China Banking Sector:Capped by dull prospects

Supported by the government’s intention to maintain economicgrowth and a loose liquidity environment under relatively amplemoney supply, China’s financial system has not seen a major crisisthat the market expected in the past three years. However, thevaluation of China’s banking sector has continued to decline eventhough the sector reported an average ROE of 20.85% and a netprofit CAGR of 19.60% during 2011-13, indicating investors’ higherrequirements on risk-adjusted returns. Going forward, the Chinesegovernment should continue to promote economic and financialreforms and try to avoid a debt crisis, which thus pose greaterchallenges to the banking sector. We believe the sector is less likelyto be re-rated ahead, and maintain our NEUTRAL sector call.

    Key Factors for Rating.

    NIM contraction should be the greater challenge to the banking sector. Alongwith further advances in interest rate liberalisation, the introduction of privatecapital into the banking industry, and the development of internet finance andother innovative financial products, China’s banks should face increasingcompetition and rising funding cost. Meanwhile, they are expected to facedifficulties in improving their interest-earning asset (IEA) yields due to financialdisintermediation and weak financing demand during the economic downturn.

    Accordingly, net interest income, which accounts for 76% of banks’ operatingincome, should grow at a slower rate, due to NIM contraction and slowdown ofasset expansion.

    The officially-announced NPL ratio (1.04% at end-1Q14) is not well acceptedby the market, and we believe the difference between official NPL data andmarket consensus will continue to exist in the future. Although banks’ NPL ratiomay increase moderately if the leverage of enterprises and individuals keepsincreasing, banks might experience some asset losses from debt securityinvestments, interbank investments and off-balance-sheet items. We believethe property sector condition will exert great influence over banks’ assetqualities. If the property sector deteriorates in the near term, banks’ assetqualities should worsen more than the market expected.

    We estimate the sector’s 2H14 net profit growth to slow to 3.2% from 10.9%in 1H14. In 2015-16, with the advance in interest rate liberalisation andcontinuous exposure to asset quality risk, we believe the net profit growth ofthe sector will slow. We estimate net profit growth of 7.3%, 2.1% and -1.9% in2014-16, respectively, and the ROE to decline from 20.26% in 2013 to 15.11%in 2016. After the completion of financial reforms, we forecast a sustainable12.9% ROE for the banking sector in a normal economic cycle.

    The short-term valuation of China’s banking sector should mainly depend onmonetary policies and property sector conditions. We believe the magnitude ofpolicy stimulus will be weaker in 2H14, but the liquidity environment will remaingenerally loose. Under this circumstance, the downside risks of banks’valuations should be limited if the property sector remains stable. However, ifproperty prices and sales volume fall sharply, banks’ share prices may dropsignificantly. We estimate a valuation range of 0.73-0.93x 2014E P/B in thefuture 12 months for H shares. Currently, the adjusted 2014E P/B for H-sharebanks is 0.81x, which indicate limited upside potential.

    We prefer banks with competitive advantages in funding cost, internationalbusiness and internet-related retail business. Moreover, certain citycommercial banks with regional advantages also carry sound safety margin.

    We recommend Chongqing Rural Commercial Bank (CRCB) amongH-share banks. We also believe Agricultural Bank of China’s (ABC)long-term competitive advantage can be maintained while its demandingvaluation leads to limited upside potential in the short run. For A-share bankstocks, we rate ABC, China Merchants Bank (CMB) and Bank of Beijing(BoB) BUYs.