EQUITIES UPDATE: Chinese Banks - Down, not out?

Cindy discusses the recent underperformance of large Chinese banks, down about 15% from their highs

Chinese Banks - Down, not out?

China’s largest banks are down about 15% from their 2018 highs on recent EM underperformance, worries about a deterioration in the US-Chinese trade outlook and concerns on new bank issues and secondary placements.

The market will not get earnings announcements from this group until August, but we expect that the banks will continue their recent trend of showing improvement in their asset quality and expansion in net interest margins. This is being driven by a steady earnings profile for corporate China, but more importantly, by the changes in the regulatory environment, specifically the crackdown on shadow banking and the highly speculative elements in the financial system.

The deleveraging campaign and the tougher regulatory environment has been a boon for large banks, increasing their loan books and raising margins. Since April 2017, there have been a myriad of new regulations targeting leverage and transparency in the most speculative parts of the financial sector, specifically wealth management products (WMPs). This effort has been relatively successful, with WMP new issuance only up a small 1.7% in 2017 and outstanding total assets in China’s trust industry, where most of these products are held, falling 3.18% year-to-date.

Another positive development for the large banks was a regulatory change announced earlier this year that will allow banks to decrease the level of reserves they hold against bad debt from 150% to as low as 120%; dependent on how quickly the bank can dispose of impaired assets. Despite progress being made on WMP and more speculative instruments, non-performing loans on the banks’ balance sheets reached a twelve year high of 1.7 trillion yuan ($268.5 billion), according to official data. This relaxed rule will give the banks an incentive to recognize and write-down dubious loans and, according to a local security house, could boost the sector’s net profit by 57% if provisions can be cut to 120%.

However, despite benefiting the large banks, the measures have been detrimental for smaller institutions that have seen an increase in their net borrowing costs being more dependent on the interbank market. They are also struggling with asset growth as they are more reliant on shadow banking for fund raising. Finally, they seem to be facing more pressure from the central authorities and have been unprepared to withstand the scrutiny of more regulatory oversight. In May, the Chairman of rural bank, Tianjin Rural Commercial, Mr. Yin Jinbao reportedly committed suicide on fears of what would be discovered when the Central Commission for Discipline Inspection sent inspectors to the area.

This comes at a time when the sector is being pressured to raise capital to shore up their balance sheets as they bring off-shadow loans back on the balance sheet and meet Basle III requirements. According to Reuters, Mainland listed financial institutions have announced approximately 400 billion yuan ($63.34 billion) in private and public placements this year, with, according to the Financial Times, about $14bn related to smaller city and rural banks.

The VFTP Thematic Model Portfolio holds a basket of large-cap Chinese banks. The next catalyst for this group will not be until their 2Q earnings reports in August. At that point, we expect them to reaffirm the recent trend of an improvement in asset quality and an expansion in net interest margins.

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