Aug. 2 (Bloomberg) -- Hang Seng Bank Ltd., Hong Kong's second-largest lender, may report its lowest first-half net income in five years as money made from lending shrank.

The bank that serves two-thirds of the city's 7 million people will report net income fell 1.2 percent to HK$4.96 billion ($636 million) from HK$5.02 billion a year earlier, according to the median estimate of 12 analysts surveyed by Bloomberg News. The bank is scheduled to report earnings today.

Hang Seng Chief Executive Vincent Cheng, 56, is expanding operations in China, the world's fastest-growing major economy, to compensate for a market where competition has increased, lending has dropped and margins have narrowed in the six years since he took the top job.

``I'm not expecting much loan growth and it's still a competitive market, so margins will be tight,'' said Andrew Salton, who helps manage about $2.5 billion in Asia ex-Japan at Standard Life Investments. ``Hang Seng's China expansion is a long-term issue, so don't expect any meaningful impact.''

Hang Seng, which is 62 percent owned by HSBC Holdings Plc, has a bad loan ratio of 2.3 percent, the lowest among the city's biggest banks. That means it typically has to set aside less money for soured debts and won't record the gains smaller rivals may make by reducing provisions.

Low Interest

The low interest-rate environment is hurting margins because of Hang Seng's large deposit base in Hong Kong, where it makes 88 percent of pretax profit. The bank lends out its excess cash, and profit on that has fallen as the Hong Kong benchmark one-month interest rate dropped to a January low of 0.07589 percent. The rate reached a year's high of 0.30246 percent on June 15, still below 1.34598 percent a year earlier.

``In a lot ways, Hang Seng is doing very well; it's just that other banks have had a stronger recovery in earnings,'' said Patrick Ho, assistant director of research at BNP Paribas Peregrine Securities Ltd. ``Hang Seng is looking very actively into wealth management services and at China. In those areas, they should have better growth.''

Bank of East Asia Ltd., the No. 4 publicly traded lender, reported on Friday that first-half profit rose 26 percent to HK$1 billion as provisions fell by half. That's less than the HK$1.1 billion median estimate of 11 analysts surveyed by Bloomberg News.

Provisions set aside for bad loans by Hang Seng may range between HK$110 million and HK$389 million in the first half, compared with HK$456 million in the first half of 2003, according to the analysts' survey. Estimates on first-half profit ranged from HK$4.71 billion to HK$5.3 billion.

Loans

Loans extended by Hong Kong banks fell 0.2 percent in May to HK$2.047 trillion from HK$2.050 trillion a year ago, according to data from the Hong Kong Monetary Authority.

Shares of Hang Seng Bank have fallen 2.2 percent this year, in line with the decline in the benchmark Hang Seng Index. The stock closed up 0.8 percent at HK$99.75 on Friday, the best performing of the city's four biggest publicly traded lenders this year.

To boost profit at the same pace as rivals, Cheng is building the bank's China business. In December, he agreed to pay HK$1.6 billion for 15.98 percent of Industrial Bank of Fujian. That was the bank's first purchase outside Hong Kong and the first acquisition since 1986 when it bought 50.3 percent of The Wing On Bank Ltd.

Industrial Bank, based in Fuzhou, the capital of Fujian province, will offer credit cards and personal loans with Hang Seng as soon as government regulations allow foreign banks to offer those services in China. The Chinese lender, set up in 1988, has 23 branches and 240 outlets on the mainland.

``We are talking about a growth market instead of a shrinking market,'' said Cheng, who spent 68 days in China last year as he negotiated the Industrial Bank purchase, in a June 2 interview. ``We are still actually a small player in the Chinese market.''

China

Hang Seng increased its lending at China branches by 77 percent to HK$3.8 billion in 2003. The mainland and other countries not including Hong Kong and the Americas made up HK$61 million in pretax profit in 2003, according to its annual report. That's about 1 percent of its total pretax profit.

``In the short term, China won't contribute to profit,'' said Lehman's Yu.

The Hong Kong bank was among the first of the city's lenders to offer retail customers the opportunity to buy yuan- denominated Class A shares when China opened up that market to a select number of foreign institutional investors this year.

To contact the reporter on this story: Michele Batchelor in Hong Kong mbatchelor@bloomberg.net

Last Updated: August 1, 2004 18:42 EDT