Light At The End Of The Tunnel for China’s Banking Sector?

After plummeting to a three-and-a-half-year low in February 2016, the Hang Seng Index has since staged a spectacular 31.2% rally as catalysts started to emerge for a rebound in the Hong Kong stock market. In 2017 alone, the index has already delivered returns of 9.2% (in HKD terms as of 17 February 2017). Despite the recent surge, the Hong Kong stock market remains undervalued and offers tremendous upside potential for investors. As highlighted in one of our articles, we think that the Hang Seng Index will hit 32,000 points by the end of 2018, supported by upward revisions in earnings forecasts for Chinese companies and recent improvements in economic indicators. However, for this rally to continue, mainland Chinese banks are a necessary component as they constitute almost a fifth of the Hang Seng Index. In this article, we take a deeper look at the underlying fundamentals of mainland Chinese banks and determine if the current rally in the Hong Kong stock market has further room to run.

Bad Debts And Margin Squeeze Take Toll On Bank Shares

China's banking sector is dominated by the "big five" state-owned commercial banks, which collectively held an approximate 40% share of China's total outstanding loans in 2015. They are the Industrial and Commercial Bank of China (HKEX.1398), China Construction Bank (HKEX.939), Agricultural Bank of China (HKEX.1288), Bank of China (HKEX.3988) and Bank of Communications (HKEX.3328). Although they have been profitable, their share prices have been weighed down over the past few years by a host of issues (Chart 1), including a slowdown in China's economy, a collapse in commodity prices, growing bad debts and a squeeze on profit margins. While market sentiment towards mainland Chinese banks has slowly turned positive in recent times, current share prices are still quite far off from the June 2015 highs seen before the sharp sell-off that eventually precipitated.

Chart 1: Share Price Performance Of The "Big Five"

As bank lending is one of China's main levers for stimulating economic growth, state-owned banks have traditionally played strategic roles in supporting state policies, granting loans at the central government's behest. A rapid build-up of debt over the past few years due to cheap credit, however, has been a source of anxiety for market participants. With a total debt-to-GDP ratio exceeding 270%, there were fears that this huge pile-up of debt could eventually trigger a systemic banking crisis in China, especially since most of the borrowing came from state-owned enterprises, many of which are struggling to stay afloat, and non-performing loan ratios among mainland Chinese commercial banks have ballooned over the years. Furthermore, a series of rate cuts and the scrapping of the bank deposit rate ceiling by the central bank have also chipped away at the banks' net interest margins, which is a key gauge of bank profitability measuring the spread between the rates at which they borrow and lend money.

Asset Quality Concerns To Ease

While the deterioration in asset quality among China's commercial banks is a genuine concern, it is worth noting that the formation of bad debts in the economy has slowed in recent quarters, with the banking sector's non-performing loan ratio of 1.74% at the end of 2016 largely flat from the previous three quarters (Chart 2). Given that much of the loan book stress is coming from state-owned enterprises in the "old economy" sectors, the ongoing reforms to trim excess industrial capacity in state-owned enterprises, along with a rebound in commodity prices, have largely improved credit quality, and is likely to have a positive impact on corporate fundamentals. Already, profits at China's industrial firms are starting to pick up steam, growing at a solid 8.5% in 2016, the highest in three years. An industrial reflation that is showing signs of life is also expected to help ease margin pressures and support earnings in the "old economy" sectors. As operating conditions improve, the non-performing loan ratio in the banking sector is likely to decline gradually moving forward.

Chart 2: Non-Performing Loans Showing Signs Of Moderation

Moreover, mainland Chinese banks remain adequately capitalised. Their capital adequacy ratios (CAR), an international standard that measures a bank's capital in relation to its risk weighted assets and its ability to absorb losses, remains well above the Basel III requirement of 8%, as well as the stringent capital adequacy requirement of 10% stipulated by the Monetary Authority of Singapore (MAS). As most of the debt defaults in China stem from state-owned enterprises, it is also worth noting that the Chinese government, which retains control over banks, foreign exchange and capital flows, is in a position to contain this debt burden and limit the risk of a systemic financial crisis.

Potential Recovery In Net Interest Margins

The average net interest margins of China commercial banks have been falling over the past few years as a result of the central bank's rate cuts and interest rate de-regulation. However, with the People's Bank of China (PBOC) shifting towards a more neutral monetary policy stance aimed at deflating asset bubbles and safeguarding China's financial system, lending rates have been on the rise, as reflected in the rebound of the ten-year Chinese government bond yields at the beginning of this year. Meanwhile, interest rates on deposits, which are guided by shorter-term rates, have been rising at a slower pace. As net interest margins largely follow the interest rate environment in the market, a widening of the interest rate spread in China could lead to a recovery in the net interest margins of commercial banks (Chart 3), a potential catalyst for their share prices to further trend upward.

Chart 3: Net Interest Margins Largely Follow Interest Rate Environment

Banking Stocks Worth A Look?

Of China's "big five" state-owned commercial banks, only the Agricultural Bank of China is not included on the Hang Seng Index. The rest, namely the Industrial and Commercial Bank of China (HKEX.1398), China Construction Bank (HKEX.939), Bank of China (HKEX.3988) and Bank of Communications (HKEX.3328) collectively constitute about 18.2% of the Hang Seng Index (as of 17 February 2017). While consensus is expecting most of these banks to record negative earnings growth for FY 2016, it is unsurprising given the slowdown in China's economy and challenging operating conditions that have crimped the banks' profitability. Market participants, however, are expecting conditions to improve gradually over the next two years, with Chinese banks estimated to record positive earnings growth in 2017 and 2018 (Chart 4).

Chart 4: Positive Earnings Growth For Chinese Banks Over Next Two Years

Based on valuations and their prices as of 17 February 2017, the four mainland Chinese banks included on the Hang Seng Index are still given the cold shoulders by market participants and are currently trading at significant discounts below their book values, largely weighed down by concerns over the huge bad debt pile-up that has driven up non-performing loan ratios over the past few years. They represent compelling value for investors at this current juncture, given that the magnitude of the discount is likely to narrow, with market participants expecting operating conditions and bank profits to start picking up over the next two years (Table 1). To sweeten to deal, the dividend yields offered by these banks are appealing relative to the estimated 3.5% currently offered by the Hang Seng Index. The consensus target prices for Industrial and Commercial Bank of China (HKEX.1398), China Construction Bank (HKEX.939), and Bank of China (HKEX.3988) also seem to suggest that these three banks are undervalued at their current prices.

Table 1: Valuations Of Mainland Chinese Banks On The Hang Seng Index

Stock Market Re-Rating To Be Driven By Banks!

At current levels, the Hang Seng Index remains well below the 32,000 points that we have envisioned it to reach by end 2018. As such, the Hong Kong stock market is still undervalued and offers tremendous upside potential for investors, with mainland Chinese commercial banks likely to be one of the main drivers behind the potential upward re-rating. The four banking stocks listed on the Hang Seng Index are some of the largest and most established companies in China, with sound business models, strong balance sheets and cash flows, and have historically shown to generate consistent growth. Trading at below book values, they are certainly worth looking into as potential candidates for your next stock investment. For a more diversified exposure to China's banking sector, investors can also consider the db x-trackers CSI300 Banks UCITS ETF (HKEX.3061), which tracks the A-share performance of sixteen mainland Chinese commercial banks listed on the CSI300 Index.

While there are reasons to be cautious over the future prospects of China's commercial banks, they are by no means doomed to an imminent collapse. Improvements in asset quality stemming from the government's supply-side reforms and a stabilisation in China's economy, as well as a potential recovery in net interest margins, are likely to be potential catalysts for the share prices of China's banks to further trend upward. China's economy is slowing, but the end to an exceptional era of export-driven growth does not signal the end to the potential for further growth. China remains one of the fastest growing economies in the world, and a further strengthening of its economy could bring gains for China's banking stocks.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.