Shanghai Pudong Development Bank headquarters, July 10, 2011. Shanghai Pudong Development Bank's net profit jumped 19.8 percent year on year to nearly 41 billion yuan ($6.7 billion) in 2013. [Photo/Asianewsphoto]

BEIJING - Tight liquidity and further liberalization of China's financial sector will continue to squeeze banks' profits and add bad loans, rating agency Standard and Poor's (S&P) said on Thursday.

Chinese banks' earnings are likely to decrease this year as they make increased provisions for bad loans, along with a narrowing spread between deposit and lending interest rates and slowing growth in non-interest rate income, S&P said in a report.

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The rating agency expects banks' returns on average assets to fall to 0.8 percent-1 percent in 2014, down from the 1.1 percent-1.2 percent range last year.

Loan quality of Chinese banks will deteriorate this year as they remain heavily exposed to debt-laden local government financing vehicles and manufacturers saddled with overcapacity.

Growth of the world's second-largest economy slowed to 7.7 percent last year as a decade-long construction boom cooled off.

However, the decline in loan quality will not be too bad, S&P said, as a stabilizing domestic economy and pragmatic policy responses to deal with emerging risks should limit the rise in non-performing loans.

As a result, S&P said the credit profile of the major banks it rates in China will remain stable.

"Our outlook on the Chinese banking sector remains stable. In our view, banks' business position, capitalization, risk position, and funding and liquidity should support their stand-alone credit profiles," said Liao Qiang, a senior director with S&P.

Spikes in the borrowing rates Chinese banks charge each other in June and the end of last year have already taken a toll on banks. Analysts say the tight liquidity conditions will not ease in at least the first half of this year as regulators seek to tame risky borrowing in the shadow banking sector.

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Chinese banks are also seeing more depositors move their money out of banks to chase higher returns offered by money market funds from China's leading Internet firms. This, coupled with tight liquidity in the interbank market, poses a challenge for some banks to comply with a regulator-mandated loan-to-deposit ratio of 75 percent.

Banking regulators have scraped the lending rate floor and asked the country's leading banks to report the rates they offer to their best borrowers to reflect a more market-based gauge of lending rates.

Regulators have also allowed banks to issue negotiable certificates of deposit to each other and are mulling a deposit insurance as a necessary step in fully liberalizing deposit rates.

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