China banks:What is the blue sky scenario?

China banks have risen by 21% on average in April, vs the HSCEI’s 17%, with expectations on southbound fund flows being a major support for the rally. We try to analyze what current prices imply, to understand the opportunity and risk from here. Current valuations (as of closing price at 15 April 2015) imply sustainable ROE of 13%, which in turn implies an NPL ratio of ~3.9%, holding other factors constant (Table 1). Note that China banks’ NPL ratio plus Special-mentioned loans ratio was ~3.8% at end 2014, implying current valuation may be close to fair value. An overshoot from here would have to mean that investors are willing to take a more benign view on future asset quality.There are factors at work that could create this outcome; for example, if LGFV debt swap program increased to RMB5trn, this could reduce the implied NPL ratio by 115bps. In a blue sky scenario, we could see China banks trade to 1.5x, which would imply an NPL ratio of just 1.4% – but overall, we still think underlying system NPLs are closer to 6.0%. We think the downside risk on asset quality expectations is mainly from insufficient policy response to macro growth deterioration and failure on execution of announced reforms.

    Aside from fund flow, what are the fundamentals supporting the current rally? China banks reported ~18% ROE for 2014.Bloomberg consensus shows that analysts expect ROE to further contract in 2015E-2017E to ~16% on average, mainly due to NIM contraction caused by interest rate liberalization, and high credit costs due to asset quality deterioration. But China banks went up by 21% since end of reporting season in March; what is supporting the rally? Aside from expectation of southbound domestic fund flow, we believe the goodwill on policy is the fundamental support o the current rally. There has always been a gap between banks’ reported ROE and market implied ROE of China banks, primarily due to perception on asset quality. The market believes the LGFV debt swap program and easing on mortgage policy on 2nd home purchase will further ease tail risks. Thus, the gap between market-assumed NPL and banks’ reported NPL narrows.

    What’s been priced in? China banks are trading at 1.1 times 2015E P/B, implying ROE of ~13% and NPL ratio of 3.9% (Table 1). Note that China banks we cover reported NPL ratio of 1.15% and Special-mention loans ratio of 2.6% at end 2014, on average. If we assume SML will eventually become NPLs, then implied impaired loan ratio could be ~3.8%. This is not far off from the market implied NPL ratio, indicating shares are at fair value. We derived the implied NPL ratio using the following steps: a) we use Gordon growth model to calculate on implied ROE base on current prices; b) we assume the difference between implied ROE and Bloomberg estimated ROE (2015E-2017E) is due to credit costs, holding everything else constant; c) base on the additional credit costs, we back up the additional NPL ratio. We assume that banks will have three years to digest the additional NPLs and that banks will make 60% NPL coverage ratio on the additional NPLs (as loss ratio is usually 60%-70% for NPL disposed). We also assume that ROE contraction from 18% in 2014 to 16% in 2016 has fully factored in NIM contraction due to interest rate liberalization.

    What is the most blue sky scenario? When market sentiment is positive, the market may be more willing to give more goodwill on reform, and thus the gap between market-implied ROE (13%) and banks’ forecasted ROE (16%) may further narrows. In our view, the most blue-sky scenario will be that the market finally believes what the banks are reporting. Bloomberg consensus shows that analysts expect China banks to report ~16% ROE on average for 2015-2017E. If market believes this, banks should trade at 1.5x FY1 P/B. The blue-sky scenario implies an NPL ratio of 1.4% on average. With weak macro growth and China’s high leverage ratio, the probability of reaching the blue sky scenario is low; nonetheless, the gap may further narrow amid positive sentiment.

    What are the positive catalysts? Mainly from the policy front. Our China economist, Haibin Zhu, expects further easing on the road ahead (please refer to China: 1Q GDP growth eased to 7.0%oya as expected; disappointing IP report reflected restructuring pains for details). A few highlights:

    1. LGFV debt swap program: banks reported NPL ratio on LGFV loans were only 7bps on average at end 2014. Market may have a much higher implied NPL ratio on LGFV loans, on and off balance sheet. If market has priced in NPL ratio of 20% for these LGFV debts (referring to the last asset cycle in late 1990s), then the debt swap program of RMB1trn/3trn/5trn could reduce implied NPL ratio 23bps/69bps/115bps bps respectively. This assumes that: a) LGFV with worst type of asset quality got swapped; b) local government won’t default on the municipal bonds; c) MOF will expand the swap program.

    2. Structural reforms: 1Q15 GDP growth was 7% YoY, but there are some positive read from the weak number. The overcapacity problem in these sectors seems to be addressed more seriously. For instance: in a few overcapacity sectors, output fell significantly in 1Q15 (cement: -3.4%; plate glass: -6.0%; pig iron: -2.3%; crude steel: -1.7%; coke: -2.0%). This shows that structural reform may be going progressing ahead of expectation.

    3. Monetary easing: we expect another 50bps RRR cut in April and 25bps rate cut in June.

    What could be the potential downside? Risk mainly from policy response:

    1. Insufficient policy response to macro growth deterioration. This could lead to further deterioration of GDP growth in subsequent quarters, triggering concerns on asset quality.

    2. Reform-related policy: execution on reform is challenging and time-consuming. If the government fails to provide evidence on reform execution, market could lose patience.