Chinese banks -Financial deleveraging:Rising funding pressure
The market could have underestimated the financial deleveraging impact
China’s domestic liquidity recently tightened notably. The interbank CD ratehas rallied strongly, leaving a narrower or negative spread for some smallerbanks. Also, several small banks reportedly have failed to meet overnight repoobligations lately. While seasonal effects apply, the liquidity tightness wasmainly due to escalating financial deleveraging, in our view. The PBOC haslifted market rates and rolled out stricter MPA rules. We expect liquidity toremain volatile and financial deleveraging to continue, with more “mini hikes”in market rates and tighter new regulations. Joint-stock banks are the mostvulnerable but this is not reflected in share prices. Buy ICBC; sell MSB / CITIC.
Financial deleveraging – mission uncompleted
China’s monetary policy has tightened gradually since 2H16. The People’sBank of China (PBOC) raised rates in monetary tools (Figure 1) and withdrewliquidity on a net basis after the Chinese New Year (Figure 2). At the sametime, the central bank rolled out stricter MPA rules to curb excessive bankingasset growth. As a result, key rates in the money market have risen andvolatility increased. We believe the PBOC aims mainly to contain the fastgrowingleverage in China’s financial sector. The system credit-to-deposit ratio– the key measurement of liquidity risk – stayed elevated at 116% as of Feb2017, way higher than the level that it should be at theoretically (Fig 6). Smallerbanks are more levered players, borrowing excessive wholesale funding toleverage up and to chase yield in the bond and shadow banking markets.
A closer look at interbank CDs: funding pressure ahead
Wholesale funding for smaller banks is mostly obtained via interbank CDs. TheCD balance of CDs jumped 89% yoy to Rmb7.3tr in Feb 2017. Joint-stock andcity/rural banks account for 99% of the issuance, which has supported 20% oftheir asset expansion over the past 12months. In the coming months, thesebanks have ambitious CD pipelines. More than 400banks have announcedplans to issue CDs worth Rmb14.6tr in 2017(up 60% yoy). However, we thinkbanks that are more reliant on CDs are more vulnerable to rising rates andtighter regulations. Some CDs were priced close to 5% recently, leading to anegative spread for CD borrowers to invest in low-risk assets. Caixin previouslyreported that CDs are likely to be reclassified as interbank liabilities, which arecapped at 33% of total liabilities. With Rmb4tr interbank CDs to mature duringMar-Jun 2017and interbank liabilities exposure approaching the limit, jointstockand city/rural banks are subject to notable funding pressure.
Not yet close to a “tipping point”, but credit could slow and hurt smaller banks
Despite the tightening, we see limited risk of an uncontrollable liquidity eventfor now, as the PBOC will do whatever it takes to inject liquidity if needed.However, continuing liquidity support could lead to a bigger asset bubble,persistent capital outflow pressure and rising execution risk for PBOC itselfover the longer term. In the near term, volatility liquidity could push up thefunding cost of smaller banks and drive down credit growth modestly to 14-15% yoy in 2017, we estimate. We see joint-stock and city/rural banks as morevulnerable to tighter regulation, due to faster broader credit growth (15-43%yoy), higher reliance on wholesale funding (30-35% of liabilities) and elevatedshadow banking exposure (20-25% of assets). We thus recommend buyingICBC and selling MSB/CITIC in H-shares amid China’s financial deleveraging.