Slowing Economy Weighs On Sector Outlook

The sluggish economy is dampening loan growth and NIM continues to narrow but will be much better than that in FY20 and 1H21; asset quality remains stable, and we are expecting 1.75% NPL ratio in 3Q21. Meanwhile, PBOC has increased the capital buffers for banks due to the high risk exposure on real estate. Maintain MARKET WEIGHT. Top picks are CMB (3968 HK) and CCB (939 HK) with a target price of HK$71.00 and HK$8.50 respectively.

WHAT’S NEW

Sluggish economy dampening loan growth. China’s GDP is currently at its lowest since Mar 20 at 4.9%. This sluggish economy has pressured banks to be more prudent when they underwrite loan applications. We are also seeing fewer loans from corporates as the current state of the economy poses risks for any expansion. Real estate companies that have strong demand for funds were also restricted by the three red lines policy. Moreover, loan demand index has fallen to an all-time low at 68.3 since the pandemic, while loan growth fell to a new low in five years to only 11.9%.

NIM will continue to narrow but will be much better than FY20 and 1H21. There were no significant rebounds on the 10-year government yield along with the requirements imposed by the government for banks to cut financing costs. Interest rates on loans are falling and this will help to stimulate economic growth. The loan interest rate in 1H21 was at 5.02% and decreased by 5bp yoy and hoh. Comparing this against the rate at the end of 2019, loan interest rate has fell 58bp. We expect that it will remain at low levels of about 5% in 3Q21. Meanwhile, the 10-year government bond yield fell again in 3Q21 from its rise in 2Q21 with its current interest rate being lower than the 5-year and 3-year average. The falling risk-free interest rate has caused the banks’ bond investment yield and coupons rate to decrease. However, cost of deposit did not fall sharply as confirmed through our channel check with the banks. Due to these factors, we expect that the NIM in 3Q21 will be 2.04%, falling 2bp qoq and 5bp yoy.

Asset quality remains stable, expecting a 1.75% NPL ratio in 3Q21. The NPL ratio is still healthy in 3Q21 as the default on loans only has a minimal impact on 3Q21’s NPL ratio. However, bonds normally default before loans; thus, we are expecting more
pressure in 4Q21. Overall, the risk is still controllable. The NPL ratio is expected to remain at around 1.75% in 3Q21. This translates to an improvement of 1bp qoq, and 21bp yoy. This increase is contributed by a relatively low base last year due to the
pandemic rather than any substantial improvement on asset quality. We share the view that large banks have better NPL indicators while rural and city banks still have certain risks. In regard to the impact of real estate defaults, PBOC believes that the overall risk is controllable, and it does not pose any systemic risk. From our calculations, Rmb153b losses (refer to figure 1) will be incurred by the industry if Evergrande defaults. This translates to an increase in NPL ratio by 9.6bp or a decrease in profit in the banking
industry by 13% in 1H21.

ESSENTIALS

Capital buffers have increased due to the high risk exposure on real estate. Chinese regulators have escalated their interventions to ease market woes following the debt crisis of Evergrande. 19 banks dubbed domestic systemically important banks (DSIBs) are required to increase their capital requirement by 0.25ppt to 1 ppt which will take effect on 1 Dec 21. All 19 banks were divided into four tiers, based on the importance of the banks. Among the 19 banks, Bank of China (BOC), China Construction Bank (CCB), Industrial and Commercial Bank of China (ICBC) and Agricultural Bank of China (ABC) were exempted as they are on the list of global systemically important banks (G-SIBs). GSIBs are designated by the Financial Stability Board, an international body that regulates and makes recommendations regarding the global financial system. Tier 4 banks are compliant with the requirements set forth by G-SIBs, and do not have to increase their capital buffer as they already have a buffer of 1-1.5%.

ACTION

Maintain Market Weight. With China’s GDP at its lowest levels since Mar 20 and with Evergande defaulting, it has negatively affected the share price of banks and has created worrying concerns over the banks’ asset quality. Although we are of the opinion that these negative news are all priced in, we are still cautious on the outlook of the sector.

• We advocate sticking to large banks such as SOEs and joint-stock banks (JSBs) that have demonstrated stronger ability in managing asset quality and NIM. High dividend SOEs and JSBs which have strong competitiveness in retail banking business will outperform. We are maintaining target prices of CCB, ICBC, CMB and CQRCB at HK$8.50, HK$6.70, HK$71.00 and HK$3.80 respectively.

China Merchant Bank (3968 HK/BUY/Target: HK$71.00) and China Construction Bank (939 HK/BUY/Target: HK$8.50) are our top picks. CMB has better asset quality and NIM compared with its peers. 53.31% of CMB’s loans were retail loans. Being the largest national joint-stock commercial bank among the Chinese banks, CMB possess a strong private banking business which supports its valuation. We think CCB’s valuation and dividend yield will be attractive for long-term investors. Its low valuation and above-average asset quality are good defensive plays. We maintain our target price of HK$71.00 and HK$8.70 for both CCB and CMB.