China's financial de-risking enters the later stage, while the positive financial development cycle continues

Overview

This report is Morgan Stanley's investor presentation on China's financial system under the Asia Summer School framework. Its central questions are the stage of China's financial de-risking and deleveraging cycle and why a positive financial development cycle can still emerge. The report covers real estate, LGFV, industrial credit, household leverage, TSF, the fiscal burden of infrastructure, bank margins and revenue, household asset allocation, payment recovery, RMB internationalization, and investment opportunities in banks and brokerages.

Core views

The report's central view is that financial risk cleanup over the past decade has significantly reduced systemic vulnerability in China: high-risk financial assets declined from 30.2% of financial assets in 2017 to 4.9% in 2025, and may fall to approximately 3% by the end of 2027. Real estate losses, local government implicit debt, and high-risk industrial credit are being gradually absorbed; the household sector still needs to continue deleveraging in areas such as consumer and business loans. Meanwhile, TSF growth has declined to a more sustainable level of around 6%, helping improve credit allocation efficiency, stabilize and potentially lift financial asset yields, and shift financial institutions from low-quality expansion toward risk absorption and quality growth. Banks benefit from stabilizing NIM and revenue growth, stable asset quality, and high dividends; brokerages benefit from active A-share markets, household asset reallocation, institutionalization, and the recovery of financing functions.

Analysis framework

The report adopts a top-down financial risk decomposition framework, dividing China's financial risks into four main areas: real estate, LGFV, industrial credit, and household credit. It combines indicators including the TSF/GDP growth differential, government net interest burden, infrastructure project cash flows, bank NIM and revenue growth, household financial asset allocation, A-share trading activity, and brokerage ROE to assess whether the financial system is transitioning from de-risking to a healthier positive cycle.

Methodology notes

• Macro Financial Risk FrameworkFinancial De-risking and Deleveraging Cycle Analysis

  Assess high-risk financial assets, real estate losses, LGFV debt resolution, industrial credit risks, and household leverage separately to determine whether systemic risks have been absorbed.

  This framework identifies the stock of risks, the pace of risk absorption, and future incremental risks, thereby assessing turning points in financial institution profitability and capital market risk appetite.

• Credit Cycle FrameworkTSF-GDP Growth Differential Analysis

  Observe changes in social financing growth relative to GDP growth to assess the quality of credit expansion and the financial asset yield environment.

  The report believes that medium-term TSF growth of around 6% is more sustainable, reducing low-quality expansion and supporting more effective credit allocation.

• Industry Investment FrameworkPositive Financial Development Cycle

  Risk reduction, stabilizing yields, household asset allocation shifts, active capital markets, and improving financial institution profitability form a positive feedback loop.

  This framework explains why banks and brokerages may still gain healthier growth momentum despite the withdrawal of stimulus policies and slowing credit growth.

Asset mapping & comparison

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

• Chinese Bank Stocks

  Direct beneficiary

  Strengths

  Stabilizing NIM and revenue growth, broadly stable asset quality, and high provisioning and dividends support valuations; long-term ROE of covered banks is expected to be approximately 9%.

  Weaknesses

  Slowing credit growth, household deleveraging, and risks in certain retail credit segments will continue to constrain growth elasticity.

  Comparison

  Compared with high-growth sectors, banks offer more defensive returns and dividend characteristics; compared with the earlier cycle, profitability pressure should ease.

  Risks

  Macroeconomic growth below expectations, renewed real estate or LGFV risks, renewed NIM declines, and continued increases in retail NPLs.

• Leading Chinese Brokerages

  Direct beneficiary

  Strengths

  Active A-share trading, recovering household equity allocation, institutionalization trends, and recovery in IPO and refinancing activity should help leading brokerages maintain double-digit ROE for a longer period.

  Weaknesses

  Business performance is sensitive to market turnover, risk appetite, and the regulatory cycle.

  Comparison

  Compared with banks, brokerages have greater sensitivity to a slow bull market in capital markets and household asset reallocation, but also greater volatility.

  Risks

  Declining market turnover, slower IPO and refinancing activity, and intensifying competition in wealth management and derivatives businesses.

• A-Share Capital Market

  Positively correlated

  Strengths

  Household assets are shifting from deposits toward equities and funds; active trading and recovering financing activity may support a slow bull market scenario.

  Weaknesses

  Although household equity allocation has recovered, it has not yet returned to 2021 levels, and the market still depends on earnings and policy expectations.

  Comparison

  The report emphasizes sustainable trading driven by asset allocation shifts rather than an influx of credit funds.

  Risks

  Macroeconomic earnings below expectations, policy tightening, and declining household risk appetite.

• China Real Estate-Related Credit

  Risks declining but still require monitoring

  Strengths

  Large losses were absorbed during 2021-2024, and local government real estate-related revenue may have bottomed in 1H24.

  Weaknesses

  Industry fundamentals remain weak; existing inventory and price pressures may continue to affect bank asset quality.

  Comparison

  Compared with the high-risk period of 2021-2024, pressure from the stock of risks has declined significantly.

  Risks

  Another decline in home prices, slower-than-expected sales recovery, and special-mention loans at banks converting into NPLs.

• LGFV and Local Government Debt

  Risks being gradually resolved

  Strengths

  The central government has clearly required existing implicit debt to be resolved by the end of 2028, and local government debt replacement and special bond arrangements are progressing.

  Weaknesses

  The recovery of local fiscal revenue and land sale revenue remains uncertain.

  Comparison

  Risks are shifting from implicit debt toward a more transparent government debt structure with longer maturities.

  Risks

  Slower-than-expected debt resolution, pressure on local government fiscal cash flows, and tighter refinancing conditions.

• Household Consumption and Retail Credit

  Under short-term pressure

  Strengths

  Deleveraging helps reduce long-term credit risks, while household financial assets continue to grow.

  Weaknesses

  Deleveraging reduces household spending support by Rmb4-5tn annually, and consumer and business loans still require adjustment.

  Comparison

  Short-term consumption elasticity is weaker than during the period of rapid credit expansion, but balance sheet quality is improving.

  Risks

  Rising retail NPLs, slowing income growth, and risk exposure in consumer and business loans.

Key data

• High-Risk Financial AssetsRmb62tn in 2017, representing 30.2% of financial assets; Rmb21tn in 2025, representing 4.9%; expected to be approximately Rmb15tn, representing 3%, by the end of 2027Reflects the main achievements of financial cleanup over the past decade.
• Absorption of Real Estate-Related LossesApproximately Rmb7tn in total losses related to “dead inventory” during 2021-2024, including approximately Rmb3.4tn absorbed by the financial systemThe report believes that most real estate credit risks have been absorbed by financial institutions, bond investors, shareholders, and supply chains.
• Local Government Implicit DebtDecreased by Rmb3.8tn to Rmb10.5tn in 2024; the central government requires existing implicit debt to be resolved by the end of 2028During 2024-2026, Rmb2tn of local government bonds annually will be used to replace LGFV debt, along with Rmb800bn of annual new special local government bond quotas for implicit debt replacement.
• High-Risk Industrial CreditAs of the end of 2025, high-risk credit accounted for 7.1% of industrial credit; potential NPLs can be absorbed at Rmb1.3tn annually over three yearsGrowth in medium- and long-term industrial loans and manufacturing loans has slowed, indicating progress in controlling incremental risks.
• Household LeverageHousehold credit/GDP rose from approximately 23% in 2009 to approximately 64% in 2020, and began to decline in 2025Excluding business loans, household leverage has actually declined since 2021.
• Impact of Household Deleveraging on ConsumptionReduces household spending support by Rmb4-5tn annuallyA short-term drag on consumption, but helpful in reducing retail credit risks.
• Sustainable TSF GrowthApproximately 6%The report considers this a more ideal and sustainable medium-term social financing growth rate.
• Government Net Interest Burden2.09% in 2024; approximately 2.61% in 2030 under a scenario maintaining the current pace of government deleveraging; approximately 2.54% under a scenario in which fiscal resources partly shift toward consumption and welfareThe report considers this level manageable, with infrastructure still able to provide downside support.
• Infrastructure Project Cash FlowROA of approximately 1.30% in 2024; EBIT rose from Rmb2.2tn in 2021 to Rmb2.9tn in 2024, covering approximately 70% of annual interest paymentsIndicates improved cash flow generation capacity of infrastructure projects.
• Bank Revenue GrowthAverage year-on-year revenue growth of major state-owned banks was 8.4% in 1Q26; the average across the full sample was 7.5%Stabilizing NIM and financial asset yields are important bases for improved bank profitability.
• Household and Non-Bank DepositsHousehold deposits grew 7.5% year on year in May 2026, while non-bank deposits grew 29.6%Shows that new savings are shifting toward financial products such as wealth management products and funds.
• Payment RecoveryTotal payment system volume increased 29% year on year in 1Q26; bank card consumption increased 3.2%Payment recovery and RMB internationalization are viewed as long-term growth drivers for financial institutions.
• Long-Term Bank ROELong-term ROE of covered banks is expected to stabilize at approximately 9%Supported by a rebound in financial asset yields, recovery in fee income, and stable asset quality.
• A-Share Activity and Equity AllocationAverage daily A-share trading value year to date in 2026 has doubled year on year; the equity share of household financial assets recovered from 9.3% in 2024 to 10.5% in 2025, but remains below 13.3% in 2021Supports a slow bull market in capital markets and recovery in brokerage businesses.
• Private Securities Fund AUMIncreased by Rmb2.37tn year on year as of May 2026The institutionalization trend benefits leading brokerages with strengths in institutional business.

Impact & implications

For investment purposes, the report views financial risk cleanup in China's financial system as the foundation for valuation recovery in banks and brokerages. For banks, relatively stable asset quality, high provisioning, high dividends, and stabilizing NIM should support profitability and valuations; for brokerages, the shift in household asset allocation from deposits toward funds and equities, active A-share trading, improved IPO and refinancing activity, and accelerating institutionalization should extend the ROE recovery cycle for leading brokerages. At the macro level, slower TSF growth is not purely negative. If it corresponds to higher-quality credit allocation and stabilizing financial asset yields, it may instead strengthen the sustainability of the financial system.

Risks

• Macroeconomic GDP growth, exports, or industrial profitability falling below expectations, causing bank revenue and asset quality improvements to undershoot expectations.
• Persistent PPI pressure or insufficient adjustment of industrial capacity could slow the absorption of industrial credit risks.
• Continued weakness in real estate sales and prices could increase incremental credit risks beyond those already absorbed.
• LGFV debt resolution, local fiscal revenue, or debt replacement arrangements falling short of expectations.
• Continued household deleveraging suppressing consumption, with consumer and business loan NPLs continuing to rise.
• NIM and financial asset yields failing to stabilize sustainably, delaying the recovery in bank profitability.
• A decline in A-share turnover, IPOs, refinancing, or fund issuance activity weakening the recovery in brokerage ROE.
• Changes in regulatory policy, capital market volatility, or external geopolitical risks affecting household asset allocation and the pace of financial opening.

What to watch

• Whether TSF growth converges toward the sustainable medium-term level of approximately 6%, and whether the TSF-GDP growth differential continues to narrow.
• Whether bank NIM, loan yields, government bond yields, and financial asset yields continue to stabilize or recover.
• Changes in bank revenue growth, net profit growth, NPL ratios, provision coverage ratios, and dividend yields.
• Recovery in real estate-related NPLs, special-mention loans, and local government land-related revenue.
• LGFV implicit debt balances, issuance of local government debt replacements, and implementation of the 2028 debt resolution timetable.
• Medium- and long-term industrial loans, manufacturing capital expenditure, PPI, and industrial profit growth.
• Household deposits, non-bank deposits, wealth management products, fund issuance, household equity allocation, and A-share trading value.
• The relative relationship between consumer and business loan growth and household income growth, as well as retail NPL trends.
• IPOs, refinancing, private securities fund AUM, institutional trading, and derivatives business activity.
• Payment system transaction volume, bank card consumption growth, and progress in businesses related to RMB internationalization.