Hong Kong banks will be able to
survive a severe downturn in China, despite having increasing exposure to the country, according to a new report from Fitch Ratings.

Based on the rating agency’s
stress scenario study, "impairment charges are likely to rise from current
low and unsustainable levels but Hong Kong banks are well-positioned to
withstand the headwinds," said Sabine Bauer, director in Fitch's Financial
Institutions Team, in the report.

"This is despite conservative
loss assumptions to reflect rising risks from an increasing portion of banks'
exposure directly and indirectly related to China,” she added.

Fitch believes that the growing
links between Hong Kong and China and the banks' expansion in the mainland
Chinese market, will differentiate future downturns from the 1997 Asian crisis,
the SARS crisis in 2002 and the global financial crisis in 2008-2009, by
potentially leaving a more pronounced impact.

The agency
used two scenarios for the study, incorporating a mild and a severe downturn in China.

The latter is a plausible prospect
but not Fitch's base case. Fitch's central case is a mild stress that
reflects a moderately deteriorating operating environment characterised by
continued volatile capital markets, slower but still healthy growth in China, a
weaker domestic property sector and moderating global trade.

Fitch's stress-loss assumptions in
the severe scenario result in average expected impairment charges of 4.3 per
cent of exposures over a three-year period, ranging up to 5.1 per cent for
the worst affected. Pre-tax losses in such a scenario could on average reach 14
per cent but could be over 30 per cent, if banks do not take sufficiently mitigating
actions, said the agent.

Domestic property exposures remain
mild as long as single-name concentrations are not prevalent and a conservative
approach to risk remains the norm. A mitigating factor is the Hong Kong
Monetary Authority's tight regulation for property lending and low
loan-to-value ratios. Fitch's three-year stress-loss assumption for mortgages
is 1.6 per cent in the severe scenario, based on data derived from historical
peak losses for the industry in 2000-2002. For secured commercial property
loans, Fitch assumes a 4 per cent stress loss.

Fitch considers that future losses
on corporate loans could reach 6 per cent over a three-year horizon. This is
likely to exceed most banks' internal assumptions, and reflects an increasing
portion of loans related either directly or indirectly to China, a market for
which losses have been limited so far. Loans specifically identified for use
outside of Hong Kong, the majority being direct lending to China, are subject
to up to 10 per cent stress-losses.

Minority stakes in Chinese financial
institutions are a concentration risk for HSBC (rated 'AA'/Negative), its
subsidiary Hang Seng Bank ('A+'/Stable), Standard Chartered (Hong Kong) and Dah
Sing Bank ('BBB+'/Stable).

Fitch's stress scenarios assume that the
value of these stakes could decline by up to 65 per cent, a steep decline which
is, however, not inconsistent with the historical performance of comparable
listed companies.