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Overweight Upgrade: Summary of the Banking Sector Analysis

Core Content

This report from Vivian Xue, dated 8 July 2016, provides an in-depth analysis of the Chinese banking sector, particularly focusing on Hong Kong-listed banks, and evaluates its current position in the investment cycle. The analysis is based on historical performance under different economic and monetary policy cycles since 2008, which are categorized into three main investment stages.

Main Investment Stages

Stage One: Economic Downturn with Monetary Easing

• Characteristics: GDP and CPI growth decline, monetary policy is loose.
• Impact on Banks: Asset expansion, valuation recovery, and relative returns due to weak industry fundamentals.
• Examples: 2008.9–2009.7, 2011.9–2012.7, 2014.4–2015.10.

Stage Two: Economic Stabilization with Neutral Monetary Policy

• Characteristics: GDP growth stabilizes or remains weak, CPI rises moderately, monetary policy is neutral.
• Impact on Banks: Absolute returns due to improved loan demand and asset quality. Relative returns if economic conditions remain weak.
• Examples: 2009.8–2009.12, 2012.8–2013.2, 2015.11–2016.5.

Stage Three: Economic Recovery with Tight Monetary Policy

• Characteristics: GDP growth recovers, CPI rises sharply, monetary policy tightens.
• Impact on Banks: Neither absolute nor relative returns, as banks become more defensive.
• Examples: 2010.1–2011.8, 2013.3–2014.3.

Current Stage: Stage Two

The report concludes that the banking sector is currently in Stage Two, characterized by:

• Weak economic growth.
• Moderate CPI increases.
• Neutral monetary policy.
• A recovery in market confidence due to supply-side reforms and other economic/financial reforms.

Key Reasons for Upgrading to Overweight

1. Fundamental Risks Fully Priced In:

   • Real NPL ratio has declined from 11.5% in 2015 to 11.1% in 1Q16.
   • Loan exposure to risky industries has decreased from 29% in 1H15 to 23% in FY15.
   • Government measures to support AMC's and reduce NPL risk have been effective.

2. Monetary Policy Outlook:

   • The PBoC is expected to maintain a neutral stance due to the L-shaped economic growth target (6.8% GDP growth).
   • CPI and M2 growth are projected to remain moderate, supporting continued monetary easing.
   • The base effect and capital outflows are expected to keep M2 growth low.

Value Reassessment Based on Reforms

• Supply-Side Reforms: Expected to lead to a healthier and more sustainable economy, thus reducing long-term asset quality risks.
• Economic Recovery: If reforms are successful, the banking sector may experience a value re-assessment.
• Positive Outlook: Improved market sentiment and confidence in reforms are key drivers for future performance.

Investment Recommendations

• Top Picks: Chongqing Rural Commercial Bank (3618.HK) and China Construction Bank (939.HK).
• Rationale: Based on the gap between real and implied NPL ratios, as well as capital adequacy considerations.

Key Figures and Data

• Real NPL Ratio: Declined from 11.5% in 2015 to 11.1% in 1Q16.
• Implied NPL Ratio: At 8.7% under the base-case scenario.
• Total Recovery Ratio: 12% (90% self-recovery at 10% cash recovery ratio and 10% sale to AMCs at 30% of original value).
• Valuation Support: Banks have experienced a decline in share prices, but the market has largely priced in the negative factors.

Conclusion

The report concludes that the banking sector has entered a more favorable investment phase (Stage Two), where both absolute and relative returns are possible. The upgrade to Overweight is based on the belief that the sector's risks are largely priced in, and the potential for value re-assessment due to successful reforms and a moderate monetary policy environment.