JP Morgan China Banks

www.morganmarkets.
com
Asia Pacific Equity Research
15 July 2011
China banks
A revisit to local government debt and the sector's
resilience against asset quality risks
Banks
Samuel Chen
AC
(852) 2800-8557
samuel.s.chen@jpmorgan.com
J.P. Morgan Securities (Asia Pacific) Limited
Cindy Xu
(852) 2800-8502
cindy.p.xu@jpmorgan.com
J.P. Morgan Securities (Asia Pacific) Limited
See page 29 for analyst certification and important disclosures, including non-US analyst disclosures.
J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may
have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their
investment decision.
We disagree with Moodys on its recent Chinese banks report: We believe
that Moodys guesstimate on the size of local government debt is based on a
misinterpretation of PBOC and CBRC data. We also disagree with Moodys
assumptions on potential delinquencies. We believe the root of the sectors
legacy NPLs is misunderstood by many investors.
Outstanding debt is within current affordability: The recent NAO report
provides much detail on the history and current status of the local government
debt. Based on debt-to-GDP or debt-to-current fiscal strength ratios, debt
affordability is still not stretched in general we think. We believe it is, by far,
not even necessary to consider bailouts, especially given that pre-emptive
measures have already been adopted by regulators in the past 18 months.
LG debt issue can be solved through Chinas growth in coming years: We
believe this issue is unlikely to pose a systemic risk given that: 1) politically and
fiscally, the central government will prevent such a crisis. We think the problem
is not poor fiscal revenues, but the current fiscal system that needs reform. 2) No
trigger for uncontrollable liquidity crunch, thanks to largely closed capital
accounts and huge liquidity inflow locked in China. 3) Strong fiscal revenue
growth expected in coming years to boost debt affordability. Budget revenue
(ex. land sales) may still increase by 20% CAGR in the next five years. 3) Over
70% of such debt is used in transportation, infrastructure and energy sectors, and
forms a good asset base that can be sold if necessary. The Chinese government
also owns other saleable assets (land, SOE stakes).
Valuations factor in a prolonged economic downturn: We believe structural
change in the nature of the economy, and substantial improvement in the
balance sheet, recurring profitability, and credit environment/infrastructure in
place after ongoing reforms will prevent bad history from repeating. Stress tests
also show the sector can withstand a very severe economic downturn without
any capital loss. We believe the current valuation of listed banks have factored
in a multi-year recession, in which huge NPLs lead to persistent profit declines.
Range-bound in the near term: Investor sentiment may remain weak in the
volatile global financial markets though, where the concern is indeed more on
Europe and its impact on the global economy. We also think there are also a
limited number of catalysts in the very short term. However, we still expect 20-
30% upside in 6-12 months, with strong downside support.
Table 1: Stress tests of asset quality's impact to earnings: NPLs and financial metrics in various 2012 earnings scenarios (sector avg.)
Source: J.P. Morgan estimates, Bloomberg. Valuations are based on market closing prices as of 13 July 2011. Data is based on listed banks avg.
Rmb bn
Earning
growth
Gross
new NPLs
new NPL as %
of 11E loans
NPL
ratio
% inc.
in NPL
Credit
costs ROE
Core tier-
1 ratio CAR PE (x) PB (x)
Implication of the new NPL formation rate (as % of 11E
balance in various sectors to be new NPLs)
Base case 22% 215 0.6% 1.0% 10% 0.54% 22.2% 9.7% 12.6% 6.1 1.2
1% manufacturing loans plus 1.5-2% property loans and LGFV
loans plus about 0.5% other corp. loans to default in 2012
Scenario 1 0% 558 2.0% 2.3% 147% 1.25% 17.2% 9.4% 12.4% 6.1 1.2
5% manufacturing loans, plus 5% property loans, plus 5% LGFV
loans plus about 3% other corp. loans to default in 2012
Scenario 2 -20% 1,037 3.3% 3.4% 274% 1.87% 14.0% 9.2% 12.2% 7.2 1.3
8% manufacturing loans, 8% property loans and LGFV loans plus
about 3.5% other corp. loans to default in 2012
Scenario 3 -30% 1,277 4.0% 4.0% 338% 2.17% 12.3% 9.1% 12.1% 8.3 1.3
10% manufacturing loans plus 10% property loans and 12% LGFV
loans plus about 3-3.5% other corp. loans to default in 2012
Scenario 4 -50% 1,757 5.3% 5.1% 465% 2.56% 8.9% 8.9% 11.8% 11.6 1.3
loans plus about 4.5% other corp. loans to default in 2012
Scenario 5 -100% 2,956 8.5% 8.0% 782% 3.40% 0.0% 8.3% 11.3% NM 1.4
loans plus about 8-10% other corp. loans to default in 2012
Figure 1: Vintage local government
debt/contingent debt, Rmb bn
Source: NAO.
Debt borrowed
before end of
2008, 3,199 ,
29.8%
Debt borrowed
after 2008 but
used for projects
already started in
2008 & before,
2,283 , 21.3%
New debt raised
since 2009 for new
projects , 5,236 ,
48.9%
- http://bg.panlv.net
2
15 July 2011
Samuel Chen
(852) 2800-8557
We strongly disagree with Moody's view
on local government debt
The sentiment toward Chinese banks is at an all-time low since the Global Financial
Crisis in 4Q2008. The major reason is intensified concern on the Chinese economy
and asset quality outlook, as a recent Moodys report warns of potential negative
outlook on the sector, citing its belief that the local government-related loans were
under-estimated by the National Audit Office. Nervousness was further fueled as
Temasek recently sold some US$3.6 billion worth of shares in CCB-H and BOC-H,
while BoA also plans to reduce its stake in CCB-H upon expiry of the lockup in late
August.
We agree that the sector can hardly deliver any meaningful share price performance
in the short term, given little positive catalysts to boost the sentiment in the sector
and lower risk appetite among global equity investor in view of the adverse
developments in European government debt. A range-bound trading pattern is more
likely in the short term. However, in this report:
We argue why we disagree with Moodys on its cautious outlook on Chinese
banks and why we are not as concerned about the local government debt, despite
a likely modest pickup in some LGFV delinquencies due to the short-term tighter
credit supply. Instead, we believe the NAO's recent thorough report on local
government debt provides many useful data points to help better understand local
government debt in China.
We argue that the bad asset quality history is unlikely to repeat, and that the
history of legacy NPLs in 1990s is also misunderstood by many investors. In fact,
the key source of legacy NPLs in China is not local government debt, but low-
efficiency SOEs in manufacturing and wholesale/retail sectors in the planned
economy era.
We provide detailed stress tests on LGFV loans and the overall earnings/balance
sheet resilience against asset-quality stress. Through those stress tests, we
illustrate that the earnings outlook is quite unlikely to be as gloomy as many
investors are worried.
We conduct a valuation exercise based on the stress tests to also show that the
current valuation has factored in a multi-year economic downturn, in which huge
NPL formation will lead to persistent profit declines for 2-3 years, so that ROEs
will shrink to high single-digit and around low-teen percentage, while NPL
eventually built to mid-to-high teen percentage. In our view, this is unlikely in th
eforeseeable future.
From both a fundamental and valuation perspectives, we remain confident on the
sectors outlook and we still expect 20-30% upside in the next 6-12 months. Possibly
triggered by more confidence in earnings post-1H11/3Q11 earnings release, we think
a rally is still likely toward late-3Q11/4Q11 as the CPI trends downwards rapidly
while economic growth in 2H11 holds still fairly strong.
3
15 July 2011
Samuel Chen
(852) 2800-8557
Moody's guesstimate on the size of LGFV loans is its own
interpretation
We believe that like any market participant, Moodys has neither enough resources
nor enough access to present valid evidence to state that the National Audit Offices
recent report underestimates the local government-related loans by Rmb3.5trn. Like
us, it may just have a few individual analysts covering the whole sector and certainly
no better access to government finances other than public data. Indeed, as it admitted
in its own report, its suspicion arises from seemingly inconsistent figures from the
PBOC, CBRC and NAO. It cited CBRCs Rmb9.1trn and an Rmb14trn it derived
from its own interpretation of PBOCs June 1 report, and took an average of the
above two figures to get the size of local government loans at Rmb12trn. In our view,
this is the wrong interpretation.
We believe Moodys misinterpreted PBOCs statement as well as CBRC data
Like many, Moodys did not read PBOCs 2010 Regional Financial Conditions
Report in detail, or misinterpreted the original wording. In its annual 2010 China
Regional Finance Report, released on 1 June 2011, the PBOC stated that loans to
local government-related entities should not be over 30%. As the PBOC officially
clarified in a most recent press release, what it said in the same paragraph following
that summary sentence is that in various regions, the loans to local government-
related entities did not exceed 30% of loans in respective regions. In other words,
30% is the ceiling of a range between 0 and 30% for various individual local
governments. Indeed, as PBOC clarified, some regions have much lower exposure.
Meanwhile, it also did not observe CBRCs data in detail. While CBRC did mention
that as of 2010 its statistics show LGFV loans were Rmb9.1trn, CBRC also said that
to better reflect the nature of the loans, it had allowed Rmb2.84trn loans with
sufficient cash flows to be reclassified as normal corporate loans; thus, LGFV loans
were Rmb6.25bn. The reclassification illustrates the sophistication in the definition,
as some entities might be local governmentrelated, but indeed operate fully as
commercial entities.
Modest data inconsistency arises from different definitions and scope
The root of data inconsistency is the definition issue, as classification by itself is a
very complicated issue. This is simply due to the specific political framework in
China. Investors need to realize that given that China is a socialist country, a
significant number of operating assets, particularly infrastructure assets (highways,
railway, ports, etc.) and other key assets, such as land and most natural resources, are
all held by the Chinese government, mainly in the three local levels of local
governments. Thus, broadly many entities are local government-controlled,
including many commercial SOE entities. It is thus often difficult for investors
to distinguish which are the debts local governments may back up and which
are pure commercial entities, even though the latter may also be government-
owned. For instance, listed entities, such as Anhui Expressway (995 HK), may
indeed be initially regarded as LGFVs, but indeed function as pure corporate entities.
Therefore, when some ministries, such as the CBRC and PBOC, started to conduct
investigation and studies in 2010, initially the definition of local government funding
vehicles became overly broad and included many commercial operating entities with
strong cash flows. This is also why later last year, after a thorough classification
based on cash flows, CBRC indeed allowed some Rmb2.84trn of loans, which were
PBOC already clarified the
misunderstood statement it had
on local government-related
loans in a recent press briefing.
The PBOC report was used by
Moodys as a major challenge to
NAO's figure on the size of LG
debt.
4
15 July 2011
Samuel Chen
(852) 2800-8557
originally classified as LGFV loans, back as usual corporate loans. Such
reclassification exercise may last throughout 2011.
PBOC data is based on the initial very broad definition, including seven
categories of entities. Such data also include loans to education and healthcare, as
well as some Rmb2trn of loans belonging to the Ministry of Railways. This is
broader than just LGFV loans.
CBRC data focused on LGFV corporate entities. While it also used quite a broad
definition, mainly based on ownership, CBRC also said earlier this year that, out
of the Rmb9.1trn LGFV loans as of 2010, Rmb2.84trn have been regarded as
normal corporate loans, namely no longer regarded as LGFV loans.
NAO data, in our view, is the most-detailed and precise figure given the
resources it has dedicated and the access. It focused on all the local government
liabilities, including explicit contractual obligations and contingent and implicit
liabilities.
We also disagree with Moodys delinquency assumptions
We also disagree with Moodys rough delinquency assumptions on various loan
categories. Neither are the rational of those assumptions consistent with reality nor
even with history during which risk control was much weaker than that in todays
environment. As can be seen in the next section, history also proves that default rates
on local government-related loans are much lower than Moodys assumptions.
First, we believe linking its perception on the quality of loans to the degree of
government obligation is contradictory to its own conclusion and not correct. As
shown in Table 2, Moodys thinks the risks are higher on debt with implicit
government obligations than on debt guaranteed by the governments. Data shows
those debts with implicit government obligations indeed have better quality (lower
past due ratios) than those of government contingent liabilities (the opposite of
Moodys assumptions). We believe that the governments contingent liabilities and
implicit obligations mean there are other entities as primary borrowers who are a
major source of debt repayment, rather than the governments. Presumably those
borrowers have at least some cash flow so that it is not the government's contractual
obligation.
Meanwhile, we also think those loans that Moodys perceived as underestimated
government-related loans at most are just some government-controlled commercial
entities that operate like corporates. This may be evident in CBRCs reclassification.
The Rmb2.84trn that has been reclassified as normal corporate loans are all in normal
categories with sufficient cash flows. While we agree that such loans are unlikely to
end up with zero NPLs, we think it is a fraction of Moodys assumption of 50-75%
eventual delinquency.
Finally, we think its assumption on the rest of the system loans at 5% likely
delinquency has no obvious evidence too. Note that, out of other loans, over 30% are
now personal loans, most of which are collateralized loans, such as mortgage loans.
We agree the current roughly -1% NPL ratio may not be sustainable in the longer
term, yet we are confident that this may be kept at low single-digit percentages.
5
15 July 2011
Samuel Chen
(852) 2800-8557
Table 2: Summary of what Moody thinks on various categories
Category
Size
(Rmb
trn)
% of 10
system Moody' view
Moody'
delinquency
assumptions Our position
Loans with explicit government
obligations 5.0 9.8% High Not material No material NPLs
Government contingent liabilities 1.9 3.9% Medium 10-30% Overdue ratio 2.23%
Loans with Implicit government
obligations 1.5 2.9%
Low give no explicit
contractual obligation 30-50% Overdue ratio 1.28%
Moody's perceived
underestimated government
loans 3.5 6.9% Poor 50-75%
If any, there could be just commercial entities, mostly in normal
categories as seen in CBRC's reclassification
Others loans 39.0 76.4% Fair 5% Currently low at about 1% but low single digit is possible.
Overall 50.90 100% 8-12% Currently low at about 1% but low single digit is possible.
Source: Moodys, J.P. Morgan estimates.
Misunderstood history: LG debt is not a major source of legacy NPLs
Many investors cited the historically large NPLs as a key reference. In our view, they
failed to recognize the big change in the nature of the Chinese economy as well as
the banking sector, and failed to take a closer look at the history in China.
Indeed, the legacy NPL problem Chinese banks suffered in 1990s was largely not an
issue with the local government debts, but the result of a change in the nature of the
economy from a planned state economy to more of a market-based open economy.
Specifically, its more relevant to SOE reforms, which will no longer happen to a
large extent, since nowadays SOEs mainly only remain in the key strategic sectors
and many surviving SOEs are quite profitable businesses. Until the mid-1990s, there
was virtually no private sector in China. In particular, in many manufacturing
sectors, the domestic market is very fragmented, and low-efficiency local SOE
manufacturing or wholesale/retail businesses dominate the local markets. The SOE
reform in the 1990s wiped out a number of those low-efficient firms, leaving banks
with huge NPLs.
This can be seen in the historical balance sheet data before the pre-IPO restructuring
in many state-controlled banks. In Figure 2, we show the NPL ratios in key relevant
sectors and their weights in NPL stocks as of 2002 or 2003. As can be seen, the local
government-related loans (or LGFV loans), mostly in transportation, infrastructure
and energy/utilities, not only have much lower NPL ratio historically, but also
accounted for a small fraction of historical NPLs.
6
15 July 2011
Samuel Chen
(852) 2800-8557
Figure 2: NPL ratios in key sectors in 2002/2003 in a few key banks:
Even before the pre-IPO financial restructuring at some big banks,
key LGFV related sectors are not key area of concerns
Source: Company reports.
Figure 3: Individual sectors' share in total NPLs balance as of
2002/2003: Most historical NPLs are in manufacturing and
wholesale/retail sectors
Meanwhile, as we show in Figure 5, by the end of 1998, the total size of local
government-related debt or contingent debt was only about Rmb0.5trn, according to
NAO, versus the NPL balance estimated to be over Rmb2trn then. This also hints
that most legacy NPLs are not local government-related debts.
Another factor to support our argument is the asset quality history of China
Development Bank, which was the first bank to provide LGFV loans and is still the
largest player in local government project financing, given its policy bank status and
business focus. We estimate that over half of CDBs loan book is local government-
related loans, and it accounted for approximately one-third of LGFV loans. In the
past 10 years, while the loan balance has increased by nearly six times to over
Rmb4.5trn as of 2010 year-end, its asset quality has been maintained at a very good
level, with NPL balance little changed and NPL ratio below 2% for 8 years.
Figure 4: CDB has kept asset quality very good, despite 21% CAGR loan growth in the past 10
years
6.4% 6.3%
2.7%
4.8%
0.4%
4.9%
8.4%
4.1%
8.0%
1.0%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
ICBC 2003 CCB 2002 BoComm 2002 BOC 2003 CMB2003
Manufacturing Wholesale/retail
Property development & related Transportation& logistics
Power and water utilities
2.4%
4.0%
0.9%
2.3% 1.6%
1.2%
6.4%
0.9%
6.2%
3.0%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
ICBC 2003 CCB 2002 BoComm 2002 BOC 2003 CMB2003
Manufacturing Trading Property development Transportation Power and utilities
50
32
23
21
17
14 15
13
28
35
31
7.47%
4.25%
2.54%
1.88%
1.18% 0.81%
0.72% 0.59%
0.96% 0.94%
0.68%
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
-
10
20
30
40
50
60
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
NPL balance NPL ratio
7
15 July 2011
Samuel Chen
(852) 2800-8557
NAOs reports gave useful details on local government debt
In our view, the NAOs report on local government debt represents the best effort so
far and is the most objective. NAO sent over 41,000 people, who worked over three
months auditing around 1.87mn debt accounts from 25,590 government bureaus and
institutions, 6,576 LGFV corporates, 54,061 other institutions and 373,805 projects,
on one-by-one basis. It covers all three major levels of local governments that
shoulder most economic responsibility, namely provincial, municipal and county
governments. The data covers not only the debt that governments have responsibility
of repayment, but also contingent liabilities, such as loans that carry government
guarantee or those loans that local governments may help bail out in case of financial
difficulty. In our view, NAOs report provides very useful clarification and
background knowledge that should help clear a lot of misunderstandings generally
seen among global investors.
History of local government debt
As shown in the NAOs report, local governments started to borrow debt from 1979,
and by 1996, most local governments already had some degree of debt.
Admittedly since late 1990s, local government-related debt has significantly
increased to Rmb10.7trn, or close to 27% of GDP as of 2010 year-end, from about
12% as of the end of 2002. This was mainly driven by the acceleration in
urbanization in China and significant boost in infrastructure in China, as well as
enlarging size of the economy. Growth rates on CAGR basis also has consistently
stayed at above 20% in the past decade.
Table 4: By 1996, all provincial governments, and most municipal governments already started to have some debt
Periods Provincial/individually-planned cities Municipal governments County governments
No. of
governments
started
borrowing
Cumulative
no. of
governments
with debt
As % of
total
No. of
governments
started
borrowing
Cumulative
no. of
governments
with debt
As % of
total
No. of
governments
started
borrowing
Cumulative
no. of
governments
with debt
As % of
total
19791980 0 0 - 4 4 0.0102 51 51 0.0184
19811985 28 28 77.78% 56 60 15.31% 300 351 12.63%
19861990 5 33 91.67% 121 181 46.17% 833 1184 42.61%
19911996 3 36 100% 172 353 90.05% 1221 2405 86.54%
Source: NAO. Note: There are 31 provincial-level governments in Mainland China, and 5 individually-planned cities which enjoy the fiscal independence within their respective provinces and directly
report to the central government in terms of fiscal affairs.
However, we stress that in considering the debt issues, investors should bear in
mind that these are not pure government debts that do not generate any cash
flows as seen in some other countries. As illustrated in later sections, most of the
debts are indeed spent in basic public infrastructure, transportation and energy
sectors, which form a sizable good asset base that could be sold if necessary. Such
debts accounted for nearly 75% of total debt utilized so far. Indeed, a significant
portion of those debts are also cash-flow producing assets at the same time, which is
also well-illustrated in CBRCs LGFV loan breakdown data.
Table 3: Scope of NAO's auditing
work on local government debt
Levels
Provincial,
municipal, county
Debt accounts 1,873,683
No. of gov. bureaus &
institutions 25,590
No. of LGFV corps. 6,576
No. of other institutions 54,061
No. of projects 373,805
Source: NAO.
8
15 July 2011
Samuel Chen
(852) 2800-8557
Figure 5: local government debts have grown significantly over the
past decade due to significant boost in infrastructure
Source: NAO, J.P. Morgan estimates.
Figure 6: Growth rates of local government-related debt since late
1990s.
Source: NAO.
Size and breakdown of local governments debt/contingent debt
According to NAO, as of 2010 year-end, local government debt (including
contingent liabilities) was Rmb10.7trn, of which Rmb8.5trn was bank loans. Out of
Rmb10.7 trillions, Rmb1.1trn remains cash and deposits, while Rmb9.6trn has been
spent. Table 5 below shows the breakdown of such debt by degree of governments
obligation and seniority of borrowing governments. As seen in Table 6, local
governments explicit repayment obligation is about Rmb6.7trn, while about
Rmb4trn are contingent and implicit liabilities, some of which might need their
support in case of financial difficulties.
Table 5: Breakdown of local government debt & contingent debt by degree of responsibility and seniority of government levels
Degree of responsibility Total Provincial Municipal County
Rmb bn Amount % Amount % Amount % Amount %
Responsible for repayment 6,711 100.00% 1,270 18.92% 3,246 48.37% 2,195 32.71%
Guaranteed by local governments 2,337 100.00% 1,198 51.25% 767 32.81% 372 15.94%
Other debt that might need local
government support 1,670 100.00% 744 44.54% 650 38.96% 276 16.50%
Subtotal 10,717 100.00% 3,211 29.96% 4,663 43.51% 2,843 26.53%
Source: NAO.
Table 6 shows the breakdown of such debt by source of funding. In total, as of 2010
year-end, Rmb8.5trn of debt is in the form of bank loans. Within the Rmb8.5trn
of local government-related loans, nearly 60%, or Rmb5.02trn, are those loans that
local governments have the responsibility for repayment, while loans guaranteed by
local governments are Rmb1.9trn (22.6%) and other relevant loans that might need
government support were Rmb1.5trn, or 18%.
Table 6: Source of funding for local government related debt
Source of debt funding Total
Local governments
responsible fore repayment
Debt guaranteed by local
governments
Other debt that might need
support in case of difficulty
Rmb bn Amount % Amount % Amount % Amount %
Bank loans 8,468 79.0% 5,023 74.8% 1,913 81.9% 1,532 91.8%
Fiscal support by supervisory govmt 448 4.2% 213 3.2% 235 10.0% - 0.0%
Bonds issued 757 7.1% 551 8.2% 107 4.6% 99 5.9%
Other social borrowing 1,045 9.8% 924 13.8% 82 3.5% 39 2.3%
Total 10,717 100.0% 6,711 100.0% 2,337 100.0% 1,670 100.0%
Source: NAO.
0.3
0.5 1.4
4.5
5.6
9.0
10.7
11.8
4.2%
5.8%
11.5%
16.9%
17.7%
26.8% 26.9%
25.5%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
-
2.0
4.0
6.0
8.0
10.0
12.0
14.0
1997 1998 2002 2007 2008 2009 2010 2011E
R
m
b

t
r
n
Local govn't debt as % of GDP
24.8%
48.2%
33.3%
26.5%
23.5%
61.9%
18.9%
10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
1
9
9
7
1
9
9
8
1
9
9
7
-
2
0
0
2

C
A
G
R
2
0
0
2
-
2
0
0
7
C
A
G
R
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
E
9
15 July 2011
Samuel Chen
(852) 2800-8557
As illustrated in Figure 7, about half of the local government debts are in more
developed Eastern China, while the Western and Central provinces accounted for
27.3% and 23.1%, respectively, as of 2010 year-end.
Figure 7: Geographical breakdown of local government debt, Rmb bn
Source: NAO.
Figure 8: Breakdown by local government-related loans by degree of
government responsibility in repayment, Rmb bn
Source: NAO.
Most of local government-related debts are funding for saleable assets
As we had argued earlier, the majority of debt at the same time also helped build
good assets that provide cash flow or can be sold if necessary. As Table 5 shows,
other than Rmb1.1trn monetary cash assets that have not been used, public
infrastructure, transportation, land reserves, and energy-related spending accounted
for nearly 75% of such utilized debt. To a large extent, such debt-raising in the past
decade is a critical ingredient to the economic success China has achieved over the
past 10-15 years.
Table 5: Breakdown by funding usage areas of debt that have already been spent
Areas fund are used
Total Responsible fore repayment Debt guaranteed by local
governments
Amount % Amount % Amount % Amount %
Public infrastructure 3,530 36.72% 2,471 42.03% 492 22.55% 567 36.53%
Transportation 2,392 24.89% 872 14.83% 1,077 49.39% 444 28.58%
Land reserves 1,021 10.62% 938 15.95% 56 2.55% 27 1.75%
Education/science/culture/health &
public housing 917 9.54% 437 7.43% 132 6.04% 348 22.39%
Agricultural/forestry/Water 458 4.77% 327 5.57% 87 4.01% 44 2.81%
Environment protection 273 2.84% 193 3.29% 40 1.85% 40 2.56%
Reducing local financial risks 111 1.15% 82 1.40% 28 1.29% 1 0.03%
Industrial 128 1.33% 68 1.16% 58 2.66% 2 0.14%
Energy 24 0.25% 4 0.08% 19 0.87% 1 0.04%
Others 758 7.89% 486 8.26% 192 8.79% 80 5.17%
Total spent 9,613 100.00% 5,880 100.00% 2,181 100.00% 1,553 100.00%
Source: NAO.
Table 6: Breakdown of local government related debt by types of borrowers
Borrowers' type Total
Local governments
responsible fore repayment
governments
LGFV corporates 4,971 46.38% 3,138 46.75% 814 34.85% 1,019 61.04%
Govmt bureaus & institutions 2,498 23.31% 1,582 23.57% 916 39.19% - 0.00%
Fiscally subsidized institutions 1,719 16.04% 1,123 16.74% 155 6.64% 440 26.38%
Public sector institutions 250 2.33% 110 1.63% 30 1.30% 110 6.57%
Other entities 1,280 11.94% 758 11.31% 421 18.02% 100 6.01%
Total 10,717 100.00% 6,711 100.00% 2,337 100.00% 1,670 100.00%
Source: NAO.
Eastern China,
5,321 , 49.6%
Central China, 2,472
, 23.1%
Western China,
2,925 , 27.3%
Local government
responsible for
repayment, 5,023 ,
59.3%
Local government
has guarantee on
debt, 1,913 ,
22.6%
Ot her relevant
debt, 1,532 ,
18.1%
10
15 July 2011
Samuel Chen
(852) 2800-8557
Meanwhile, about half of the debt is new debt for new projects since 2009
According to NAO, in the outstanding debt, about Rmb5.4trn are debts already
borrowed before the end of 2008, or are those borrowed since 2009, but used for
projects already started before the end of 2008. As seen in Figure 6, this includes
Rmb3.2 trillion of debts that were already borrowed before the end of 2008, and
Rmb2.28 trillion follow-on funding for projects already started in 2008 or before.
Based on such data, we could derive the change in balance. As shown, during the
past two years, local governments in total repaid Rmb2.4trn of debts already.
Figure 9: Breakdown of local government-related debt by project
vintage, Rmb bn
Source: NAO.
Figure 10: Reconciliation in the change of balance of local
government related debt between end of 2008 and 2010
Source: NAO, J.P. Morgan estimates.
Not a systemic risk in the foreseeable
future
The huge growth in new loans in the past two years mainly is driven by an increase
in the leverage of Chinese government. We also argued in the past 18 months that
local government-related loans will not pose a significant systemic risk. Our main
argument is premised on a few observations:
Chinas centralized hierarchical political system means the central government
naturally will intervene to prevent any systemic debt crisis, especially given that
the size of Chinas government debt is still manageable from debt-to-GDP
perspective.
Outstanding debt is currently still within affordability. More importantly, the
governments debt affordability is still improving, in view of the expected strong
fiscal revenue growth in China in the next few years and that Chinese
governments possess large amount of saleable assets.
Lack of any liquidity trigger. Historically and globally most NPLs emerged as a
result of liquidity issues. Given that most of such debt is domestic and that L/D
ratios remains consistently at about 66%, and a largely closed capital account,
there is no trigger for a systemic liquidity crisis that leads to credit crunch or
emergence of large NPLs.
Debt borrowed
before end of
2008, 3,199 ,
29.8%
Debt borrowed
after 2008 but
used for projects
already started in
2008 & before,
2,283 , 21.3%
New debt raised
since 2009 for new
projects , 5,236 ,
48.9%
5.6
2.4 2.3
5.2
10.7
0.0
2.0
4.0
6.0
8.0
10.0
12.0
B
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11
15 July 2011
Samuel Chen
(852) 2800-8557
Lastly, stress tests show that banks have a strong balance sheet and solid
operating profitability to withstand a huge pickup in provisioning or loan loss.
This is not to say, however, that the local government debt will be free of NPL issue.
Indeed, even now it does have very low NPL ratios, and in our current models, we
also assume that about 1-2% of LGFV loans can become NPL per annum. We,
however, dont expect the delinquency ratios of LGFV loans to end up as high
single-digit percentage.
LG debt burden can be reduced in the next few years
through Chinas economic growth
Its a centralized hierarchical system, politically and fiscally
In our view, in assessing the underlying credit risks of the local government debt,
investors must put them in a broader China context, particularly if this becomes a
systemic issue. China is a highly centralized hierarchical system in which the
supervisory governments have implicit claim and responsibility on assets and
liabilities held by their direct subordinate governments. Thus, in reality it is quite
impossible for a single local government to fail on its explicit debt without any
bailout from its supervisory governments or the central government. While this is not
to say there will be no individual loan default cases, as some entities may be more
commercial entities without explicit government backing, we believe the central
government will ensure no large-scale defaults to happen.
Meanwhile, the central government is responsible, since the root of local government
debts is also the problem in the current fiscal system design in China. As can be seen
in Figure 11, there is an imbalance in the budget revenue share and budget
expenditure share between central and local governments. Local governments in
China indeed shoulder the majority of responsibility in economic development.
During 2010, collectively local governments accounted for over 80% of the
economic expenditure in China. Indeed, over the past 10 years, consistently around
90% of fixed-asset investment per annum is at local level rather than the central
government level. Clearly, given that the local governments carry the majority of
economic development projects, most of the project financing has become local
government debt. However, most of such debt is used to finance infrastructure,
transportation, energy development, which forms good asset base.
Its worth noting that under current fiscal-system design, central government revenue
transfer has always been an important source of local government revenues every
year. Obviously, if there is no such supplementary mechanism to tackle such
imbalance in revenue and expenditure share, it would mean enlarging fiscal deficit at
local governments level and enlarging surplus at central government level. In
reality, currently the central government solves such deficit primarily through
revenue transfer and subsidies, to support certain projects and less-developed
regions. As seen in Figure 12, after such transfer, there is largely break-even at the
local governments fiscal balance. Thus, from this perspective, when considering
the local government revenues, investors have to consider the central
governments annual transfer and subsidies as an integral part of the revenue
source for local governments.
Local government debts arise
from the current fiscal systems
design problem, rather than poor
revenues at local governments.
12
15 July 2011
Samuel Chen
(852) 2800-8557
Figure 11: Local government debts mainly arise from problems in
the current fiscal system design in China: Local governments
accounted for over 80% of budgetary expenditures
Source: CEIC.
Figure 12: Currently the central government mainly uses a central
government transfer/subsidy to resolve the imbalance between local
governments' revenue and expenditures
Source: CEIC.
The size of Chinese government debt is still manageable
Compared with many developed countries, Chinas total government debt is still at a
very manageable level. As seen in Figure 13, even after including the local
governments debt and contingent liabilities, as well as some central governments
implicit liabilities in AMC bonds/some policy bonds, the overall government debt
remains at about 50% even after a pickup in 2009. This is still well below many
developed countries.
Figure 13: Debt to GDP: Despite a pick up in 2009, total government debts in China remain at
very manageable levels, considerably lower than many developed countries
Source: CEIC and J.P. Morgan estimates. Note: Others categories include some AMC bonds or part of policy banks' bonds. All these
are domestic. Note in reality policy banks' bonds can at least be partially self-funded.
Meanwhile, even on a static basis, the current local government debt outstanding is
well within their fiscal affordability as a whole. According to NAO, in aggregate
local governments debt outstanding was Rmb6.7trn, and this was only 52.25% of
the overall local governments fiscal resources for debt repayment. Even including
all contingent liabilities, Rmb10.7trn was also only 70.45% of the fiscal strength of
local governments. Therefore, in general the current debt outstanding is still within
current affordability.
Moreover, its quite impossible that all the contingent or implicit liabilities will need
local governments to repay debt, since there are already cash flow generating
primary borrowers. Indeed, according to NAO, the overdue debt ratios on those debts
with government guarantee, or those likely to get implicit government support in
case of financial stress as of 2010, stood at only 2.23% and 1.28%, respectively.
48.9%
47.8% 47.6%
45.0% 45.4% 45.1%
47.7% 47.2%
45.9%
46.7%
47.6%
48.9%
68.5%
65.3%
69.5% 69.3% 69.9%
72.3%
74.1%
75.3%
77.0%
78.7%
80.0%
82.2%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
90.0%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Revenue share Expenditure share
(344) (396)
(533)
(677) (738)
(870)
(1,005)
(1,213)
(1,477)
(2,060)
(2,844)
(3,299)
65
70 67 59
88
171
143 137
337
239
12
(64)
(3,500)
(3,000)
(2,500)
(2,000)
(1,500)
(1,000)
(500)
-
(100)
-
100
200
300
400
500
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
R
m
b

b
n
R
m
b

b
n
Deficit before central govn'mt transfer Fiscal balance after central govn'mt transfer
17.7%
15.6%
17.3% 16.8% 16.7%
16.9%
17.7%
26.8% 26.9%
25.5%
5.4%
5.8%
6.6% 6.5%
6.7%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
2007 2008 2009 2010 2011E
central government debt Local government debt Others (policy bonds etc.)
13
15 July 2011
Samuel Chen
(852) 2800-8557
Fiscal revenue growth should remain strong to improve debt affordability
Provided that the Chinese government may keep economic growth at a certain level
in the next few years, we believe the local government debt issue may also be less of
an issue in three years time. In the past 10 years, local governments total revenues in
aggregate have grown at a CAGR of approximately 25%. While land sales revenue
grew from virtually none to last years significant Rmb2.9trn, a major driver for the
revenue growth remains budget sources, including local governments own budget
revenue and central government's fiscal revenue transfer. We estimate that even if
we assume some contraction in land sales in each of the next few years, expected
20% CAGR budget revenue growth shall keep local government revenue
growth at about 16% in the next 5 years to over Rmb20trn a year by 2015.
Figure 14: Local governments total revenues have been growing strongly
Source: CEIC, J.P. Morgan estimates.
We discuss below three major sources of local government revenues:
Local governments own budgetary revenue: This represents their share in
taxes and some non-tax revenues. Over the past 10 years, the local governments'
budget revenue grew at a CAGR of 20.3%. This indeed was only slightly less
than 40% of local governments annual revenue indeed. Its worth noting that the
local governments revenue growth is largely consistent with the nations
aggregate government revenue growth. While the central government obtains the
majority of some key tax incomes, such as VAT, income tax and tariffs et cetera,
the local governments share the majority of business operation taxes and some
non-budgetary revenue, such as land sales proceeds and surcharges on education,
city reconstruction and water/drainage. Overall, the sources of revenue pool are
still similar.
Central government transfer: While the percentage of central government
revenue transfers back to the local governments varied slightly every year, the
growth rate in such revenue sources are largely consistent with the local
governments own budget revenues, given that the growth rates in central
government revenue and local government revenue are quite consistent. Over the
past 10 years, the central government revenue transfer grew at a CAGR of 21.4%,
and accounted for over 30% of the local governments total revenues on national
aggregate basis.
Non-budget revenues, including some surcharges and levies, but mainly land
sales revenue: Such non-budget revenues predominantly belong to the local
governments. There are some levies and surcharges, such as levies for city
0.6 0.6 0.8 0.9 1.0 1.2 1.5 1.8
2.4
2.9 3.3
4.1
5.1
6.2
7.4
8.8
10.2
0.4 0.5 0.6 0.7
0.8
1.0 1.1
1.4
1.8
2.3
2.9
3.2
4.1
4.9
5.8
6.8
7.8
0.0 0.0
0.1
0.2
0.3
0.4 0.6
0.9
1.3
1.0
1.4
2.9
2.5
2.5
2.6
2.9
2.9
-
3
6
9
12
15
18
21
99 00 01 02 03 04 05 06 07 08 09 10 11E 12E 13E 14E 15E
R
m
b

t
r
n
Budget local revenue central govnmt subsidy & transfer Ex-budget land sales revenue
Land sales revenue is important
and gives local governments
extra financial resources for
local economic development,
but is not as big a source of
revenue as some media or
investors thought
14
15 July 2011
Samuel Chen
(852) 2800-8557
reconstruction funds, water/drainage funds, education funds. Land sales proceeds,
however, accounted for the vast majority of such revenue in recent years. Given
the lack of historical data on those levies, we use land sales as a proxy to such
revenue stream. In 2010, despite tough austerity measures on the property sector,
land sales revenue surged to new high and doubled from 2009 level to
Rmb2.9trn, or over 25% of total local governments revenue sources.
Figure 15: Central government's fiscal subsidy and revenue transfer
to local governments has been rising
Source: J.P. Morgan estimates, CEIC.
Figure 16: Growth in China's total budgetary revenue and China's
local governments budget revenue are largely consistent
Source: CEIC.
Lastly, in our view, land sales revenue will not collapse: While we assumed some
contraction or no further growth in land sales revenue in the next 4-5 years, in our
view, it might be too naive to think that land sales revenue may collapse. Our view is
that China is very different to some Western developed countries, which have largely
seen completion of the urbanization and whose population density is much lower
than some Asian countries.
In China, urbanization is half way through, with urbanization rate still at about
47% vs. 60-80% or above in developed countries, and land prices in suburban
areas or less-developed areas can improve with more infrastructure development.
Population density is much higher. This means scarcity value in lands, supported
by much higher underlying housing demand than that in developed countries.
Income growth in China is much faster than that in many developed countries.
This is unlikely to change in the next decade or so.
We believe that in foreseeable future while land sales proceeds could drop due to less
land sales, land price indeed can hardly fall from the current level in the
medium/longer term. This will be particularly the case in most tier-2/3 cities or even
smaller cities, where urban development is accelerating and economic growth is
gaining more momentum. Indeed, despite lingering fear of a slowdown in land sales,
YTD in many places, land sales remain very strong.
No liquidity trigger for rapid asset quality deterioration
In general, history shows that foreign debt is much more vulnerable than
domestically funded debt, given the higher uncertainty in refinancing. The Chinese
government debt is predominantly domestic debt. In the case of local government
debt, due to the absence of municipal bonds largely, the majority of such debts are
domestic bank loans. In our view, in foreseeable future, given a largely closed capital
account, there is no liquidity trigger for systemic risks on such debt.
3,692
4,358
5,427
63% 61% 65%
67%
66%
69%
67%
64%
63%
68%
77% 74%
62% 65%
67%
67% 67%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
0
2,000
4,000
6,000
8,000
10,000
12,000
99 00 01 02 03 04 05 06 07 08 09 10 11E 12E 13E 14E 15E
R
m
b

b
n
Central government revenue central government subsidy as % of central govnmt revenue
17.0%
22.3%
15.4% 14.9%
21.6%
19.9%
22.5%
32.4%
19.5%
11.7%
20.0%
14.5%
21.8%
9.1%
15.7%
20.7%
27.0%
21.2%
28.8%
21.5%
13.7%
24.6%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
00 01 02 03 04 05 06 07 08 09 10
National Budget Rev. Local Budget Rev.
15
15 July 2011
Samuel Chen
(852) 2800-8557
Although there is obvious monetary tightening and tight control on credit supply,
the overall liquidity condition is fully under the central government control.
Although market liquidity becomes tighter as PBOC continues to sterilize
foreign-currency fund inflows arising from trade surplus/current-account surplus,
these remain the central bank's foreign assets, at over Rmb23trn as of May 2011,
or approximately 50% of 2011E GDP.
In the banking sector, its also worth noting that despite a significant pickup in
the loan growth in 2009, deposit growth has largely matched loan growth and
Rmb-denominated L/D ratio has been largely remained at approximately 66%-
67%.
Figure 17: Liquidity keeps flowing into China due to ballooning
trade/current account surplus in recent years: PBOCs ballooning
FX-assets on its balance sheet
Source: CEIC.
Figure 18: SystemRmb-denominated L/D ratios remains largely
unchanged at a very low 66-67%
Source: PBOC, CEIC.
In our view, unless the government made an obvious policy mistake through severe
over-tightening, asset quality risks from liquidity crunch is not imminent, since it's
entirely within the governments control. One of the necessary conditions for China
to potentially have liquidity risks must be full convertibility of the Rmb currency,
which may not happen in the next few years.
Short-term liquidity pressure, however, could affect some LGFV loan quality
While we do not see a significant pickup in the local government debt default, on
isolated cases there certainly can be some NPLs too as always. After all, the degree
of government involvement in various debts is different and some entities set up by
the local governments are commercial entities anyway. Given the regulators effort to
improve the lending practice and quality of LGFV loans, inevitably some weaker
local government-related loans might be under refinancing pressure and could be
NPLs.
Its worth noting that given the significant pickup in debt since 2009, the amount to
be repaid by local governments in 2011 significantly may pick up significantly to
Rmb1.87trn vs an estimated Rmb1.1trn in 2009 and Rmb1.3trn in 2010. In isolated
cases, there could be delinquency or temporary overdue. This is also somewhat
reflected in our current base-case assumptions for various listed banks. However, we
believe most such cases may be successful restructured with limited eventual loss
rates.
On the other hand, in the past two years, local government revenues have also picked
up by about 55%. Thus, in terms of debt repayment as a percentage to annual
revenues, the ratio only picked up modestly. Meanwhile, also note that are still
0
5,000
10,000
15,000
20,000
25,000
D
e
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1
RMB L/D ratio L/D ratio
The government credit
tightening and stringent control
on local government debt
financing poses a key near-term
challenge to the sector.
16
15 July 2011
Samuel Chen
(852) 2800-8557
Rmb1.1trn of monetary assets that remain in the form of cash/bank deposits, which
may help alleviate near-term cash flow.
We believe such issues will be significantly relieved post-2012 as the repayment
burden drops over time, while expected strong fiscal revenue growth will also help
boost the local government's ability to repay loans.
Table 7: Repayment schedule of local government-related debt
Repayment year Total Local governments responsible
fore repayment
governments
2011 2,625 24.5% 1,868 27.8% 365 15.6% 392 23.5%
2012 1,840 17.2% 1,298 19.4% 297 12.7% 245 14.7%
2013 1,219 11.4% 799 11.9% 227 9.7% 194 11.6%
2014 994 9.3% 618 9.2% 227 9.7% 149 8.9%
2015 801 7.5% 493 7.4% 178 7.6% 130 7.8%
2016 or after 3,238 30.2% 1,634 24.4% 1,043 44.6% 561 33.6%
Total 10,717 100.0% 6,711 100.0% 2,337 100.0% 1,670 100.0%
Source: NAO.
There is no need for a master bailout plan yet
We do not agree with Moodys cautious asset quality outlook on the basis that the
Chinese central government still has no master plan. In our view, the Chinese
government has already implemented various measures to tackle this issue, which in
our view is enough. We simply see no need for any bailout plan at this stage or in
the foreseeable future.
Meanwhile, we believe the Chinese government genuinely hopes to boost the
competitiveness and soundness of its banking sector, whose healthiness plays a
critical role in supporting the economy. We thus believe the central government will
give strong backing to the banking sector to avoid any major credit quality issues.
There are already enough measures and attention on local government debt
Over the past 18months, various relevant ministries, such as CBRC, PBOC, MOF
and NDRC, have worked to improve the quality of existing LGFV loans and
mitigated the future credit risks.
Curbing the growth on local government debt. Since early 2010, the regulators
have used a combination of various tools or explicit guidelines to urge banks to
slow down LGFV loans growth. As seen in Figure 3, the growth in local
government debt has already significantly slowed down to 18% in 2010 and has
been further slowing down this year. New project launches also slowed down.
Moreover, the central government no longer allows using existing LGFV entities
to finance public sector projects without any cash flows.
A State Council document in June last year emphasized that local governments
should be responsible for the existing debt as of end of June 30, 2010, effectively
validating the guarantees or implicit government responsibility on such debt.
Earlier this year, CBRC repeated the same message forbidding more lending to
existing LGFV entities to finance new public sector projects.
Ongoing examination, monitoring and classification of LGFV loans based on
cash flow generating capability. Banks have largely cleaned up package LGFV
17
15 July 2011
Samuel Chen
(852) 2800-8557
loans" and matched lending to underlying project cash flows. Many excess
borrowing that have not been spent are taken back.
Cleanup and improvement in underlying loan terms to get more protection.
Backed by the central government, since late last year CBRC has worked with
banks to negotiate with local governments to get more collateral or asset/equity
injection into LGFV entities, and additional valid third-party guarantee.
Admittedly during the governments cleanup, some weaker LGFV loans may
experience liquidity pressure and thus emerge as NPLs, though often can be
restructured with eventually low loss rates. However, we also believe this makes
outstanding loans more robust in terms of quality and collateral. Moreover, as we
mentioned earlier, we are not concerned also because we see expected strong fiscal
revenue growth and still-abundant alternative financial resources (assets available for
sale if necessary) to boost affordability in the coming years. Therefore, we believe at
this stage, it is way too early for the government to announce a bailout" plan, since
this issue may eventually be digested by Chinas strong economic growth in the next
2-3 years.
Other approaches that can help solve the issue
We also see other approaches the central government can adopt to solve the LG debt
issue without a need for bailout plan.
Tackling the fiscal root: Even without fiscal reform, simply increasing revenue
transfer to local governments could also help increase their ability to repay debts.
However, this might lead to moral hazard issues. In our view, in the longer
term, the government needs to reform the current fiscal system and match
local government's revenue share to their responsibility in the economic
development (i.e. expenditure share).
More flexibility in local governments bond issuance. The MOF will continue to
issue on behalf of some provincial governments in the domestic market. The
central government has already considered allowing more provincial
governments and qualified municipal governments to issue muni-bonds in the
domestic bond market.
The government is also carefully developing the asset securitization market in
China. China Development Bank also has the task to be a pioneer in such areas in
securitizing some LGFVs loans.
A bailout may be the last option, but indeed not a bad option to banks at all
While bailout and transfer of any potential bad loans arising from the local
governments can be a viable solution, it would require consensus and agreement
among major parties involved, including ministries such as CBRC, NDRC, MOF,
and PBOC, local governments, and banks. We, however, see moral-hazard issues as
key obstacles in such options. Given that in reality many of these loans are made by
banks voluntarily from various considerations, its impossible to force all banks to
transfer their loans at given prices, if banks viewed the potential default rate or loss
rate differently.
Even if we assume that there would be a bailout, banks will not suffer much from
such a plan. Even if we assume banks to transfer all loans at potential risks, the
majority of which may not turn out to be NPLs, the earnings impact from potential
loss would still be modest. As seen in the Table 8, even if we assume banks to share
loss equivalent to 20% or 30% of their total outstanding LGFV loans without
18
15 July 2011
Samuel Chen
(852) 2800-8557
sufficient cash flow, the actual earnings impact is mostly single-digit percentage of
2011 earnings. Clearly as a percentage of 2012 or 2013 earnings, the impact may be
even smaller, given that PPOP in the next two years may continue to expand at a
solid pace. Note that this assumed loss rates are already very extreme, which implies
60-90% loss rates on such loans transfer, in the case of 3-3-3 split (central
government, relevant local governments and banks each taking one-third of loss).
Table 8: Estimated impact in bailout scenarios, in which governments take out all last 2 categories of LGFV loans and banks to share losses.
Source: J.P. Morgan estimates.
Banking sector has strong ability to withstand losses
This time history will not repeat
We believe that most Chinese banks are quite unlikely to experience huge NPL
formation as seen in 1990s, simply given that structural change in the nature of the
Chinese economy as well as the banking sector. Both the probability of default and
loss rates on NPLs has significantly improved. Meanwhile, the banking sector also
had much higher capability to absorb very high credit loss.
Nature of economy substantially changed. As we mentioned, the SOE reform
during Chinas transition from planned economy into a market economy has been
completed and such event will no longer repeat.
Loan mix has changed: Loan mix and borrowers mix have improved
significantly. In late-1990s, there was virtually no mortgage or other personal
loans and many unviable SOE dominated banks loan book. As of end of 2010,
retail loans accounted for 22% of total system loans, most of which are mortgage
and other fully collateralized or guaranteed lending. In addition, a SME loan,
mostly to private sector has increased to approximately 20% too. While SMEs in
general carries more operating risks, given very underpenetrated SME banking in
general, there has been in general stringent cherry-picking among SME
Rmb bn ICBC CCB BOC ABC BoComm CMB Citic Minsheng Industrial SPDB Huaxia SZDB
1Q11 LGFV loan balance 510 284 380 390 152 130 118 77 95 100 46 30
2011 total loans 7,726 6,432 6,421 5,631 2,582 1,665 1,464 1,224 996 1,329 615 637
1Q11 LGFV loans as % of 11E total loans 6.6% 4.4% 5.9% 6.9% 5.9% 7.8% 8.1% 6.3% 9.5% 7.5% 7.5% 4.7%
Cash flow coverage breakdown
Fully covered (>=100% 67% 67% 64% 62% 67% 85% 78% 70% 72% 55% 71% 75%
Largely covered (>=70%) 18% 15% 16% 16% 20% 8% 13% 16% 10% 20% 15% 10%
Partially covered (>=30%, <70%) 9% 8% 8% 9% 7% 5% 2% 8% 7% 16% 7% 15%
Barely covered (<30%) 6% 10% 12% 13% 6% 2% 7% 6% 11% 9% 7% 5%
Assuming transferred amount (last 2 catogaries) 76.5 51.1 76.0 85.8 19.7 9.1 10.7 10.8 17.1 25.0 6.4 6.0
Bank loss: of banks take 20% loss on risky loans 15.3 10.2 15.2 17.2 3.9 1.8 2.1 2.2 3.4 5.0 1.3 1.2
Estimated provisioning already taken on such loans 7.7 5.1 7.6 8.6 2.0 0.9 1.1 1.1 1.7 2.5 0.6 0.6
Additional provisioning needed 7.7 5.1 7.6 8.6 2.0 0.9 1.1 1.1 1.7 2.5 0.6 0.6
As % of 2011E Loans 0.1% 0.1% 0.1% 0.2% 0.1% 0.1% 0.1% 0.1% 0.2% 0.2% 0.1% 0.1%
as % of 2011E earnings 2.7% 2.2% 4.4% 4.7% 2.9% 1.9% 2.6% 3.3% 5.7% 7.2% 5.9% 4.6%
Bank loss: of banks take 30% loss on risky loans 26.8 17.9 26.6 30.0 6.9 3.2 3.7 3.8 6.0 8.8 2.3 2.1
Additional provisioning needed 19.1 12.8 19.0 21.5 4.9 2.3 2.7 2.7 4.3 6.3 1.6 1.5
Credit cost impact 0.0% 0.3% 0.4% 0.5% 0.3% 0.2% 0.3% 0.3% 0.6% 0.7% 0.4% 0.3%
Impact to 2011 earnings 6.7% 5.5% 11.1% 11.8% 7.3% 4.8% 6.6% 8.4% 14.3% 18.1% 14.8% 11.5%
19
15 July 2011
Samuel Chen
(852) 2800-8557
borrowers which has helped banks' credit risk control. This is also proven during
2008's Global Financial Crisis. Those SOEs still alive today which still accounted
for over one third of loan book are typically quite profitable business in key
strategic sectors with heavy government control. In the foreseeable future we
dont see any change given an expected stable political environment.
Asset mix also has changed: Loan to asset ratio in the sector has dropped from
over 80% in mid 1990s to currently about 53% in system. Most non-loan assets
are very simple and liquid domestic assets, mostly in the form of sovereign bonds
or central bank reserves. In other words, sectors balance sheet is still under-
leveraged.
Lending norms and overall credit infrastructure significantly improved. To
be fair, the government has spent much effort to build a financially sound
banking system over the past 10 years. It has also devoted much effort to improve
credit culture and infrastructure in plan to urge banks to be more commercial.
Nationwide extensive credit bureau system has been installed and been
extensively used in the past 5 years. The regulator CBRC arguably has
consistently guarded against any potential risks and installed stringent regulatory
norms, urging banks to avoid potential risks. Meanwhile, many banks have also
gone through thorough internal reform and reorganization, which typically
involves IT system upgrade, much more centralized risk control and depriving
lower-tier branches of their credit approval authority, installation of stringent
collateral/guarantee requirement which limits loss.
Structural improvement in underlying operating profitability. Increased
credit pricing flexibility, lower statutory tax rate and rapid development in fee
business are among the major drivers for a significant boost in sustainable
revenue generation capability and pre-provisioning operating profitability. As
seen in Figure 19 below, the sector profitability has consistently improved over
the past 10 years, and pre-provisioning operating ROA tripled to about 2%
expected for 2011E/2012E. Therefore, the ability to absorb NPL-driven credit
provisioning per annum significantly boosted. With sector L/A ratio at about
53%, and Operating ROA at about 2%, the listed Chinese banks can remain
profitable with roughly 3.5% or in some cases even 4% annual credit charges. In
other words, many banks will stay profitable even if NPL ratio jumps from
current 1% to around 6%-8% within one year. As we already illustrated in Table
1 on the cover page, this will imply incredibly high NPL formation at nearly 20%
a year in a few sectors that investors had most concerns on.
20
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Samuel Chen
(852) 2800-8557
Figure 19: Chinese banks have substantially improved their pre-prov.
operating ROA in the past 10 years
Source: Company reports and J.P. Morgan estimates.
Figure 20: Sector loan to asset ratios have declined significantly over
the past 10-15 years
Source: PBOC, CBRC.
Stress tests on the LGFV loans
Stress tests show that earnings risks from potential pickup in LGFV loans default are
still very manageable, let alone risk of weaker balance sheet. While its not our base
case, in stress tests we assume three scenarios, namely 10%, 15% and 20% of LGFV
loans default abruptly within 2011, and banks make additional provisioning
equivalent to 50% of such default, without considering the general provisioning they
have made so far. As illustrated in Table 9, even assuming 20% of LGFV loans
default suddenly within 2011, many banks can still keep ROE at mid-teen percentage
and some banks including ICBC, CCB, ABC and CMB can even maintain ROE at
around 20%, thanks to superior pre-provisioning operating profitability. Given that
the sector is trading at 7-8x 11E PE, this would mean even in extreme cases,
valuation would remain very cheap at 10x earnings should 20% of LGFV defaults
immediately in current year, which in our view is very unlikely.
Table 9: Stress test results of 11E ROE in various LGFV NPL ratio Scenarios: even if 20% LGFVs loans default immediately in 2011, ROE will
stay at mid-high teen percentage.
11E ROE ICBC CCB ABC BOC BoComm CMB Citic Minsheng SPDB Industrial Huaxia SZDB
Base case 23.8% 23.0% 23.3% 18.4% 20.6% 23.8% 20.3% 20.1% 19.0% 22.0% 16.6% 20.9%
10% LGFV loan 21.9% 21.8% 21.2% 16.6% 18.6% 20.9% 17.7% 18.0% 16.6% 18.9% 13.5% 18.8%
15% LGFV loan 21.0% 21.2% 20.1% 15.7% 17.6% 19.5% 16.3% 16.9% 15.3% 17.4% 11.9% 17.7%
20% LGFV loan 20.1% 20.6% 19.0% 14.8% 16.5% 18.0% 15.0% 15.8% 14.1% 15.8% 10.3% 16.6%
Table 10: Stress test of 11E provisioning as % of PPOP in various LGFV default scenarios: Even if 20% of LGFV loans default in 2011, and
banks makes 50% provisioning on those default, total provisioning would still account for no more than 20% of PPOP in general
ICBC CCB ABC BOC BoComm CMB Citic Minsheng SPDB SPDB Huaxia SZDB Total
Base case 11.0% 11.9% 18.8% 14.0% 18.7% 12.4% 13.9% 18.1% 16.0% 13.1% 25.5% 21.9% 14.3%
10% LGFV loan 11.9% 12.5% 19.8% 15.1% 19.7% 13.8% 15.3% 19.2% 17.4% 14.7% 27.2% 23.0% 15.2%
15% LGFV loan 12.4% 12.8% 20.3% 15.6% 20.3% 14.5% 16.0% 19.7% 18.1% 15.5% 28.1% 23.5% 15.7%
20% LGFV loan 12.8% 13.1% 20.8% 16.1% 20.8% 15.2% 16.7% 20.3% 18.8% 16.3% 29.0% 24.0% 16.2%
0.6%
0.7%
0.8%
1.1%
1.4%
1.5%
1.4%
1.5%
2.0%
1.6%
1.8%
2.0%
2.1%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2009 2010 2011E 2012E
Medium JSBs State-controlled banks Listed banks avg.
83
83
79
80
77 75
70
75
63
64
63
59
54
53 51
53 53
0
5
10
15
20
25
30
35
30
40
50
60
70
80
90
1994 1996 1998 2000 2002 2004 2006 2008 2010
%
%
Loan/asset ratio (LHS) Loan growth (RHS)
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15 July 2011
Samuel Chen
(852) 2800-8557
Table 11 below illustrates the details of our stress test analysis, under Scenario 1.
Table 11: New key balance sheet metrics and impact relative to 2011 estimates, under stress test scenario 1: assuming 10% LGFV loans
default within 1 year.
Rmb bn LGFV Assumed
% of
11E Topline Credit
Credit
cost
11E
revised
11E
earning
11E
Revised
11E
ROE
11E
Equity
11E
revised
11E
revised
1Q11 New NPL loans impact charges impact Coverage impact 11E ROE Impact Impact CAR tier-1
ICBC 510 51 0.7% 2.9 26 0.4% 171% (9%) 21.9% (1.8%) (1.7%) 12.2% 10.2%
CCB 284 28 0.4% 1.6 14 0.2% 189% (6%) 21.8% (1.2%) (1.1%) 12.9% 10.3%
ABC 390 39 0.7% 2.2 20 0.4% 172% (10%) 21.2% (2.1%) (1.9%) 11.8% 8.9%
BOC 380 38 0.6% 2.2 19 0.3% 159% (11%) 16.6% (1.8%) (1.6%) 12.6% 9.7%
BoComm 152 15 0.6% 0.9 8 0.3% 153% (11%) 18.6% (2.0%) (1.8%) 11.7% 8.9%
CMB 130 13 0.8% 0.7 7 0.4% 181% (13%) 20.9% (2.8%) (2.5%) 11.6% 8.4%
Citic 118 12 0.8% 0.7 6 0.4% 141% (14%) 17.7% (2.6%) (2.1%) 12.3% 9.7%
Minsheng 77 8 0.6% 0.4 4 0.3% 190% (11%) 18.0% (2.1%) (1.8%) 12.4% 8.6%
SPDB 100 10 0.8% 0.6 5 0.4% 192% (14%) 16.6% (2.4%) (2.1%) 13.4% 9.4%
Huaxia 46 5 0.7% 0.3 2 0.4% 149% (20%) 13.5% (3.1%) (2.3%) 12.5% 9.1%
SZDB 30 3 0.5% 0.2 2 0.3% 173% (11%) 18.8% (2.1%) (1.6%) 10.8% 7.6%
Industrial 95 9 1.0% 0.5 5 0.5% 154% (15%) 18.9% (3.0%) (2.7%) 11.9% 8.5%
Total 2,312 231 0.6% 12.7 116 0.3% 170% (10%) 19.9% (1.9%) (1.7%) 12.2% 9.1%
Source: Company data, J.P. Morgan estimates.
Table 12: Valuation of Chinese banks in various LGFV default scenarios
Source: J.P. Morgan estimates, Company data, Bloomberg. Valuations based on market closing prices as of 13 July 2011.
Strong earnings resilience against broader asset quality pressure
Devils argument from some investors would be that the deterioration in LGFV loans
quality may come along with deterioration in some other sectors amid a weaker
economy. We agree to large extent and we conduct stress tests assuming
deterioration in industrial sectors combined with weak property market to address
such concerns.
Methodology and key assumptions for stress tests on 2012 earnings
We assume our 2011E earnings are fairly realistic given profit outlook and asset
quality outlook in 2011 are still very visible. Most investors would also agree
1Q11 % of Impact on 11E BVPS
LGFV loans 10 loans Scen. 1 Scen. 2 Scen. 3 Base case Scen. 1 Scen. 2 Scen. 3 Scen. 1 Scen. 2 Scen. 3 Base case Scen. 1 Scen. 2 Scen. 3
ICBC-H 510 7.5% (9%) (13%) (17%) 7.6x 8.3x 8.7x 9.1x (2%) (2%) (3%) 1.7x 1.7x 1.7x 1.7x
CCB-H 284 5.0% (6%) (9%) (12%) 7.2x 7.6x 7.9x 8.1x (1%) (2%) (2%) 1.5x 1.6x 1.6x 1.6x
ABC-H 390 7.9% (10%) (15%) (20%) 7.7x 8.6x 9.1x 9.7x (2%) (3%) (4%) 1.7x 1.7x 1.7x 1.8x
BOC-H 380 6.7% (11%) (16%) (21%) 6.5x 7.3x 7.8x 8.3x (2%) (2%) (3%) 1.1x 1.1x 1.2x 1.2x
BoComm-H 152 6.8% (11%) (16%) (21%) 6.1x 6.9x 7.3x 7.8x (2%) (3%) (4%) 1.2x 1.2x 1.2x 1.2x
CMB-H 130 9.1% (13%) (18%) (26%) 9.5x 10.9x 11.6x 12.8x (2%) (4%) (5%) 2.0x 2.0x 2.1x 2.1x
Citic-H 118 9.4% (14%) (20%) (28%) 5.6x 6.6x 7.0x 7.8x (2%) (3%) (4%) 1.0x 1.0x 1.0x 1.1x
Minsheng-H 77 7.3% (11%) (17%) (23%) 6.5x 7.4x 7.9x 8.4x (2%) (3%) (4%) 1.2x 1.2x 1.2x 1.2x
H-Share 2,042 7.0% (8%) (12%) (17%) 7.6x 8.3x 8.6x 9.1x (2%) (2%) (3%) 1.7x 1.7x 1.7x 1.7x
SPDB 100 8.7% (14%) (21%) (27%) 7.2x 8.4x 9.1x 9.9x (2%) (3%) (4%) 1.2x 1.3x 1.3x 1.3x
Huaxia 46 8.7% (20%) (30%) (40%) 8.6x 10.8x 12.3x 14.4x (2%) (3%) (5%) 1.2x 1.2x 1.3x 1.3x
SZDB 30 7.4% (11%) (16%) (22%) 7.5x 8.4x 9.0x 9.6x (2%) (2%) (3%) 1.5x 1.5x 1.5x 1.6x
ICBC-A 510 7.5% (9%) (13%) (17%) 7.1x 7.8x 8.2x 8.6x (2%) (2%) (3%) 1.6x 1.6x 1.6x 1.6x
CCB-A 284 5.0% (6%) (9%) (12%) 7.0x 7.4x 7.6x 7.9x (1%) (2%) (2%) 1.5x 1.5x 1.5x 1.5x
ABC-A 390 7.9% (10%) (15%) (20%) 6.4x 7.2x 7.6x 8.1x (2%) (3%) (4%) 1.4x 1.4x 1.5x 1.5x
BOC-A 380 6.7% (11%) (16%) (21%) 6.9x 7.8x 8.3x 8.8x (2%) (2%) (3%) 1.2x 1.2x 1.2x 1.2x
Bocomm-A 152 6.8% (11%) (16%) (21%) 6.2x 7.0x 7.4x 7.9x (2%) (3%) (4%) 1.2x 1.2x 1.2x 1.2x
CMB-A 130 9.1% (13%) (18%) (26%) 8.0x 9.2x 9.8x 10.8x (2%) (4%) (5%) 1.7x 1.8x 1.8x 1.9x
Citic-A 118 9.4% (14%) (20%) (28%) 6.7x 7.7x 8.3x 9.2x (2%) (3%) (4%) 1.2x 1.2x 1.2x 1.3x
Minsheng-A 77 7.3% (11%) (17%) (23%) 6.5x 7.3x 7.8x 8.4x (2%) (3%) (4%) 1.2x 1.2x 1.2x 1.2x
Industrial 95 11.1% (15%) (23%) (30%) 6.9x 8.1x 8.9x 9.9x (3%) (4%) (5%) 1.4x 1.4x 1.5x 1.5x
Total 2,218 7.1% (9%) (13%) (17%) 6.9x 7.6x 8.0x 8.4x (2%) (3%) (3%) 1.4x 1.4x 1.5x 1.5x
Impact on 11E EPS 11 PE in var. scenrios 11E PB in var. scenarios
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Samuel Chen
(852) 2800-8557
broad deterioration is unlikely to happen in the remainder of 2011 given a still
fairly strong economy, as 1H11 GDP growth remained 9.6%.
We assume our various key assumptions (loan growth at approximately 13%,
modest 8-10bps NIM expansion, 22% non-interest income growth and 17% costs
growth for the listed banks under coverage in aggregate) are valid, so that
downside to earnings would come only from additional provisioning arising from
additional new NPLs.
We assume for the additional NPLs in various stress test scenarios, banks make
50% provisioning on those new NPLs. In reality loss rates may vary and we
believe 50% is indeed fairly conservative in view of collateral value and
collection track record in the past 10 years.
We admit that in reality there could be some uncertainty to those assumptions but we
think downside those assumptions are limited.
Table 13 shows for every additional 100bps of 11E outstanding loans to become
NPL, roughly the downside to our current 2012 earnings is about 13% on average.
Table 13: Sensitivity of 2012 earnings downside to every 100bps additional NPLs (from 11E outs. loans)
Table 14 shows our current base-case assumptions, and implied asset quality
deterioration need to take earnings down to various stress test scenarios.
Rmb mn
Every 1% 11E
loans to be
new NPL
Add.
provision
@ 50% loss
Additional
credit costs
Reduced
NII
NIM
impact
Est. 12E Op
ROA
New 12E Op.
ROA
Base case
12E
earnings
Downside
to 12E
earning
Downside
to 12E
BVS
12E base
case ROA
chg to
JPM 12E
ROA
base case
12E ROE
chg to
12E ROE
(bps)
BoComm-H 25,815 12,908 0.47% 1,549 0.03% 2.02% 2.00% 63,814 -14.4% -2.9% 1.31% -0.19% 21.7% (319)
ABC-H 56,313 28,156 0.47% 3,520 0.03% 2.06% 2.04% 174,539 -11.6% -2.7% 1.38% -0.16% 25.2% (296)
BOC-H 64,209 32,105 0.47% 3,765 0.03% 1.89% 1.85% 153,019 -14.9% -2.6% 1.17% -0.33% 18.9% (286)
CCB-H 64,319 32,159 0.47% 3,923 0.03% 2.32% 2.30% 205,170 -11.2% -2.4% 1.57% -0.18% 23.5% (266)
CMB-H 16,649 8,325 0.47% 982 0.03% 2.24% 2.21% 44,395 -13.4% -2.9% 1.52% -0.20% 24.3% (330)
ICBC-H 77,265 38,632 0.47% 4,636 0.03% 2.30% 2.28% 253,820 -10.9% -2.4% 1.59% -0.17% 23.8% (262)
Citic-H 14,637 7,319 0.47% 908 0.04% 2.19% 2.16% 36,644 -14.3% -2.5% 1.37% -0.20% 19.1% (277)
Minsheng-H 12,237 6,119 0.47% 832 0.04% 2.07% 2.04% 30,763 -14.4% -2.4% 1.31% -0.19% 19.0% (277)
Huaxia 6,152 3,076 0.47% 372 0.03% 1.31% 1.29% 9,701 -22.7% -3.1% 0.73% -0.16% 14.5% (334)
SPDB 13,290 6,645 0.47% 831 0.03% 1.46% 1.44% 30,974 -15.4% -2.7% 1.11% -0.17% 18.8% (294)
SZDB 6,367 3,183 0.46% 376 0.03% 1.67% 1.64% 12,833 -17.7% -3.2% 0.98% -0.17% 19.4% (350)
Industrial 9,955 4,978 0.47% 652 0.03% 1.69% 1.67% 27,425 -13.1% -2.7% 1.13% -0.15% 22.5% (298)
Total/Average 367,208 183,604 0.47% 22,603 0.03% 1.77% 1.74%1,043,095 -12.6% -2.6% 1.04% -0.19% 22.2% (284)
23
15 July 2011
Samuel Chen
(852) 2800-8557
Table 14: Our base case estimates
Rmbmn
Share
price
12E
EPS
(Rmb)
12E
PE
(x)
12E
BVS
(Rmb)
12E
PB
(x)
12E
earning
growth
JPMe
12E
ROE
12E new
NPL
%11E
loans
JPMe
12E
NPL
ratio
11E NPLs
(Rmbmn)
JPMe
11E
NPL
ratio
11E
credit
costs
12E
credit
costs
BoCom-H 6.71 1.13 4.8 5.71 1.0 26% 21.7% 0.6% 1.1% 27,218 1.1% 0.72% 0.60%
ABC-H 3.97 0.54 6.1 2.32 1.4 28% 25.2% 0.6% 1.4% 93,457 1.7% 0.76% 0.62%
BOC-H 3.59 0.53 5.5 3.00 1.0 19% 18.9% 0.7% 1.0% 64,489 1.0% 0.46% 0.58%
CCB-H 6.08 0.82 6.1 3.76 1.3 18% 23.5% 0.6% 1.0% 65,573 1.0% 0.51% 0.49%
CMB-H 18.24 2.06 7.3 9.35 1.6 25% 24.3% 0.3% 0.6% 10,099 0.6% 0.40% 0.43%
ICBC-H 5.63 0.72 6.4 3.29 1.4 19% 23.8% 0.7% 1.0% 75,525 1.0% 0.47% 0.45%
Citic-H 4.63 0.78 4.8 4.41 0.9 21% 19.1% 0.5% 0.7% 9,038 0.6% 0.48% 0.61%
Minsheng-H 7.04 1.01 5.7 5.73 1.2 27% 19.0% 0.4% 0.7% 7,775 0.6% 0.63% 0.63%
Huaxia 11.06 1.42 7.8 10.35 1.1 28% 14.5% 0.8% 1.4% 10,209 1.7% 0.65% 0.68%
SPDB 10.01 1.66 6.0 9.58 1.0 20% 18.8% 0.3% 0.5% 7,169 0.5% 0.53% 0.53%
SZDB 17.54 2.50 7.0 14.14 1.2 32% 19.4% 0.5% 0.6% 3,753 0.6% 0.57% 0.76%
Industrial 14.30 2.54 5.6 12.26 1.2 23% 22.5% 0.1% 0.4% 3,886 0.4% 0.47% 0.51%
Total 6.1 1.2 22% 22.2% 0.6% 1.0% 378,192 1.0% 0.55% 0.54%
Source: J.P. Morgan estimates, Bloomberg. Valuations as of market closing prices on 13 July 2011.
Table 15: Scenario 1 (Flat earnings in 2012 vs. 2011E). On average NPL balance needs to grow by around 150% or annual gross NPL formation
to reach about 200bps, assuming other assumptions are valid
12E
NPL%
New NPLs as
% of 11E loan
12E incr. in
NPLs
% incr. vs.
11E NPLs
chg to 12E
BVS est.
12E BV
growth
12E
PE
12E
PB
12E
ROE
Credit
cost
Core
tier-1
CAR
BoCom-H 2.4% 2.1% 41,629 153% -3.4% 16.4% 4.8 1.0 17.5% 1.35% 9.3% 11.7%
ABC-H 3.1% 2.5% 101,273 108% -3.2% 16.1% 6.1 1.4 20.1% 1.46% 9.1% 12.5%
BOC-H 2.0% 1.7% 80,045 124% -1.7% 13.8% 5.5 1.0 16.0% 1.17% 9.9% 12.3%
CCB-H 2.3% 2.0% 98,541 150% -2.0% 13.7% 6.1 1.4 20.1% 1.21% 10.6% 13.1%
CMB-H 2.0% 1.8% 27,443 272% -3.6% 18.7% 7.3 1.7 19.7% 1.19% 9.0% 12.0%
ICBC-H 2.3% 2.2% 125,889 167% -2.2% 17.8% 6.4 1.4 20.2% 1.22% 11.2% 12.8%
Citic-H 1.8% 1.7% 20,508 227% -2.3% 13.7% 4.8 0.9 15.9% 1.26% 9.7% 12.3%
Minsheng-H 2.0% 1.9% 19,526 251% -3.0% 30.2% 5.7 1.3 15.3% 1.37% 9.9% 12.4%
Huaxia 2.0% 1.5% 3,975 39% -1.8% 10.7% 7.8 1.1 12.3% 0.98% 9.3% 12.6%
SPDB 1.5% 1.4% 14,937 208% -2.6% 15.9% 6.0 1.1 16.0% 1.05% 9.7% 14.6%
SZDB 1.7% 1.9% 9,366 250% -3.8% 15.1% 7.0 1.3 15.1% 1.43% 7.4% 10.9%
Industrial 1.6% 1.5% 14,522 374% -3.3% 16.1% 5.6 1.2 18.6% 1.20% 8.3% 11.3%
Total 2.3% 2.0% 557,654 147% -2.5% 16.0% 6.1 1.2 17.2% 1.25% 9.4% 12.4%
Source: J.P. Morgan estimates, Bloomberg. Valuation as of market closing prices on 13 July 2011.
Table 16: Scenario 2 (2012 earnings to decline by 20% vs. 2011E). On average NPL balance need to more than triple, or annual gross NPL
formation to surge to 330bps to get this scenario, assuming other assumptions are valid
12E
NPL%
New NPLs as
% of 11E loan
12E incr. in
NPLs
% incr. vs.
11E NPLs
chg to 12E
BVS est.
12E BV
growth
12E
PE
12E
PB
12E
ROE
Credit
cost
Core
tier-1
CAR
BoCom-H 3.3% 3.2% 69,909 257% -6.0% 13.3% 6.1 1.0 14.2% 1.87% 9.0% 11.5%
ABC-H 4.3% 3.9% 177,526 190% -5.5% 13.3% 7.6 1.5 16.3% 2.10% 8.9% 12.3%
BOC-H 3.0% 2.9% 152,017 236% -3.6% 11.7% 6.9 1.0 12.9% 1.69% 9.7% 12.1%
CCB-H 3.6% 3.5% 195,545 298% -4.3% 11.1% 7.6 1.4 16.2% 1.92% 10.4% 12.8%
CMB-H 3.0% 3.0% 47,306 468% -6.4% 15.2% 9.1 1.7 16.0% 1.75% 8.7% 11.7%
ICBC-H 3.7% 3.7% 245,042 324% -4.4% 15.1% 8.0 1.5 16.3% 1.95% 10.9% 12.6%
Citic-H 2.8% 2.9% 37,353 413% -4.5% 11.1% 6.1 0.9 12.9% 1.80% 9.5% 12.1%
Minsheng-H 2.9% 3.0% 32,956 424% -5.2% 27.2% 7.1 1.3 12.4% 1.88% 9.6% 12.2%
Huaxia 2.7% 2.2% 8,552 84% -3.7% 8.6% 9.8 1.1 10.0% 1.33% 9.1% 12.5%
SPDB 2.4% 2.5% 29,389 410% -5.2% 12.8% 2.9 1.1 13.0% 1.56% 9.4% 14.4%
SZDB 2.5% 2.8% 14,842 396% -6.3% 12.2% 8.8 1.3 12.2% 1.82% 7.2% 10.8%
Industrial 2.7% 2.7% 26,908 692% -6.1% 12.7% 7.0 1.2 15.1% 1.78% 8.1% 11.1%
Total 3.4% 3.3% 1,037,346 274% -4.7% 13.3% 7.2 1.3 14.0% 1.87% 9.2% 12.2%
Source: J.P. Morgan estimates, Bloomberg. Valuation as of market closing prices on 13 July 2011.
24
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Samuel Chen
(852) 2800-8557
Table 17: Scenario 3 (2012 earnings to decline by 30% vs. 2011E). On average NPL balance need to more than quadruple, or annual gross NPL
formation to surge to 400bps to get this scenario, assuming other assumptions are valid
12E
NPL%
New NPLs as
% of 11E loan
12E incr. in
NPLs
% incr. vs.
11E NPLs
chg to 12E
BVS est.
12E BV
growth
12E
PE
12E
PB
12E
ROE
Credit
cost
Core
tier-1
CAR
BoCom-H 3.8% 3.7% 84,049 309% -7.3% 11.8% 6.9 1.0 12.5% 2.12% 8.9% 11.4%
ABC-H 4.9% 4.5% 215,652 231% -6.7% 11.9% 8.6 1.5 14.4% 2.41% 8.8% 12.2%
BOC-H 3.5% 3.4% 188,004 292% -4.5% 10.7% 7.9 1.0 11.3% 1.96% 9.7% 12.0%
CCB-H 4.3% 4.2% 244,047 372% -5.4% 9.8% 8.7 1.4 14.3% 2.27% 10.2% 12.7%
CMB-H 3.5% 3.6% 57,238 567% -7.8% 13.5% 10.4 1.7 14.2% 2.03% 8.6% 11.6%
ICBC-H 4.4% 4.5% 304,619 403% -5.6% 13.7% 9.1 1.5 14.4% 2.31% 10.8% 12.5%
Citic-H 3.3% 3.4% 45,776 506% -5.6% 9.8% 6.9 0.9 11.3% 2.07% 9.4% 12.0%
Minsheng-H 3.4% 3.5% 39,670 510% -6.4% 25.7% 8.1 1.3 10.9% 2.14% 9.5% 12.1%
Huaxia 3.0% 2.6% 10,841 106% -4.6% 7.5% 11.2 1.1 8.8% 1.50% 9.1% 12.4%
SPDB 2.9% 3.0% 36,615 511% -6.5% 11.2% 3.3 1.1 11.4% 1.82% 9.3% 14.3%
SZDB 2.8% 3.2% 17,580 468% -7.5% 10.7% 10.0 1.3 10.8% 2.02% 7.1% 10.7%
Industrial 3.3% 3.4% 33,102 852% -7.6% 10.9% 8.0 1.3 13.3% 2.07% 8.0% 11.0%
Total 4.0% 4.0% 1,277,192 338% -7.1% 12.0% 8.3 1.3 12.3% 2.17% 9.1% 12.1%
Source: J.P. Morgan estimates, Bloomberg. Valuation as of market close prices on 13 July 2011.
Table 18: Scenario 4 ( 2012 earnings to halve vs. 2011E). On average NPL balance need to increase by fivefold, or annual gross NPL formation
to surge to nearly 500bps to get this scenario, assuming other assumptions are valid
12E
NPL%
New NPLs as
% of 11E loan
12E incr. in
NPLs
% incr. vs.
11E NPLs
chg to 12E
BVS est.
12E BV
growth
12E
PE
12E
PB
12E
ROE
Credit
cost
Core
tier-1
CAR
BoCom-H 4.8% 4.8% 112,329 413% -9.8% 8.7% 9.7 1.1 9.1% 2.43% 8.7% 11.2%
ABC-H 6.1% 5.9% 291,905 312% -9.0% 9.1% 12.1 1.5 10.4% 2.81% 8.6% 12.0%
BOC-H 4.5% 4.5% 259,976 403% -6.3% 8.6% 11.0 1.0 8.2% 2.29% 9.5% 11.9%
CCB-H 5.6% 5.7% 341,050 520% -7.6% 7.3% 12.1 1.4 10.3% 2.74% 10.0% 12.5%
CMB-H 4.6% 4.8% 77,101 763% -10.6% 10.0% 14.5 1.8 10.3% 2.37% 8.3% 11.3%
ICBC-H 5.8% 6.0% 423,772 561% -7.8% 11.0% 12.8 1.5 10.4% 2.78% 10.5% 12.2%
Citic-H 4.3% 4.6% 62,621 693% -7.8% 7.3% 9.7 0.9 8.2% 2.40% 9.2% 11.8%
Minsheng-H 4.4% 4.6% 53,100 683% -8.6% 22.7% 11.4 1.3 7.9% 2.45% 9.3% 11.9%
Huaxia 3.6% 3.4% 15,418 151% -6.5% 5.4% 15.6 1.1 6.3% 1.73% 8.9% 12.2%
SPDB 3.8% 4.1% 51,067 712% -9.1% 8.1% 4.6 1.1 8.3% 2.15% 9.1% 14.0%
SZDB 3.6% 4.1% 23,056 614% -10.0% 7.8% 14.0 1.4 7.8% 2.25% 7.0% 10.5%
Industrial 4.3% 4.6% 45,488 1170% -10.4% 7.5% 11.2 1.3 9.7% 2.44% 7.7% 10.7%
Total 5.1% 5.3% 1,756,883 465% -9.8% 9.3% 11.6 1.3 8.9% 2.56% 8.9% 11.8%
Table 19: Scenario 5 (NPLs wipes of all profits in 2012 to zero). In aggregate NPL balance need to blow out and increased eight-fold, or NPL
formation rate surging to 850bps to get this scenario, assuming other assumptions are valid.
12E
NPL%
New NPLs as
% of 11E loan
12E incr. in
NPLs
% incr. vs.
11E NPLs
chg to 12E
BVS est.
12E BV
growth
12E
PE
12E
PB
12E
ROE
Credit
cost
Core
tier-1
CAR
BoCom-H 7.2% 7.6% 183,028 672% -16.3% 0.9% NM 1.2 - 3.61% 8.1% 10.6%
ABC-H 9.1% 9.3% 482,536 516% -14.8% 2.2% NM 1.6 - 4.20% 8.0% 11.4%
BOC-H 7.0% 7.3% 439,906 682% -10.8% 3.4% NM 1.1 - 3.39% 9.0% 11.4%
CCB-H 9.0% 9.5% 583,559 890% -13.2% 0.8% NM 1.5 - 4.28% 9.4% 11.9%
CMB-H 7.2% 7.8% 126,760 1255% -17.6% 1.4% NM 1.9 - 3.65% 7.6% 10.6%
ICBC-H 9.2% 9.9% 721,655 956% -13.5% 4.2% NM 1.6 - 4.57% 9.8% 11.5%
Citic-H 6.8% 7.5% 104,734 1159% -13.3% 0.9% NM 1.0 - 3.63% 8.7% 11.3%
Minsheng-H 6.8% 7.4% 86,673 1115% -14.3% 15.1% NM 1.4 - 3.65% 8.8% 11.4%
Huaxia 5.2% 5.2% 26,861 263% -11.2% 0.1% NM 1.2 - 2.36% 8.5% 11.9%
SPDB 6.2% 6.8% 87,198 1216% -15.6% 0.3% NM 1.2 - 3.52% 8.4% 13.5%
SZDB 5.4% 6.2% 36,746 979% -16.1% 0.5% NM 1.5 - 2.89% 6.5% 10.1%
Industrial 7.1% 7.7% 76,454 1967% -17.6% -1.1% NM 1.4 - 3.77% 7.1% 10.1%
Total 8.0% 8.5% 2,956,112 782% -16.7% 2.6% NM 1.4 - 3.40% 8.3% 11.3%
Strong earnings resilience against asset quality pressure
In our view, if the economy deteriorates notably, scenario 1 is more likely to happen.
In our view, the worst-case scenario would be scenario 2 or 3, which already reflects
very drastic deterioration in industrial sector and property sector and a significant
25
15 July 2011
Samuel Chen
(852) 2800-8557
default rate in LGFV loans too. Note that even under those scenarios, Chinese banks
may remain profitable, with most banks still achieving low teen to mid-teen
percentage ROEs.
Looking at the current loan breakdown, we think its quite unlikely for sector
NPL ratio to surge to double digits within 1 year. To illustrate our points, we
randomly select one big state banks (CCB) and one medium-sized bank (Minsheng)
to show what kind of annual NPL formation needed in various sectors in
combination to get the NPL ratios under various scenarios highlighted above.
As seen in Table 18 below, in CCBs case, if its 2012 earnings were to decline by
20%, which would imply a 17% ROE and 3.6% NPL ratio after almost 200bps credit
costs (refer to Table 14), the implication on its NPL formation is that CCB will
witness 8% of its 11E manufacturing loans, plus 8% 11E property corporate loans
and 8% of 11E LGFV loans (in reality there are indeed some overlap between LGFV
and property loans, i.e. the land reserve loans), plus about 2.7% of other less risk
corporate loans (energy etc) and some personal loans to default within 2012. We
believe it clearly requires a slump in the economy to materialize such degree of asset
quality deterioration. Similarly we can conduct the same analysis on other banks
such as Minsheng. The results indeed are not too different as shown in table below.
Table 20: What NPL ratios in various scenarios imply in terms of annual NPL formation in key areas that investors are concerned most-CCB
case study
Rmb mn
12E NPL
ratio
Gross new
NPLs
Property
NPLs
% of prop.
Dvelpmt
Manu
NPLs
% of
manu LGFV
% of
LGFV
Other corp.
NPLs
% of other
corp.
Our base case 1.0% 37,651 6,527 1.5% 11,550 1.0% 5,680 2.0% 12,342 0.5%
Flat vs. 2011E 2.3% 126,316 21,758 5.0% 57,750 5.0% 14,200 5.0% 31,056 1.2%
Down by 20% 3.6% 223,319 34,812 8.0% 92,400 8.0% 22,720 8.0% 71,835 2.7%
Down by 30% 4.3% 271,821 43,516 10.0% 115,500 10.0% 34,080 12.0% 77,173 2.9%
Down by 50% 5.6% 368,825 65,273 15.0% 138,600 12.0% 42,600 15.0% 120,799 4.6%
Breakeven 9.0% 611,334 87,031 20.0% 207,901 18.0% 56,800 20.0% 258,050 9.8%
Table 21: What NPL ratios in various scenarios imply in terms of annual NPL formation in key areas that investors are concerned most-
Minsheng case study
Rmb mn
12E NPL
ratio
Gross new
NPLs
Property
NPLs
% of prop.
Dvelpmt
Manu
NPLs
% of
manu LGFV
% of
LGFV
Other corp.
NPLs
% of other
corp.
Our base case 0.7% 5,193 996 1.0% 317 1.0% 1,540 2.0% 1,521 0.3%
Flat earning 2.0% 23,002 4,979 5.0% 1,586 5.0% 3,850 5.0% 11,769 2.0%
Down by 20% 2.9% 36,432 7,966 8.0% 2,537 8.0% 6,160 8.0% 18,949 3.3%
Down by 30% 3.4% 43,146 9,958 10.0% 3,171 10.0% 9,240 12.0% 19,958 3.4%
Down by 50% 4.4% 56,576 14,937 15.0% 3,805 12.0% 11,550 15.0% 25,465 4.4%
Breakeven 6.8% 90,149 19,916 20.0% 5,708 18.0% 15,400 20.0% 48,307 8.3%
Share price already priced in scenario of multiple-year prolong weakness
As Illustrated above, we may argue that its nearly impossible to get overall double
digit NPL ratios on overall loan book. We think valuation has factored in a multi-
year asset quality deterioration that leads to persistent earnings declines for 2-3 years.
It also needs a multi-year recession and prolonged weakness in the Chinese economy
to get double digit mid-teen or high teen percentage NPL ratios in key sectors that
investors are concerned about. Even in such case, earnings might decline by 20-30%
every year in the next 2-3 years so that troughs at about half of 2011E earnings. Even
in this extreme scenario, the sector remains profitable, with high single digit ROE.
Yet even under such scenario, PE on such trough earnings might still be reasonable
at low to mid-teen times.
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15 July 2011
Samuel Chen
(852) 2800-8557
Valuations have far factored in an overly pessimistic
economic outlook on China
Valuation implies very low long-term profitability
As Table 22 shows, assuming our 11.5-12% cost of equity and 5.5-6% LT growth
rates applied for beyond 2013, the current valuation implies sector's long-term ROE
is about 12% only, vs. currently about 22% estimated for 2011/2012. A long-term
ROE at 12% implies that throughout a credit cycle, on average the sector's annual
credit charges needs to be 140bps, almost doubling compared with the past 12 years'
average annual credit costs. We also mentioned earlier even after a persistent 2-3
years profit shrinking due to huge pickup in NPLs to mid-teen percentage, ROE
could remain at high single digit to about 10% at trough. Therefore, we believe a
cycle average 12% may be overly pessimistic.
Table 22: The current valuation implies sustainable ROE at just 12-13% on average for the sector in the longer term
Price PE (x) PB (x) ROE Normalized Implied
(LC) 11E 12E 11E 12E 11E 12E ROE COE LT Grth ROE COE
BoComm-H 6.71 6.1 4.8 1.2 1.0 19.6% 21.7% 15.2% 11.6% 5.5% 11.3% 15.7%
ABC-H 3.97 7.7 6.1 1.7 1.4 23.3% 25.2% 15.8% 11.5% 5.5% 13.3% 13.4%
BOC-H 3.59 6.5 5.5 1.1 1.0 18.4% 18.9% 13.9% 11.4% 5.3% 10.9% 14.6%
CCB-H 6.08 7.2 6.1 1.5 1.3 23.0% 23.5% 17.0% 11.4% 5.5% 12.8% 14.7%
CMB-H 18.24 9.5 7.5 2.0 1.6 24.2% 24.3% 17.4% 11.4% 5.8% 14.6% 13.1%
ICBC-H 5.63 7.6 6.4 1.7 1.4 23.8% 23.8% 17.2% 11.4% 5.5% 13.2% 14.5%
Citic-H 4.63 5.6 4.8 1.0 0.9 20.3% 19.1% 14.0% 11.5% 6.0% 10.6% 15.6%
Minsheng-H 7.04 6.5 5.7 1.2 1.0 20.1% 19.0% 13.9% 11.5% 6.0% 11.8% 13.6%
H-share banks 7.1 5.9 1.4 1.2 21.6% 21.9% 15.6% 11.4% 5.6% 12.3% 14.4%
ABC-A 2.71 6.4 5.0 1.4 1.2 23.3% 25.2% 15.8% 11.5% 5.5% 11.8% 15.3%
BOC-A 3.13 6.9 5.9 1.2 1.0 18.4% 18.9% 13.9% 11.4% 5.3% 11.3% 13.9%
CMB-A 13.08 8.0 6.4 1.7 1.4 24.2% 24.3% 17.4% 11.4% 5.5% 13.5% 14.2%
Huaxia 11.06 8.6 7.8 1.2 1.1 16.6% 14.5% 13.3% 11.6% 5.8% 12.6% 12.3%
Minsheng-A 5.74 6.5 5.7 1.2 1.0 20.1% 19.0% 13.9% 11.5% 6.0% 11.7% 13.6%
SPDB 10.01 7.2 6.0 1.2 1.0 19.0% 18.8% 14.1% 11.6% 6.0% 12.2% 13.3%
SZDB 17.54 7.5 6.9 1.5 1.2 20.1% 19.0% 13.7% 11.6% 6.0% 13.3% 12.0%
ICBC-A 4.34 7.1 6.0 1.6 1.3 23.8% 23.8% 17.2% 11.4% 6.0% 12.5% 15.2%
BoComm-A 5.57 6.2 4.9 1.2 1.0 19.6% 21.7% 15.2% 11.6% 5.5% 11.4% 15.6%
Citic-A 4.48 6.7 5.7 1.2 1.0 20.3% 19.1% 14.0% 11.5% 6.0% 11.6% 13.9%
Industrial 14.30 6.9 5.6 1.4 1.2 22.1% 22.6% 14.0% 11.7% 6.0% 12.5% 13.0%
A-share banks 7.1 6.0 1.3 1.1 20.5% 20.4% 14.8% 11.5% 5.8% 12.2% 13.8%
Sector avg. 7.1 6.0 1.4 1.2 20.9% 20.9% 15.1% 11.5% 5.7% 12.3% 14.1%
Source: J.P. Morgan estimates, Bloomberg.
Valuation are close to floor franchise value
Lastly, we believe valuation metrics are close to the embedded franchise value of the
listed banks. We don't think virtually all the banks will survive even in very adverse
economic downturn. In general, even for troubled banks with heavy NPL burden,
which PE firms may turn over for maximum upside potential once they make
successful business turnarounds, a 3-4x price to PPOP may still be regarded as very
attractive levels. This is especially the case given that we believe the sector may
remain fairly profitable even in scenarios with heavy NPLs in key areas that
investors worried most.
Current valuations are largely
trough valuations and have
factored in a very pessimistic
outlook on the sector, in our
view
27
15 July 2011
Samuel Chen
(852) 2800-8557
Figure 21: Price to PPOP are close to historical trough
Source: J.P. Morgan estimates, Bloomberg. Valuations as of market close price as of 13 July
2011.
Figure 22: Stocks are trading at almost floor franchise value: market
cap to deposits are at about 10% on average
Source: J.P. Morgan estimates, Bloomberg. Valuations as of market close price as of 13 July
2011.
Valuation is also below 1std deviation to historical 6-year mean
Based on JP Morgan estimates, the current 12M forward valuations of ABC-H,
Minsheng-H, BoComm-H, and most A-shares are very close to historical troughs
seen only during the most panic days in Global Financial Crisis in 4Q08. All H-
shares and nearly half of A-share banks are trading below 1 standard deviation below
the six-year mean average. In absolute terms, 12M forward PB quite a number of
banks are trading close to 1x book. These all imply a very favorable risk-reward
profile we think.
Table 23: 12M forward valuation metrics comparison: Current vs. historical trading range
Source: J.P. Morgan estimates, Bloomberg. Valuations as of market close price as of 13 July 2011.
Confident in sectors' fundamental outlook, near-term
stocks rangebound
From both a fundamental outlook and valuation perspective, we maintain our
positive view on the sector, both in the medium term and longer term. We firmly
believe investors have been overly pessimistic on China's macro outlook. We believe
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A
B
o
C
o
m
-
H
B
o
C
o
m
m
-
A
C
i
t
i
c
-
H
x
11E 12E
15%
13% 13%
12%
14%
12%
12%
10%
11% 11%
10%
10%
10% 10% 10%
9% 9%
9% 8%
0%
2%
4%
6%
8%
10%
12%
14%
16%
C
M
B
-
H
I
C
B
C
-
H
C
M
B
-
A
C
C
B
-
H
M
i
n
s
h
e
n
g
-
H
I
C
B
C
-
A
C
C
B
-
A
A
B
C
-
H
I
n
d
u
s
t
r
i
a
l
C
i
t
i
c
-
H
B
O
C
-
A
B
O
C
-
H
S
Z
D
B
S
P
D
B
M
i
n
s
h
e
n
g

A
B
o
C
o
m
-
H
B
o
C
o
m
m
-
A
A
B
C
-
A
H
u
a
x
i
a
x
11E 12E
Company name
Mean PB Mean PE PB PE PB PE PB PE PB PE PB PE PB PE
ABC-H 1.7 7.8 1.5 6.8 12% 16% 4% 8% 1.9 9.0 1.5 6.8 -1% 0%
BoComm-H 1.8 10.4 1.0 4.9 87% 114% 30% 44% 3.5 18.7 0.9 4.8 -7% -2%
BOC-H 1.6 10.5 1.0 6.0 49% 76% 10% 13% 2.4 18.3 0.8 5.0 -26% -16%
CCB-H 2.1 11.1 1.4 6.6 45% 69% 12% 24% 3.7 19.1 1.0 5.4 -26% -17%
CMB-H 2.9 13.1 1.8 8.0 67% 63% 4% 16% 6.4 24.9 1.4 7.1 -20% -12%
ICBC-H 2.1 11.3 1.5 6.9 41% 64% 12% 16% 3.6 20.2 1.2 6.4 -18% -7%
Citic-H 1.4 9.5 0.9 5.2 84% 117% 5% 3% 2.7 23.3 0.7 4.9 -27% -6%
Minsheng-H 1.3 7.3 1.1 6.1 92% 92% 5% 4% 1.7 9.8 1.1 5.9 -2% -4%
H-share banks 2.0 10.5 1.4 6.5 44% 64% 11% 17% 3.3 18.0 1.1 5.9 -18% -10%
ABC-A 1.4 6.4 1.3 5.6 10% 14% 4% 6% 1.6 7.4 1.2 5.6 -1% -1%
BOC-A 2.0 13.8 1.1 6.3 84% 117% 18% 21% 4.0 29.2 1.1 6.3 0% 0%
CMB-A 2.9 13.5 1.5 7.0 92% 92% -14% 13% 7.8 30.3 1.5 6.9 -3% -1%
Huaxia 1.9 14.2 1.1 8.2 71% 73% 0% -8% 4.7 36.9 1.1 7.9 -3% -4%
Minsheng-A 2.0 12.7 1.1 6.0 81% 111% -11% -13% 4.9 34.2 1.0 5.6 -6% -7%
SPDB 2.6 12.3 1.1 6.5 129% 88% -8% 15% 7.2 26.2 1.1 5.7 -3% -13%
SZDB 2.6 20.7 1.3 7.2 93% 189% -8% n.a. 6.8 153.2 1.2 5.8 -8% -18%
ICBC-A 2.4 12.9 1.4 6.5 69% 99% 9% 13% 4.8 26.8 1.4 6.5 0% 0%
Industrial 2.6 11.8 1.3 6.2 107% 91% -11% -9% 7.3 31.3 1.1 4.9 -14% -21%
A-share banks 2.3 12.6 1.3 6.4 75% 96% 6% 12% 4.8 28.6 1.3 6.3 -2% -2%
Historical Current (13 July) Hisotical Peak Historical Trough Downside to trough % upside to mean upside (downside) to -1 stdv
28
15 July 2011
Samuel Chen
(852) 2800-8557
many overseas investors have limited understanding on China in general and have
relied on some sensational media report as their information source.
Having said that, we believe in the near term stocks may only trade in a range-bound
pattern. Since future can not be proven until time proves it, sentiment can hardly
improve when there is uncertainty in the economy, and some share overhang
specifically in a few stocks will linger in the next few months. We also see no
positive catalyst that can boost sentiment on the sector in the short-term. Meanwhile,
global financial markets may also remain volatile in view of the adverse development
in some European countries government debt issues. While the problems are mainly
in Developed Markets indeed, emerging markets may still be hit equally or even
more as more funds may flow back to developed countries. Clearly from top down
perspective, investors naturally are cautious. On the other hand, we see strong
downside support from already very low valuation metrics and good dividend yields
in bigger banks.
We still look for 20-30% upside to be achieved likely in late 3Q11 or early 4Q11.
We believe as the CPI trends down likely toward the end of 3Q10, and with still
fairly strong 1H11 profit numbers, we believe sentiment may improve modestly.
From a 6-12M perspective, we reiterate our view that within H-shares we generally
prefer some medium-sized banks with larger PB/ROE mismatch. At current levels,
these include Minsheng-H, Citic-H and BoComm-H at current levels. Having said
that, we acknowledge high level of risk aversion among equity investors. We thus
recommend balancing portfolios with some exposure to larger state banks which
have stronger balance sheets and higher operating profitability to withstand extreme
economic downturn. We recommend ICBC-H. With stocks trading down to almost
1x 12M forward PB,we think BOC-H is a deep value holding in the longer term,
although we think in the short term it still may not outperform peers given a less
attractive NIM outlook until the US enters rate hike cycle. While CCB-H, ABC-H
and CMB-H may still deliver a very solid operating performance, share overhang
may limit the share price performance in the short term.
Figure 23: 11E PB vs. 11E ROE charts
Source: J.P. Morgan estimates, Bloomberg. Valuations as of market close prices on 13 July 2011.
BOC-A
BoComm-A
CCB-A
Huaxia
Minsheng-A
SPDB
SZDB
ICBC-A
Citic-A
BOC-H
BoComm-H
CCB-H
ICBC-H
Citic-H
Minsheng-H
CMB-H
CMB-A
ABC-H
Industrial-A
0.80
1.00
1.20
1.40
1.60
1.80
2.00
2.20
16.0% 18.0% 20.0% 22.0% 24.0%
1
1
E

P
B
11E ROE
29
15 July 2011
Samuel Chen
(852) 2800-8557
Companies Recommended in This Report (all prices in this report as of market close on 14 July 2011)
Agricultural Bank of China - H (1288.HK/HK$3.96/Neutral), Bank of China - H (3988.HK/HK$3.55/Neutral), China Citic
Bank - H Share (0998.HK/HK$4.58/Overweight), China Construction Bank (0939.HK/HK$6.03/Overweight), China
Merchants Bank - H (3968.HK/HK$18.04/Neutral), China Minsheng Banking - H (1988.HK/HK$7.07/Overweight),
Industrial and Commercial Bank of China - H (1398.HK/HK$5.64/Overweight)
Analyst Certification: The research analyst(s) denoted by an AC on the cover of this report certifies (or, where multiple research
analysts are primarily responsible for this report, the research analyst denoted by an AC on the cover or within the document
individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views
expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of
any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views
expressed by the research analyst(s) in this report.
Important Disclosures
Important Disclosures for Equity Research Compendium Reports: Important disclosures, including price charts for all companies
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https://mm.jpmorgan.com/disclosures.jsp or by calling this U.S. toll-free number (1-800-477-0406).
Explanation of Equity Research Ratings and Analyst(s) Coverage Universe:
J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the
average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Neutral [Over the next six to twelve months,
we expect this stock will perform in line with the average total return of the stocks in the analyst's (or the analyst's team's) coverage
universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks
in the analyst's (or the analyst's team's) coverage universe.] The analyst or analyst's team's coverage universe is the sector and/or country
shown on the cover of each publication. See below for the specific stocks in the certifying analyst(s) coverage universe.
Coverage Universe: Chen, Samuel: Agricultural Bank of China - H (1288.HK), Bank of China - A (601988.SS), Bank of China - H
(3988.HK), Bank of Communications Co (3328.HK), China Citic Bank - H Share (0998.HK), China Construction Bank (0939.HK),
China Merchants Bank - H (3968.HK), China Merchants Bank Co., Ltd - A (600036.SS), China Minsheng Banking - A (600016.SS),
China Minsheng Banking - H (1988.HK), Industrial and Commercial Bank of China - A (601398.SS), Industrial and Commercial Bank of
China - H (1398.HK), Noah Holdings Ltd (NOAH)
J.P. Morgan Equity Research Ratings Distribution, as of June 30, 2011
Overweight
(buy)
Neutral
(hold)
Underweight
(sell)
J.P. Morgan Global Equity Research Coverage 47% 42% 11%
IB clients* 50% 46% 32%
JPMS Equity Research Coverage 45% 47% 8%
IB clients* 70% 64% 52%
*Percentage of investment banking clients in each rating category.
For purposes only of FINRA/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold
rating category; and our Underweight rating falls into a sell rating category.
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Other Disclosures
30
15 July 2011
Samuel Chen
(852) 2800-8557
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31
15 July 2011
Samuel Chen
(852) 2800-8557
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