COVID-19 may cause short-term headwinds but do not miss the 40% upside from China’s Big Four banks

In our previous few articles, we have been consistently highlighting the valuation mismatch of the Chinese banking industry, especially the Big Four banks (HKEX:3143). Even though they are expected to be hit by the outbreak of COVID-19, we still think this sector is too cheap to be ignored.

Ferlyn Tan
|
Published on 01 May 2020

COVID-19 may cause short-term headwinds but do not miss the 40% upside from China’s Big Four banks | Open a FREE FSMOne account and manage all your investments conveniently in ONE place

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• The PBOC has set up RMB 300 billion of special central bank lending at preferential rates and this is expected to have a downward pressure on the net interest margin. However, in a bid to help the banks, the PBOC could cut the deposit rate to help cushion profitability in 2020.

• Lower reserve requirements will also help to offset falling loan yields since idle funds can now be channelled into lending, helping to support the banks’ margins.

• An increase in credit costs is imminent, but most of the bad debts are usually concentrated in rural banks. The Big Four banks generally have the highest asset quality, with the lowest NPL ratio across the Chinese banking sector.

• As Chinese banks are encouraged to extend more loans to help corporations to tide through this pandemic, loan growth has been picking up. Moreover, with the government likely to continue curbs on shadow financing, this could drive borrows to the banks for their funding needs.

• The Big Four banks are still trading at levels that do not reflect their true value. Based on their respective fair PB ratios, we see an average upside potential of 40.0% across these four banks. Income-seeking investors will also be pleased to know that the Big Four banks are offering attractive dividend yields at 5.1% on average.

A well-functioning banking system is vital for an economy to grow and it is without a doubt that banks play one of the most important roles in any country.

Over 40 years after China’s economic reforms and opening up to the world, China has become the world’s second-largest economy. Rising consumption and an increasing urbanisation rate have become the main growth engines behind China’s economy today, creating new profit drivers for the banking industry.

However, the share prices of the largest banks in China have yet to fully reflect their intrinsic values. Even with COVID-19-expected to have a negative impact on the sector, we still think the Big Four Chinese banks are too cheap to be ignored.

What’s going on?

About two months ago, China shut down its economy to tackle the outbreak of COVID-19. Malls, restaurants and factories were closed, travel bans were imposed, and that brought much of the nation’s economic activity to a halt.

While it is great news that the number of newly reported cases in China has fallen dramatically, the economic impact due to the outbreak has sent shock waves across most businesses and supply chains. Both retail sales and industrial production were stopped abruptly, with many companies struggling to stay afloat in such a challenging business environment.

This also suggests that many companies are likely to be facing difficulties servicing their loans, especially those that are reliant on their monthly operating cash flow to pay for their liabilities. To help companies affected by the coronavirus epidemic, the People’s Bank of China (PBOC) has increased central bank lending and extended loans at preferential rates and the national banks and a couple of locally incorporated banks are recruited to do the job.

While China has restarted its economic engine, it may take a while before things return to normal. In the meantime, the Chinese banks have already started to feel the heat from the COVID-19 economic impact. Offering loans at preferential rates would suggest a further compression in net interest margins (NIM) and despite government efforts to pump liquidity into the system, money may not flow to the less-credit worthy firms, driving up loan defaults in the coming quarters.

Therefore, it is unsurprising that even the Big Four banks were not spared during the sell-off in the last three months. However, even if we factor in a falling net interest spread, a double-digit increase in operating costs, and a surge in credit costs, we still think there is a serious mismatch between the Big Four banks’ valuations and their fundamentals.

Narrowed net interest margin may be supported by savings rate cuts

According to the PBOC, they have set up a RMB 300 billion of special central bank lending targeted at supporting epidemic control and ensuring supplies, whereby the weighted average interest rate of the preferential loans is 2.56%. They have also lowered the interest rates by 25bps for agriculture-related companies and SMEs. On top of that, Chinese authorities have called upon the Big Four banks to increase their loans to SMEs by more than 30% this year.

PBOC has also lowered the one-year loan prime rate (LPR) by 10bps in mid-Feb and further cuts in the LPR may follow suit as the PBOC has just recently cut the reverse repo rates by 20bps on 31 March 2020.

At this juncture, the average interest rate of the Big Four banks’ loans is roughly 4.4% as of FY2019 (Table 1). However, since the banks use the LPR as guidance to decide their lending rate, we are likely to see a fall in loan interest rates that will negatively affect their bottom lines.

Table 1: Big Four banks interest rates and the PBOC’s lending facilities

	Loan amount (millions RMB)	Interest on loans (%)
Big Four banks
ICBC	15,897,368	4.4%
China Construction Bank	14,046,564	4.5%
Agricultural Bank	12,859,889	4.4%
Bank of China	12,141,412	4.3%
PBOC lending facilities
Special central bank lending	300,000	2.56%
Source: Respective annual reports, People's Bank of China Data as of April 2020

That being said, we would like to highlight that the impact of the preferential loans will not be drastic given the huge amount of loans sitting in the banks’ balance sheet as opposed to the RMB 300 billion special lending set up by the PBOC.

Besides, in a bid to help the banks, the PBOC is currently in discussions to cut the deposit rate to cushion profitability in 2020. Lowering the deposit rate can provide more breathing room for the banks by offsetting the falling loan rates and widening the NIM. Similarly, PBOC has also cut the reserve requirement ratio (RRR) for the Big Four banks since the start of the year to encourage them to extend more loans. This may also help to offset the falling loan rates since the idle funds are now channelled into lending which could help to support the banks’ margins.

Therefore, while we believe there will still be downward pressure on NIM from the lower lending yield, it may not be as badly affected as imagined.

Increasing credit costs but capital adequacy ratio remains strong

Loan repayment is definitely a big concern for the banks, especially in the current challenging operating environment. As it may take a while before operating conditions normalise, companies with weak cash positions, or are unable to refinance their loans due to their poor credit ratings, will eventually have to default, translating to increased credit costs for the banks.

While an increase in non-performing loans (NPL) is imminent as a result of COVID-19, we would like to highlight that most of the bad debts are usually concentrated in rural banks. The Big Four banks generally have the highest asset quality, with the lowest NPL ratio across the entire Chinese banking sector (Chart 1).

Chart 1: NPL ratios of the Chinese banks

On top of that, the Big Four banks have strong capital adequacy ratios, suggesting that they are well-placed to absorb losses and can withstand a substantial volume of bad loans. This should provide some buffer for the Big Four banks to tide through any surge in bad loan provisions in 2020.

Table 2: Capital adequacy of the Big Four banks remain strong

	CET1 Ratio	Capital Adequacy Ratio	*Minimum CET1 ratio	*Minimum Capital Adequacy Ratio
Industrial and Commercial Bank of China (HKEX:1398)	13.2%	16.8%	10.0%	13.0%
China Construction Bank (HKEX:939)	13.9%	17.5%	9.5%	12.5%
Bank Of China (HKEX:3988)	11.2%	16.1%	10.0%	13.0%
Agricultural Bank Of China (HKEX:1288)	11.3%	15.6%	9.5%	12.5%
Source: Bloomberg Finance L.P., iFAST compilations *minimum requirement is based on CBRC requirement, capital conservation buffer, countercyclical buffer and GSIB buffer Data as of April 2020

It is also worth noting that the Big Four banks’ tend to lend to the larger national holding companies with strong backing from the government, which are usually able to withstand a downturn better than the smaller players. While policymakers have recently encouraged banks to continue providing low-cost funding to SMEs, which is expected to be hit hard by COVID-19, the Big Four banks’ exposure to SME lending is not substantial (Chart 2).

Chart 2: Big Four banks generally have lower exposure to the SMEs

Loan growth will continue to support bank earnings

The silver lining in the current COVID-19 outbreak is that loan growth has been picking up, as Chinese banks are encouraged to extend more loans to help corporations to tide through this pandemic. It was reported that loans continued to grow steadily at over 12% year-on-year during the most difficult time in China (Chart 3). Moreover, with the government likely to continue curbs on shadow financing, this could drive borrows to the banks for their funding needs.

Chart 3: Loans continued to grow at a steady rate

Besides, although the loan-to-deposit ratio (LDR) of Chinese banks has been on an upward trend over the last decade, it is still much lower compared to other developed economies. As such, there is certainly more room for loan growth in the long-term as the LDR of Chinese banks converge to that of its developed peers (Chart 4).

Chart 4: Loans-to-deposit ratio of the China banking industry remains low

Huge mismatch between fundamentals and valuations for the Big Four banks

Despite the short-term headwinds, we believe the Big Four banks are still trading at levels that do not reflect their true value. Our valuation methodology is built on a 2020E fair PB ratio derived from the Gordon Growth Model as shown on the table below (Table 3).

Table 3: Valuation of the Big Four banks

	PB ratio	Target price (HKD)	Current price (HKD)	Upside Potential	Dividend Yield
Industrial and Commercial Bank of China (HKEX:1398)	0.95	6.85	5.27	29.9%	4.6%
China Construction Bank (HKEX:939)	0.90	8.10	6.32	28.2%	4.5%
Bank Of China (HKEX:3988)	0.80	4.68	2.97	57.6%	6.0%
Agricultural Bank Of China (HKEX:1288)	0.90	4.70	3.26	44.3%	5.2%
Average:				40.0%	5.1%
Source: Bloomberg Finance L.P., iFAST estimations Data as of April 2020

In light of the current situation, capital preservation has never been more crucial. Therefore, even though the Big Four banks have met their respective capital requirements, we believe there is a possibility that they may cut their dividends to preserve capital.

To reflect the risk of a potential dividend reduction, we slashed the Big Four banks’ estimated dividend payout for 2020 by -10%, similar to what they did in 2015. Despite the downward adjustment in dividends, the Big Four banks are still attractive yield-plays for income-seeking investors given their average dividend yield of 5.1% for 2020.

In most recent news, HSBC (HKEX:5) has announced that they will be cancelling their dividends from now to 3Q20 due to pressure from the UK banking regulator, and we believe this could direct investors to other alternative yield plays, such as the Big Four banks. Furthermore, there has been an increase in buying interest in the Big Four banks from southbound investors over the past few months, and we believe this could help support the banks’ share prices (Table 4).

Table 4: Increasing buying interest from the southbound investors

	Mainland investors' holdings on 31/12/2019	Mainland investors' holdings on 28/4/2020
Industrial and Commercial Bank of China (HKEX:1398)	23.2%	27.0%
China Construction Bank (HKEX:939)	6.5%	10.1%
Bank Of China (HKEX:3988)	6.2%	9.5%
Agricultural Bank Of China (HKEX:1288)	16.6%	26.0%
Source: Hong Kong Stock Exchange, iFAST compilations Data as of April 2020

While you can certainly invest in each of the individual banks, investors who prefer diversified exposure to the Big Four banks can opt for the BMO Hong Kong Banks ETF (HKEX:3143), which has a combined exposure of almost 50% to the Big Four banks. For investors who have a longer investment horizon and can look beyond the short-term challenges, we think this may be a good time to start accumulating shares of the Big Four banks.

Chart 5: China H financials price vs. book value

Disclaimer:

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COVID-19 may cause short-term headwinds but do not miss the 40% upside from China’s Big Four banks

Ferlyn Tan

Published on 01 May 2020

What’s going on?

Narrowed net interest margin may be supported by savings rate cuts

Table 1: Big Four banks interest rates and the PBOC’s lending facilities