Chinese banks still worth a look despite rise in NPLs, say analysts

Lower NPL provision coverage seen positive to mainland banks’ profits over the longer term

PUBLISHED : Thursday, 25 February, 2016, 1:28pm
UPDATED : Thursday, 25 February, 2016, 1:31pm

Banks with risk control capacity, capital strength, risk-based pricing power and margin resilience could become winners in the Chinese market, although headwinds brought on by the continuous economic slow down persist, analysts said.

Ahead of their Chinese peers, HSBC and Standard Chartered both announced worse-than-expected annual earnings this week, with the latter reporting its first losses in 26 years, partly due to sluggish Asian business, as trading conditions continue to deteriorate while China loses steam.

Struggling at the epicentre of the economic shake up, Chinese banks face even bigger challenges as the quality of their assets deteriorated, pushing non-performing loan (NPL) ratios higher. Latest official numbers show NPLs and special-mention loans (SMLs) with mainland banks had risen sharply to 4.2 trillion yuan (HK$5 trillion) by the end of 2015 from 2.9 trillion yuan in 2014 – with analysts saying the official number could still be an underestimate.

However, some analysts still believe certain mainland Chinese banks are worth attention.

“It will be very hard to see a turnaround performance of bank shares as investors tend to stay away from this sector unless there is a solid rebound in the macro economy,” said Alex Fan, managing director of GF Securities in Hong Kong. “However, sentiment wise, the current low valuations of bank shares on both mainland and Hong Kong markets also make them sensitive to major market rebounds.”

Mainland media reported last week that the Chinese authorities were considering lowering the provision coverage ratio requirement on banks, in a bid to expand credit and curb the sharp economic slowdown.

The minimum requirement is currently 150 per cent, while the sector coverage ratio was 181 per cent at the end of 2015, down from 232 per cent at the end of 2014, according to the China Banking Regulatory Commission.

Analysts with UBS estimated the move, if adopted, would be positive to banks’ profit. But the effect won’t be imminent or of great strength as banks tend to prioritise on controlling NPLs rather than using the freed-up capital to generate returns, particularly given that economic growth is still trending downward and the credit cycle is yet to bottom out.

It will be very hard to see a turnaround performance of bank shares as investors tend to stay away from this sector unless there is a solid rebound in the macro economy
Alex Fan, GF Securities Hong Kong

“Statistically, we estimate a 10 per cent release of provision coverage would boost banks’ 2016 pre-provision operating profit by 4-7 per cent, based on our 2016 NPLs balance forecasts for the banks under our coverage,” UBS analysts wrote in a research note issued last week.

“However, we do not think banks would release their provisions immediately if the requirement was loosened, since provisions are more influenced by NPL trends. Since asset quality is still deteriorating due to the slowing economy, we believe pressure on provisioning remains,” UBS said.

In the Hong Kong market, UBS recommends Bank of China (BOC), citing it as a key beneficiary of the “One Belt, One Road” initiative and rising US interest rates. China Construction Bank (CCB) is also recommended for its strong capital position and the likely rise in infrastructure spending in China, while China Citic Bank is favoured for its stronger consumer lending and internet-related businesses.

Analysts with Nomura said they preferred CCB and Industrial and Commercial Bank of China (ICBC) on solid fundamentals and attractive upside potential, according to a note issued last week.

They also rated Chongqing Rural Commercial Bank as a “Buy” due to its relatively higher net interest margin and provision buffers compared to peers.

Nomura also recommended BOC due to “the resuming momentum for yuan’s internationalisation over the next 12 months”, analysts wrote in the report.

They also noted risks that may impede the stocks from reaching their target prices, including faster-than-expected NPL rebound due to a weak economy, worse-than-expected margins owing to deposit rate deregulation and other financial reforms, and faster capital depletion on higher loan default ratios.

As for lower NPL provisions, Nomura analysts pencilled in a decline of the NPL coverage floor from 150 per cent currently to 120 per cent in 2016, and a further drop to 100 per cent in 2017/2018. In contrast, US banks had 60 per cent NPL coverage as of 2014.

“We see the NPL coverage ratio normalisation as necessary when banks move deeper into the NPL cycle, but we don’t see this leading to a substantial increase of new loans in 2016-2018 as banks’ risk appetite may remain low with NPLs plus SMLs piling up,” the note said.