China Banks – Beneficiaries of a Strengthening Economy and Increasing Rates

 

Investment Summary
Investment opportunities are emerging in China’s banking sector on the back of improving asset quality, receding downward pressure on Return-on-Equity (ROE) and attractive valuations. With numerous regulatory tightening measures in place and corporate earnings on an uptrend, we see a lower systemic risk in the financial system.

We forecast Chinese banks’ average ROE to moderate by 200bps from the 2016 level to around 12-13% in the next three years. Key factors that can help lessen the downward pressure on ROE include decent loans growth, a relatively steady rate environment, and a slowdown in non-performing loans (NPL) formation. These will be favourable for net interest margin (NIM) expansion. The stabilisation may also help some quality banks with less capital pressure to re-rate and trade around 1x forward Price-to-Book ratio. The sector’s high dividend yield of around 5% is appealing for income-oriented investors, and should be another factor supporting the sector’s valuations.

Within the sector, we prefer large banks with resilient NIM, relatively less exposure to shadow banking business, and attractive valuations. We like Agricultural Bank of China (1288 HK), Bank of China (3988 HK), Bank of Communications (3328 HK)and Industrial & Commercial Bank of China (1398 HK), with China Construction Bank (939 HK) being our top pick.

 

Improving asset quality
Asset quality improvement will continue this year even as corporate funding cost stays on the uptrend. The asset quality of large banks remained stable while small and mid-cap banks had a mixed showing. Asset quality indicators – such as NPL ratio, overdue loan >3m ratio and special mention loan ratio – suggested that the overall NPL formation has passed the peak. Gross NPL formation had peaked in 2016, especially for the Big-4 banks with their average NPL formation dropping by 28bps y/y to 1.9% last year. The performance was less uniform among the smaller and joint-stock banks. China Merchants Bank’s gross NPL formation declined more significantly by 95bps y/y to 2.24% in 2016, while Bank of Communications saw a moderate rise by 20bps y/y to 1.53% in 2016. Meanwhile, credit cost had also peaked in 2016. We expect credit cost will moderate going forward but continue to stay above the historical average level in the near-term.

 

Asset quality will also benefit from the improvement in corporate earnings and profitability, which should lessen the interest burden on borrowers. Revenue growth of A-share non-financial companies accelerated from -11% y/y in 2016 to 25% in 3Q17. Similarly, A-share non-financial earnings growth rose from 26% y/y in 2016 to 39% y/y in 3Q17, while profitability improved from its trough in 2013-2014 and has stabilised over the past few quarters. Notably, Producer Price Index has rebounded strongly, helping to drive down and maintain corporate real funding cost at close to 0%. The significant reduction in interest burden will bode well for the industrial sectors.

Meanwhile, both the government and the sector itself have taken the initiative to further stabilise asset quality. These included the supply-side reforms aimed at reducing overcapacity. For instance, the capacity reduction in the steel industry since 2015 has led to profit margin recovery of marginal producers. Banks have also made an effort to cut down their loans exposure to risky sectors, such as manufacturing, wholesale and retail.

 

Chinese banks popular choice for southbound inflow
Southbound capital flow from Mainland China has been on the rise since the Stock Connect program commenced, hitting more than CNY300bn in 2017. The southbound Stock Connect inflow has recently accounted for more than 16% of Hong Kong’s equity turnover, a major uplift from an average of 8% in 2016. Within the scene, H-share Chinese banks have been consistently ranked among the top-10 most actively traded stocks. The relatively attractive dividend yield and A-H price gap for dual-listed Chinese banks has been the major draw for onshore domestic insurance money and mutual funds that look to diversify their portfolios.

 

Valuation: quality large banks could trade close to book value
In the year to date, H-share Chinese banks have underperformed the MSCI China Index. Their share prices have gained 27% year-to-date, lagging the 56% surge of MSCI China. The market is at a stage where investors are seeing incentives to take profit on sectors or stocks that have delivered stellar performance but are trading at a demanding valuation and against structural or policy headwinds, such as real estate. We view H-share Chinese banks as an alternative defensive play owing to i) reduced risks of a hard landing of China’s economy and an outburst of systemic financial crisis, ii) NIM expansion and stabilisation, iii) improving asset quality and balance sheet transparency. H-share Chinese banks are trading at a relatively attractive valuation of 0.77x 12-month forward P/B with a forecasted dividend yield of more than 5% for 2018e. Within the sector, we prefer large banks with resilient NIM, relatively less exposure to shadow banking, and attractive valuations. We like Agricultural Bank of China (1288 HK), Bank of China (3988 HK), China Construction Bank (939 HK) and Industrial & Commercial Bank of China (1398 HK), with CCB (939 HK) being the top pick. Our target price for Chinese banks is derived based on a three-stage dividend discount model with a sustainable growth of 3.5%, a discount rate of 11-13% and a long-term dividend payout ratio of 50%.

The 3Q17 banking results highlighted and confirmed our view of large banks’ outperformance. The Big-4 banks delivered stable loans growth and modest NIM expansion. Improvement in assets quality has been on track, with Agricultural Bank of China speeding up the process of NPL disposal and lowering NPL ratio. On the other side of the spectrum, small and mid-cap banks were pressured on NIM and pre-provisions profits growth. A divergence in the sector’s asset quality trend was emerging, reflecting individual banks’ pace of NPL disposal.

 

Agricultural Bank of China

Company description
Agricultural Bank of China (ABC) was established in 1951 as an agricultural cooperative bank. After transferring the policy-related banking business to Agricultural Development Bank of China and separating its administrative ties with rural credit cooperatives, ABC became a state-owned commercial bank. It provides credit support for agricultural businesses but also has a share of urban business financing. The bank carried out its first recapitalisation and non-performing loan carve-out in the late 1990s. After several financial restructurings, ABC was formally transformed into a joint-stock limited company and was listed in Hong Kong in 2010.

ABC is the third largest bank in China by total assets, total loans and total deposits. The bank has the second largest domestic network with more than 23,000 branches in China. ABC is the leading bank in the rural and county areas, which contributed 38% of its FY2016 revenue.

 

Investment thesis
Our recommendation for investing in Chinese banks is to focus on quality core holdings, and the Big Four state-owned banks are our preferred choices. Among them, Agricultural Bank of China (ABC) has one of the lowest exposures to risky assets, and the strongest liquidity and deposit franchise among its peers.

Stable NIM expansion with strong deposit growth – While ABC’s pre-provision profit growth of 5% y/y was the lowest among the Big Four, its NIM continued to expand to 2.3% in 3Q17 with higher asset yield and stable funding cost. Its 9% deposit growth was also higher than its peers. However, non-interest income growth remained relatively weak with net fee income contracting 8% q/q and 29% y/y.

Sharp improvement in asset quality – Non-performing loan (NPL) ratio fell sharply to 2.0% in the quarter, and NPL coverage further improved to 194%, which was the highest in the sector. This should buffer ABC’s earnings going forward. However, its capital position was the weakest among the Big Four, with CET 1 ratio staying flat at 10.6% and total CAR edging up to 13.4%.

Initiate with a BUY rating – We think ABC should benefit more from higher interbank rates thanks to its surplus deposits. The stock offers a relatively high forecasted dividend yield of around 6% for 2018e. Our fair value estimate implies a potential upside of 21%.

Near term catalysts

  • – Rural areas strengthening due to the rising middle class
  • – Further improvement in asset quality
  • – Better-than-expected stabilization in net interest margin trend

 

China Construction Bank (939 HK)

Company description
China Construction Bank (CCB) is the second largest commercial bank and one of the Big Four state- owned banks in China. It was the first among the Big Four to be listed in Hong Kong in 2005. A full-service, nationwide franchise, CCB employs more than 300,000 people, and operates more than 14,000 branches. The extensive network enables CCB to compete for both retail customers and large corporate clients on its capability of providing coordinated, nationwide services. CCB’s reported assets and customer loans amounted to CNY21 trillion and CNY11.5tn respectively in 2016.

Quality play with strong pre-provision profit growth
When it comes to investing in China’s banking sector, our recommendation is to focus on quality core holdings. We think China Construction Bank (CCB) is one such choices. Its strong balance sheet, relatively low risk profile and high profitability make it more resistant to macro headwinds than its peers.

Quality core holding within the sector – CCB’s 3Q17 results highlighted a robust pre-provision profit growth at 11% y/y – the highest among its peers – driven by net interest margin (NIM) expansion and tight cost control. Its NIM, at 2.2%, was also the best showing among its peers. The NIM outlook is expected to remain positive due to better asset pricing ability and favourable funding cost.

Stable asset quality – NPL ratio edged down to 1.5% and gross NPL formation rate was down slightly to 0.6%. NPL coverage ratio further improved to 163%, which was significantly higher than the regulatory requirement. The capital position stayed solid with CET 1 ratio and total CAR improving to 12.8 and 14.7% respectively, again the best among peers.

Initiate with a BUY rating – With an improving asset quality and capital efficiency, CCB should be able to deliver above industry average returns in the medium term. We expect a relatively stable ROE outlook, allowing the stock to trade towards its book value. With a forecasted 2018e dividend yield of more than 5%, CCB has the better risk/reward profile in the sector.

 

Industrial and Commercial Bank of China (1398 HK)

Company description
Industrial and Commercial Bank of China (ICBC) is the largest commercial bank in China in terms of assets, loans and deposits. As of the end of 1Q 2017, it had total assets of CNY25 trillion, total loans of CNY14tn, and total deposits of CNY19tn, implying a market share of 12% in loans and 12% in deposits. It has more than 16,500 branches in China and more than 400 branches overseas as of the end FY2016. ICBC is a leading provider of commercial banking services and has a dominant position in consumer and corporate banking segments.

Investment thesis
ICBC’s diversified business mix, strong balance sheet and high profitability makes it a quality bank within the sector that is more resilient to the moderation of China’s economic growth. Pre-provision profit growth remained solid and was up 9% on strong deposit growth.

ICBC’s non-performing loan (NPL) ratio stayed flat at 1.6% in 3Q17. Gross NPL formation rate, overdue loan ratio and special mention loan ratio were all down. NPL coverage ratio continued to improve to 148% and is forecasted to reach 150%+ by the end of this year, which would then be in line with its peers. Capital position remained relatively strong with CET1 ratio and total CAR ratio at 12.9% and 14.7% respectively in 3Q17.

NIM stayed more or less flat at 2.2% in 3Q17, lagging behind other Big Four banks, with a small portion of loans being re-priced. We expect ICBC’s NIM expansion to recover thanks to better loan pricing and targeted reserve requirement ratio cuts. Meanwhile, ICBC has retained its strong deposit base, with a deposit growth of 9% y/y for 9M17, higher than its peers.

ICBC is a strong BUY rating amongst our team. Target upside is 30% in the next 12-months.