabilize, earnings recovery may be below expectations.

• Chinese brokerages and capital-market-related institutions

  beneficiaries of a positive financial cycle

  Strengths

  Active A-share trading, recovering IPOs, household asset allocation shifting toward equities and funds, and strengthening institutionalization trend.

  Weaknesses

  Capital-market revenues are sensitive to market sentiment and trading volatility.

  Comparison

  Leading brokerages are more likely to sustain double-digit ROE for longer through institutional business, trading capability, derivatives, cross-border allocation, and execution of large deals.

  Risks

  If trading cools, financing pace slows, or regulatory reforms lag expectations, brokerage earnings flexibility could decline.

• Real-estate-related credit assets

  risk source clearly eased

  Strengths

  Most historical losses were absorbed during 2021-2024; local government land and real-estate-related revenues may have bottomed out in H1 2024.

  Weaknesses

  Sector fundamentals remain weak, and special mention loans may still require additional provisioning.

  Comparison

  The report estimates that total 'dead stock'-related losses of about Rmb7tn have been absorbed by multiple parties.

  Risks

  If house prices, sales, or developer financing worsen again, the risk digestion cycle for banks and local finances may lengthen.

• Local government financing platforms and local debt

  policy resolution targets

  Strengths

  The debt resolution timetable is clear, and debt swap arrangements are large and ongoing.

  Weaknesses

  Some implicit debts remain long-dated with weak cash flow, still requiring fiscal and debt-replacement coordination.

  Comparison

  Implicit debt had contracted by Rmb3.8tn in 2024 to Rmb10.5tn.

  Risks

  If fiscal revenue, land sales, or infrastructure cash flows are weaker than expected, pressure on local debt resolution may rise.

• Household financial assets

  financial-allocation migration driver

  Strengths

  Household financial assets continue to grow, with increased allocation outside deposits and room for higher wealth management, fund, and equity allocations.

  Weaknesses

  Household deleveraging weakens consumption and retail credit growth in the short term.

  Comparison

  The share of equities in household financial assets rebounded to 10.5% in 2025 but is still below the 13.3% level in 2021.

  Risks

  If income expectations weaken or market volatility rises, household risk appetite may fall.

Key data

• High-risk financial assetsAround Rmb62tn in 2017, 30.2%; around Rmb21tn in 2025, 4.9%; expected to fall to around Rmb15tn, about 3%, by year-end 2027Used to measure the progress of risk clearance in the financial system.
• Real-estate-related loss absorptionAbout Rmb7tn in losses were absorbed between 2021 and 2024, with the financial system absorbing about Rmb3.4tnIncludes burdens carried by banks, non-bank channels, bond investors, shareholders, and supply chains.
• Local government implicit debtDown to Rmb10.5tn at end-2024, down Rmb3.8tn in 2024The center requires all existing implicit debt to be resolved by end-2028.
• LGFV swap arrangementEach year from 2024 to 2026, Rmb2tn of local government bonds; starting in 2024, about Rmb800bn of new special bonds allocated each year for five consecutive yearsUsed for swapping local government financing vehicles and implicit debt.
• Industrial sector capex slowdownBy a debt metric, 85.1% of industrial subsectors saw slower capital expenditure in May 2026 versus the first half of 2024Indicates that incremental industrial credit risk is being contained.
• Household deleveraging impactThe report estimates annual support to household spending is reduced by about Rmb4-5tnTemporarily suppresses consumption but helps lower credit risk.
• Sustainable TSF growthAbout 6%The research team considers this a more desirable and sustainable social financing growth rate over the medium term.
• Government net interest burdenIf current government leveraging and infrastructure pace continue, it could rise to 2.61% of GDP by 2030; if fiscal resources gradually shift toward consumption and welfare, it is about 2.54% by 2030The report considers this level still manageable.
• Bank income trendAverage year-on-year income growth of state-owned large banks rose to 8.4% in 1Q26Stabilization of net interest margins and financial asset yields is key support.
• Household financial-asset migrationHousehold deposit year-on-year growth slowed to 7.5% in May 2026, while non-bank deposits grew 29.6% year-on-yearSuggests new savings may shift to wealth management, funds, and capital market products.
• Payment recoveryTotal payment system volume in 1Q26 grew 29% year-on-year, and bank-card consumption grew 3.2%Payment recovery and RMB internationalization are viewed as long-term growth drivers for financial institutions.
• Capital market activitySince early 2026, A-share average daily turnover has doubled year-on-year, and A-share IPO scale is up 95% year-on-yearSupports the view of a slow-bull market in capital markets and broker ROE recovery.

Impact & implications

The implications for the China financial sector are constructive: risk clearance lowers tail risk, and the slower TSF growth is moving financial institutions away from low-quality expansion toward recovery in asset yields and risk pricing. Banks benefit from stable net interest margins, steady asset quality, high provision levels, and attractive dividends, while brokerages benefit from higher trading, financing, institutionalization, derivatives, and rising cross-border allocation demand. At the macro level, household deleveraging may suppress consumption in the short term, but over the long term it supports healthier balance sheets and a more sustainable financial cycle.

Risks

• Continued household deleveraging may suppress consumption and retail credit growth in the short term.
• Consumer and business loans saw relatively fast growth in the past, and some areas still need further normalization and risk digestion.
• A renewed downturn in the real estate market could lead to additional provisions and credit losses.
• Resolution of local government implicit debt depends on policy execution, fiscal capacity, and debt-swap pace.
• If industrial profits do not recover sustainably, some high-risk credit may still be exposed.
• The slow-bull view on capital markets depends on ongoing household asset-allocation migration, active market turnover, and continued regulatory reform.
• If loan yields and financial asset yields do not stabilize, bank net interest margin and ROE recovery could be impeded.

What to watch

• Whether the share of high-risk financial assets continues to fall toward about 3% by end-2027 as expected.
• Whether TSF growth remains near a sustainable medium-term range around 6%, and whether the TSF-GDP growth gap continues to narrow.
• Changes in real-estate-related nonperforming loans, special mention loans, and local government land revenue.
• Progress of LGFV debt swap execution, remaining implicit debt, and advancement toward the 2028 resolution target.
• Long-duration industrial loans, manufacturing capex, PPI, and growth in manufacturing profits.
• Changes in household deposits, non-bank deposits, wealth management, funds, and equity allocations.
• Bank net interest margins, loan yields, NPL ratio, provision coverage ratio, and dividend yield.
• A-share average daily turnover, IPO and refinancing volumes, private securities fund AUM, and share of institutional trading.
• Payment system total volume, growth in bank-card spending, and progress in RMB internationalization-related business.