The monetary easing cycle in China since November is hurting Chinese banks’ earnings, but not necessarily impacting their share prices. Investors who have been offloading banking shares amid bad-debt concerns and shrinking margins should perhaps reconsider, as they could be missing out on a rally triggered by the deregulation launched by Chinese regulators, a report by Barclays pointed out. A textbook practice for investment managers in the world’s major equity markets was to avoid banking shares when there is an easing cycle, as history is replete with the bloody lessons of banks who have generally performed worse or at best in-line relative to the country’s benchmark index. This time around, Chinese banks maybe an exception. Not only can the one trillion yuan debt-swap programme to replace local government’s existing debt help alleviate the default stress plaguing many banks, but further reforms by the bank themselves such as allowing employees to own more shares and spin off some underlying assets could come as a positive surprise to the market. “Further deregulation and reform, especially those specific to the banking sector, could continue to support share price performance,” Barclays said, adding that the process may be a gradual process and will be positive over the medium to long term. It said Chinese banks have outperformed the MSCI China index by 6 per cent since the People’s Bank of China started to cut interest rates in November. The central bank has cut rates by a cumulative 90 basis points since then. It was certainly not the earnings outlook that has been supporting Chinese banks in the equity market: every 25 basis points rate cut will narrow Chinese lenders’ margins by 12 basis points on a full-year basis, or a 7 per cent reduction in their 2016 net profits, according to Barclays analysts led by Sharnie Wong. “We believe share price performance going forward will highly depend on whether the progress of further reform specific to the banking sector will be sufficient to offset the ongoing pressure to earnings from interest rate and RRR cuts,” the report said. Instead, in Barclays’ view, it has been progress on deregulation and reforms by the central bank, which would alleviate the lenders’ bad-debt pressure. Any progress on Employee Stock Ownership Program (ESOP) reform by Chinese banks is positive for the banking sector as it improves transparency and sustainability of their long-term return on equity, it said. China Merchants Bank is a potential outperformer as it was the first to announce a plan to issue a maximum of 435 million A shares through an ESOP. Bank of Communications and CITIC Bank are also seen as the next candidates to roll out such plan, according to Barclays. The execution of the spin-off in wealth management and credit card businesses in order to streamline operations and unleash the value of the underlying businesses would also give a reason for investors to buy. In addition, further upside of the banking shares will depend on largely whether the Ministry of Finance would announce more debt swap quotas for local governments to reduce banks’ credit risks and boosts capital adequacy. In March, Beijing announced a 1 trillion yuan of bond issuance quota for this year for local governments to swap with existing debt. “We continue to prefer Bank of China as it is least negatively affected by benchmark interest rate cuts and domestic deposit rate liberalisation among the banks under our coverage due to its greater overseas exposure,” it said.