OREANDA-NEWS. Hong Kong banks' exposure to mainland China is declining but remains a significant concentration and key risk for the sector, says Fitch Ratings. The territory's deep financial and trade linkages with the mainland supported high growth rates over the previous decade, but will translate into continued deceleration in economic growth alongside China's own deceleration. This will mean loan impairments should rise gradually, with China-related credit quality remaining a key area to watch for Hong Kong banks in 2016.

Fitch expects Hong Kong banks' mainland China exposure (MCE) to decline further in 2016, in line with decelerating demand growth in cross-border lending and trade finance. Our outlook on banks' ratings and the broader sector are both stable, due largely to Fitch's view that banks will maintain solid fundamentals amid tight regulation despite cyclical loan deterioration and weakening profitability. The Outlook on the Sovereign rating is also stable, reflecting Hong Kong's credible policy framework and exceptionally strong sovereign and external balance sheets.

But event risk remains a key sensitivity for both the economy as a whole and the banking sector specifically. A sudden and sharp slowdown of mainland China's economy could be highly disruptive to Hong Kong, while not our core scenario.

Banks' 2015 results thus far show a gradual but not dramatic deterioration in China-related asset quality from a very low base. Fitch estimates that the China-related NPL ratio will rise to about 1.5%-2.0% by end-2016, up from 0.8% at end-September according to data from the Hong Kong Monetary Authority.

More broadly, Hong Kong's extensive economic and financial linkages with China pose challenges. The potential for risks from China's ongoing adjustment and rebalancing to spill over to Hong Kong have been the main constraint to the territory achieving a 'AAA' rating. Real GDP growth has fallen to 1.9% yoy in 4Q15 from 2.5% a year earlier, with slowing growth in China translating into weaker exports, visitor volumes and retail sales in Hong Kong. Fitch forecasts Hong Kong's GDP growth to fall to 1.6% in 2016. Nonetheless, Fitch acknowledges Hong Kong's China links offer opportunities as well as risks for the territory in the longer term.