Chinese Banks:Time to accumulate big banks

Incremental improvements in asset quality and NIM; Buy quality names.

    We turned more positive on big Chinese banks after our recent trip to China, aswe saw evidence of incremental improvements in asset quality and margin.

    The strict implementation of supply-side reforms is driving up the profitabilityof industrial SOEs, which were perceived as the most troubled areas. Propertyrisks have moderated as consolidation momentum has picked up. This shouldrelieve asset quality concerns for these two sectors (c.35% of total credit) andalso be supportive for banks’ asset yields. As a result, we cut the NPLformation rate by 7bps/8bps to 0.6% in 2017/18 for big banks, and lift NIMassumptions by 4bps/9bps. We upgrade ABC-H and BoCom-H to Buy.

    Supply-side reforms to relieve asset quality risk in the most troubled sectors.

    Following our recent trip to China, we believe that local governments arerigorously carrying out supply-side reforms that rebalance supply-demanddynamics. As such, the profitability of industrial SOEs (c.12% of system credit)is likely to be sustained in coming quarters. A-share listed industrial SOEs arelikely to achieve 70% yoy profit growth in 2017 before this moderates to 20%in 2018, based on consensus estimates. This should lead to less NPL formationand reduced asset yield pressure given fewer “evergreening” loans. In contrast,the financial condition of non-industrial SOEs (19% of system credit) has beenworsening. However, as many are in nationally strategic sectors, such astransport and public utilities, their credit risks are inherently low, in our view.

    Tightening to continue, benefiting big banks but hurting leveraged players.

    We expect China’s financial deleveraging campaign to be orderly before theleadership transition. The campaign has already made progress by cutting offexcess non-productive leverage, shortening the financing chains, and trimmingshadow banking. Meanwhile, financial sector support to the real economyremains resilient, as suggested by a pick-up in corporate long-term loans. Weexpect financial deleveraging to continue, resulting in elevated market ratesand consistent regulatory tightening. This should drive up NIM for big banksand boost loan growth for them, while smaller banks could be forced to slowdown asset expansion due to capital and regulatory pressure.

    Buy quality banks; catalysts: 2Q/3Q results, SOE profit, Southbound tradingWhile China’s structural issues remain unresolved, still debt-driven withinefficient capital allocation, we expect cyclical improvements to drive anearnings recovery for big banks (5%/6% yoy in 2017/18 vs. -1% in 2016).

    China’s big H-share banks have underperformed the MSCI China by c.12%YTD, which is unsustainable in our view. We see three catalysts to drive a reratingof big banks: 1) 2Q and 3Q results showing gradual NIM expansion,stronger asset growth and strengthened NPL coverage; 2) sustained.

    profitability of industrial SOEs; and 3) stronger fund inflow from Southboundtrading, given dividend yield recovering to 5.5% (2018E), a widening A/Hpremium, and persistent underweighting. We still prefer big banks over smallerones in a more properly regulated environment. We raise our TPs by 10% forH-share and 5% for A-share banks, taking into account better earnings andless RMB devaluation. Downside risks: over-tightening in credit and propertymarkets; notable CPI pick-up. See pages 34-39 for rating changes and risks.