OREANDA-NEWS. China's ongoing policy support is likely to sustain growth in agricultural lending and ease asset quality pressures for banks' rural exposure in the short term, says Fitch Ratings. The impact is uncertain in the longer term, with the possibility that banks will not be adequately compensated for the higher risk associated with agricultural lending.

Agricultural lending comprises rural lending and agricultural-related lending to urban entities and individuals. Policy support for agricultural-lending is expected to continue in China through the medium term in line with the government's view on the strategic importance of the agricultural sector. Central policy makers have taken a multi-faceted approach in the past few years to encourage financial institutions to boost rural lending, with targeted reserve requirement cuts in 2014 and 2015, and by extending favourable supervisory and fiscal treatment.

Agriculture looks poised to absorb an increasingly large portion of the banks' loan quota, judging from these policies, combined with targeted lending curbs to overcapacity sectors such as manufacturing and real estate. Agricultural loans have already risen significantly to 28% of total loans in 2014, from 22% in 2007, and we expect the proportion to rise further.

There are greater risks associated with agricultural-related lending, primarily stemming from the weaker financial profile of rural businesses, the lower income of rural households and a less developed credit culture. There are also issues associated with the relative availability of stable collateral in rural versus urban areas in part owing to less clear land use rights in rural areas. Rural lending also heightens operational challenges for banks, and raises questions as to how consistently underwriting standards are applied in these areas.

Large-scale state-directed lending could cause over-investment and capital misallocation if lending rates do not reflect the credit risk of rural entities and households. If risk-adjusted returns remain low, the impact of a sustained increase in policy-directed lending could be negative for banks' credit.

Ensuring that banks are adequately compensated for the greater risk associated with agriculture-related lending will be key in maintaining the banks' credit profiles as their loan books expand.