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					                                                                                                         Core Pacific - Yamaichi
      2011 Investment Strategy



  OVERWEIGHT                                          China banking sector
Timothy Li                         Overweight on undervaluation. ICBC and CCB are our top picks.
Tel: 852 2826 0005
timothy.li@cpy.com.hk
                            We believe NIM will be widened for 2011F. We also expect four more interest rate hikes
                            and three more RRR hikes in the coming 12 months. After incorporating those factors, we
                            still believe there is value for investment in the sector and thus recommend OVERWEIGHT
                            on the sector. We select ICBC and CCB as our top picks with upside potential of 33.6%
                            and 32.8% respectively. We maintain BUY on ICBC (1398 HK) and CCB (939 HK) with their
                            target prices of HK$8.07 and HK$9.31 respectively based on Gordon Growth Model.

                                 NIM will be widened for 2011F. The slow down in loan growth for 2011F is favourable
                                 to NIM as banks will have greater credit pricing power to price their loans. Also, the
                                 expected interest rate hikes tend to be favourable to NIM expansion. The more active
                                 liabilities management, especially through more active time deposit taking ahead of interest
                                 rate hikes, help lock up funding cost at low deposit rate levels during the interest rate
                                 hike cycle. Greater emphasis on SME and rural area loans by some banks will help
                                 widen NIM.

                                 The expectations of loan loss reserve and coverage to impaired loans on medium-
                                 sized banks cannot be ruled out. For the coverage to impaired loans ratio, we forecast
                                 all the eight H-share banks will meet the 150% expectation by the end of 2011. However,
                                 regarding the loan loss reserve ratio, we anticipate medium-sized banks including China
                                 Merchants Bank (3968 HK), China Citic Bank (998 HK) and China Minsheng Banking
                                 (1988 HK) will be below the 2.5% threshold. We cannot rule out that the implementation
                                 of the expectations may be stricter and possibly applicable to medium-sized banks.

                                 We expect four more interest rate hikes in the coming 12 months after the interest
                                 rate hike in October 2010. The current 1-year deposit interest rate of 2.50% implies
                                 real interest rate of –190bps. We expect four more interest rate hikes in the coming 12
                                 months with about 25bps each time on the benchmark lending and borrowing interest
                                 rate of 1-year term. We further expect two more interest rate hikes in 2012F with about
                                 25bps each time. With the hike announced on 19 October 2010, the total number of our
                                 expected interest rate hikes during the current interest rate hike cycle is 7 with about
                                 175bps. The magnitude is close to the current negative interest rate environments and
                                 the historical interest rate hikes in the previous two interest rate hike cycles.

                                 The negative real interest rate will be eliminated after our expected seven
                                 interest rate hikes based on our house forecast CPI yoy growth of 4.0% for 2011F as
                                 the resulting 1-year deposit interest rate will also be 4.0%. (i) Our house expectation of
                                 slow down in the PRC GDP yoy growth from 10.0% for 2010F to 8.8% for 2011F; and (ii)
                                 Expected sluggish GDP growth of major export markets in European countries and the
                                 US in 2011F will retard the PRC CPI growth and thus the frequency of the interest rate
                                 hikes in the PRC.

                                 OVERWEIGHT PRC banking sector. ICBC (1398 HK) and CCB (939 HK) are our top
                                 picks. After concerns on fund raisings and IPOs among H-share banks for nearly one
                                 year, the valuation of the sector is now undemanding. We prefer big banks to medium-
                                 sized banks due to attractive valuation of 8.0x to 9.6x 2011F PER and 1.4x to 1.9x
                                 2011F P/B as well as stably high 2011F ROE of 18.7% to 21.9%. On the other hand,
                                 the 4.8% high 2011F dividend yields of ICBC and CCB suggest limited downside risk.
                                 We maintain BUY and select ICBC and CCB as our top picks with their GGM derived
                                 target prices of HK$8.07 and HK$9.31 respectively.



10
                                                                                                           December 2010
        Core Pacific - Yamaichi
                                                                                                                              2011 Investment Strategy


                                         NIM will be widened for 2011F
                                         NIM will be widened for 2011F. The slow down in loan growth for 2011F is favourable to net
                                         interest margin (NIM) as banks will have greater credit pricing power to price their loans. Also,
                                         the expected interest rate hikes tend to be favourable to NIM expansion.

                                         The more active liabilities management especially through more active time deposit taking ahead
                                         of interest rate hikes help lock up funding cost at low deposit rate level during the interest rate
                                         hike cycle. This is supported by the fact that the percentage of savings deposit among total
                                         deposit of the PRC banking industry for 9M10 is declining while that of time deposit is rising.
                                         Greater emphasis by banks on SME and rural area loans will help widen NIM.

                                         Combining the slower increase in average balance of interest-earning assets than that of net
                                         interest income, we believe the net interest margin will widen for 2011F among the eight
                                         H-share banks.


Figure 1: NIM among banks                                                       Figure 2: Percentage of time and savings deposit
        %                                            CMB                CNCB                                   Time                            Saving
  3.5                                                                             70%
                                                     Minsheng           ICBC
  3.4
  3.3                                                CCB                BOC
                                                                                  60%
  3.2                                                ABC                BoCom
  3.1                                                                             50%
  3.0
  2.9                                                                             40%
  2.8
  2.7
                                                                                  30%
  2.6
  2.5
  2.4                                                                             20%
  2.3
  2.2                                                                             10%
  2.1
  2.0                                                                              0%

             2007             2008            2009              2010F   2011F             01/10    02/10    03/10     04/10    05/10   06/10   07/10    08/10   09/10

Source: companies and Core Pacific-Yamaichi                                     Source: PBOC and Core Pacific-Yamaichi


                                         The expectations of loan loss reserve and coverage to impaired loans on medium-
                                         sized banks cannot be ruled out. It is believed that CBRC expect: (i) loan loss reserve ratio
                                         on loan assets; and (ii) coverage to impaired loans ratio of major commercial banks will be
                                         increased to 2.5% and 150% respectively.

                                         For the coverage to impaired loans ratio, we forecast all the eight H-share banks will meet the
                                         150% expectation by the end of 2011. However, regarding the loan loss reserve ratio, we anticipate
                                         medium-sized banks including China Merchants Bank, China Citic Bank and China Minsheng
                                         Banking will be below the 2.5% threshold. We cannot rule out that the implementation of the
                                         expectations can be possibly applicable to medium-sized banks given the expectation of stabilized
                                         monetary policy in 2011.




                                                                                                                                                                        11
December 2010
                                                                                                                                                                   Core Pacific - Yamaichi
           2011 Investment Strategy


Figure 3: Coverage to impaired loans                                                              Figure 4: Loan loss reserve ratio
       %                  2009                    2010F                  2011F                           %                2009                     2010F                  2011F
 350                                                                                               4.0

 300                                                                                               3.5

 250                                                                                               3.0

                                                                                                   2.5
 200
                                                                                                   2.0
 150
                                                                                                   1.5
 100
                                                                                                   1.0
  50
                                                                                                   0.5

   0                                                                                               0.0
           BoComm   CMB          CCB     ICBC         BOC     CNCB       ABC     Minsheng                    BoComm    CMB       CCB        ICBC      BOC      CNCB       ABC     Minsheng
Source: companies and Core Pacific - Yamaichi                                                     Source: companies and Core Pacific - Yamaichi


                                          Owing to the general decline in asset quality as a result of interest rate hike cycle, we expect
                                          the impaired loan allowance coverage ratio will need to be raised even without the PRC authorities
                                          expectations. Credit cost will thus generally rise with or without the expectations.

                                          Figure 5: Credit cost

                                                      %                              2009                             2010F                                2011F
                                                1.4
                                                1.2
                                                1.0
                                                0.8

                                                0.6
                                                0.4

                                                0.2
                                                0.0
                                                            BoComm          CMB             CCB               ICBC            BOC            CNCB             ABC          Minsheng
                                          Source: companies and Core Pacific - Yamaichi

                                          We expect four more interest rate hikes in the coming 12 months after the interest rate
                                          hike in October 2010. The PBoC announced an asymmetrical interest rate hike on 19 October
                                          2010. Both benchmark lending and borrowing interest rate of 1-year term increased by 25bps.
                                          The demand deposit interest rate was unchanged while the 5-year term deposit interest rate
                                          was added 60bps.

                                          Given the growth of the PRC consumer price index (CPI) of 4.4% yoy for October 2010, the
                                          current 1-year deposit interest rate of 2.50% implies real interest rate of –190bps. In order to
                                          combat the high inflation rate in China, we believe the interest rate will rise.

                                          In the past 20 years, there were two interest rate hike cycles in the PRC. The benchmark
                                          1-year lending rate hikes surged: (i) 342bps between 1993 and 1995; and (ii) 189bps between
                                          2006 and 2007.

                                          We expect four more interest rate hikes in the coming 12 months with about 25bps each time
                                          on the benchmark lending and borrowing interest rate of 1-year term. We further expect two
                                          more interest rate hikes in 2012F with about 25bps each time. Combining with the interest rate
                                          hike announced on 19 October 2010, the total number of our expected interest rate hikes
                                          during the current interest rate cycle is seven with about 175bps. This is close to the hike
                                          magnitude of the current negative interest rate environments and the historical interest rate
                                          hikes in the previous two interest rate hike cycles in the PRC.
12
                                                                                                                                                                     December 2010
        Core Pacific - Yamaichi
                                                                                                                                                                        2011 Investment Strategy


                                             Based on our house forecast that the CPI yoy growth will be 4.0% for 2011F, the negative real
                                             interest rate will be eliminated after our expected seven interest rate hikes as the resulting
                                             1-year deposit interest rate will also be 4.0%. (i) Our house expectation of slow down in the
                                             PRC GDP yoy growth from 10.0% for 2010F to 8.8% for 2011F; and (ii) Expected sluggish GDP
                                             growth of major export markets in European countries and the US in 2011F will retard the PRC
                                             CPI growth and thus the frequency of the interest rate hikes in the PRC.

Figure 6: 1-year deposit interest rate and real interest rate trend                            Figure 7: Basic RRR of big four commercial banks
  % (p.a.)              1 year deposit rate (% )              1 year real interest rate (% )      19%
  5                                                                                               18%
   4                                                                                              17%
   3                                                                                              16%
   2                                                                                              15%
   1                                                                                              14%
   0                                                                                              13%
  -1                                                                                              12%
  -2                                                                                              11%
  -3                                                                                              10%
  -4                                                                                                  9%
  -5                                                                                                  8%
        01/01
        04/01
        07/01
        10/01
        01/02
        04/02
        07/02
        10/02
        01/03
        04/03
        07/03
        10/03
        01/04
        04/04
        07/04
        10/04
        01/05
        04/05
        07/05
        10/05
        01/06
        04/06
        07/06
        10/06
        01/07
        04/07
        07/07
        10/07
        01/08
        04/08
        07/08
        10/08
        01/09
        04/09
        07/09
        10/09
        01/10
        04/10
        07/10
        10/10




                                                                                                           12/06

                                                                                                                   03/07
                                                                                                                           06/07

                                                                                                                                   09/07

                                                                                                                                           12/07
                                                                                                                                                    03/08

                                                                                                                                                            06/08
                                                                                                                                                                     09/08

                                                                                                                                                                             12/08
                                                                                                                                                                                     03/09

                                                                                                                                                                                             06/09
                                                                                                                                                                                                     09/09

                                                                                                                                                                                                              12/09
                                                                                                                                                                                                                      03/10

                                                                                                                                                                                                                              06/10
                                                                                                                                                                                                                                      09/10
Source: PBoC, National Bureau of Statistics of China, Core Pacific-Yamaichi                    Source: PBoC

                                             We also expect three more RRR hikes in the coming 12 months after the RRR hikes in
                                             November 2010. The required reserve ratio (RRR) was lifted by 1% point with 0.5% point each
                                             time for two times in November 2010. The basic RRR for major state-owned commercial banks
                                             became 18.0% effective from 29 November 2010. Assuming that (a) China’s authorized ceiling
                                             of loan-to-deposit ratio is 75%; and (b) the PBOC notes account for 5.5% of bank deposit in
                                             China, we estimate the feasible peak for the basic RRR of major state-owned commercial
                                             banks will be at 19.5%. We thus anticipate three more RRR hikes with 0.5% point each time.

                                             Loan growth will slow down for 2011F. We expect the new loan growth for 2011F will be
                                             RMB6.5 trillion, compared with RMB9.63 trillion and targeted RMB7.5 trillion new loan growth
                                             for 2009 and 2010F respectively. In other words, loan assets in the PRC grew 31.7% yoy
                                             and 18.8% yoy for 2009 and 2010F respectively. The loan asset growth for 2011F will retard to
                                             13.7% yoy.

                                             Loan-to-deposit ratio will fall. The yoy growth rates of M2 and deposit to the PRC banking
                                             industry were generally slowing down during 10M10. As the state monetary policy for 2011 will
                                             tend to be stabilized, we believe the M2 growth will decelerate for 2011. We expect the deposit
                                             growth of the PRC banking sector will retard from 28.2% yoy for 2009 to 17.0% yoy for 2011.
                                             As loan growth is slower than that of deposit growth in 2011, the LDR ratio for 2011 will fall.
Figure 8: M2 and total deposit yoy growth (long-term)                                          Figure 9: M2 and total deposit yoy growth (10M10)
        %                M2                        M1                    Total Deposits          yoy growth (% )                                   M2                          M1                             Total Deposits
  40                                                                                             40

  35
                                                                                                 35
  30

  25
                                                                                                 30
  20

  15                                                                                             25

  10
                                                                                                 20
    5

    0                                                                                            15
        01/03
        04/03
        07/03
        10/03
        01/04
        04/04
        07/04
        10/04
        01/05
        04/05
        07/05
        10/05
        01/06
        04/06
        07/06
        10/06
        01/07
        04/07
        07/07
        10/07
        01/08
        04/08
        07/08
        10/08
        01/09
        04/09
        07/09
        10/09
        01/10
        04/10
        07/10
        10/10




                                                                                                            01/10          02/10      03/10         04/10           05/10       06/10        07/10           08/10       09/10        10/10

Source: PBoC and Core Pacific-Yamaichi                                                         Source: PBoC and Core Pacific-Yamaichi
                                                                                                                                                                                                                                              13
December 2010
                                                                                                                               Core Pacific - Yamaichi
        2011 Investment Strategy


                                          Higher contribution from fee income. As the disintermediary is a long-term trend, banks
                                          explore fee income businesses and gradually place greater reliance on fee income from (a)
                                          bank card fee income; (b) settlement, clearing and cash management income; and (c) personal
                                          wealth management fee income. We expect the contribution of net fee income to operating
                                          income will further rise during 2011.



                                          Overweight PRC banks. ICBC (1398 HK) and CCB (939 HK)
                                          are top picks
                                          Overweight PRC banking sector. After concerns on fund raisings and IPOs among the H-share
                                          banks for nearly one year, the valuation range of the counters is 7.6x to 10.5x 2011F PER with
                                          0.4x to 0.6x 2010-12F PEG. Their 2011F P/B valuations are 1.3x to 2.2x with 2011F ROE of
                                          16.7% to 22.4%. We believe the value for investment in the sector gradually emerges and thus
                                          recommend OVERWEIGHT on the sector. In addition, we maintain our BUY recommendations
                                          on CCB, ICBC, ABC (1288 HK), BoComm (3328 HK) and China Merchants Bank (3968 HK).

                                          We prefer big banks to medium-sized banks. In general, big four banks are currently trading
                                          at 8.0x to 9.6x 2011F PER with 0.4x to 0.6x 2010-12F PEG. Their 2011F P/B valuations are
                                          currently at 1.4x to 1.9x with 2011F ROE of 18.7% to 21.9%. Though some medium-sized
                                          banks are at even lower valuation, they will be more vulnerable to worse than expected loan
                                          impairment when asset quality deteriorates mainly due to their lower mentioned loss reserve
                                          ratios . We prefer big banks with generally undemanding valuation and high ROE.

                                          ICBC and CCB are our top picks as undervalued players. Among the big four banks, NIM
                                          of BOC is the lowest and most fluctuating due to its highest exposure to lower NIM business
                                          outside China.

                                          On the other hand, the high 2011F dividend yields of ICBC and CCB of both 4.8% suggest
                                          limited downside risk. The attractive valuation of both 1.9x 2011F P/B and stably high ROE
                                          further support ICBC and CCB as undervalued players. We select ICBC and CCB as our top
                                          picks with upside potential of 33.6% and 32.8% respectively. We maintain BUY on ICBC and
                                          CCB with their Gordon Growth Model derived target prices of HK$8.07 and HK$9.31 respectively.


Table 1: Sector valuation (as at 30 November 2010)
Company Bloomberg Price     Rating     Target   Market                   P/E          PEG          P/B                  Yield                ROE
           code                         price    cap                      (x)          (x)          (x)                  (%)                 (%)
                   (HK$)               (HK$) (HK$mn)              10E    11E     12E 10-12E 10E    11E    12E    10E    11E   12E     10E     11E    12E
BoCom     3328 HK    8.11    BUY         9.35   407,650           10.3     8.4   6.9   0.5   1.8    1.5    1.3    3.3    4.1   5.0    19.7   19.5    20.2
CMB       3968 HK 20.10      BUY        27.35   347,086           13.5   10.5    8.8   0.5   2.7    2.2    1.8    1.9    2.4   2.9    23.7   22.4    21.5
CNCB       998 HK    5.42 Under review      -   235,627           11.3     9.0   7.6   0.5   1.8    1.3    1.1    2.1    2.7   3.1    17.5   16.7    15.3
Minsheng 1988 HK     6.91 Under review      -   163,941            8.9     7.6   6.4   0.6   1.5    1.3    1.1    2.0    2.4   2.8    16.8   17.8    17.4
ABC       1288 HK    4.05    BUY         4.85 1,018,288           11.2     9.6   7.0   0.4   2.0    1.7    1.5    7.1    4.2   5.7    19.8   19.4    22.3
ICBC      1398 HK    6.04    BUY         8.07 1,806,836           10.9     9.2   7.7   0.6   2.2    1.9    1.6    4.0    4.8   5.7    21.9   21.5    21.6
CCB        939 HK    7.01    BUY         9.31 1,736,943           11.1     9.1   7.2   0.5   2.2    1.9    1.5    4.0    4.8   6.2    21.9    21.9   23.0
BOC       3988 HK    4.16    HOLD        5.73 1,092,461            9.9     8.0   6.3   0.4   1.6    1.4    1.2    4.4    5.0   6.3    17.9   18.7    20.0
Average                                                           10.9     8.9   7.2   0.5   2.0    1.6    1.4    3.6    3.8   4.7
Source: Bloomberg and Core Pacific-Yamaichi estimates




14
                                                                                                                                     December 2010

				
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