Hong Kong Banks：Managing HK$3.5trn of China risk

Equity Research18 March 2014 Barclays Capital Inc. and/or one of its affiliates 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. This research report has been prepared in whole or in part by equity research analysts based outside the US who are not registered/qualified as research analysts with FINRA. PLEASE SEE ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 17. Hong Kong Banks Managing HK$3.5trn of China risk The Hong Kong banking sector has HK$3.5trn (=RMB2.8trn) of credit exposure to Mainland China, including both on and off-balance-sheet items (letters of credit, guarantees and undrawn commitments), equivalent to 1.8% and 21% of China and Hong Kong’s banking system assets, respectively. We estimate this comprises HK$1.9trn of loans and HK$1.55trn of other debt and off-balance-sheet items. Hong Kong supplies HK$2.2trn of liquidity to China on a net basis. This is small in the context of China’s large banking system, but the liquidity drag to Hong Kong is material, equivalent to 24% of HK’s system deposits. We believe some degree of greater two-way RMB movement is positive for banks, which benefit from corporates increasingly hedging their FX positions. Banks generally do not take direct exchange risk other than acting as counterparty for client transactions. Asset quality overall is a key risk to banks’ profitability and capital, not only in relation to China-related lending, given that credit cost and NPLs are at record lows, and with interest rates in Hong Kong likely to normalise over the medium term. BEA (UW) and BOCHK (EW) have the largest exposure to China and trade finance, while Hang Seng Bank (OW), our top pick, is least exposed and also has the strongest risk management track record among the local banks. FIGURE 1 Size of Hong Kong banking system’s exposure to Mainland China – key indicators Other debt and off-balance sheet items (est) HK$1.55trn HK$ 2.22trnTrade finance (est) HK$456bnLoans (est) HK$1.48trn-0.5 1.0 1.5 2.0 2.5 3.0 3.5 Total China exposureNet supply of liquidity to ChinaHK$trnTotal HK$3.5trn Source: HKMA, CEIC, Barclays Research estimates Note: Total China exposure based on HKMA’s Sept-13 “Non-bank Mainland China statistics and Net supply of liquidity based on Nov-13 external claims data. INDUSTRY UPDATE Asia ex-Japan Banks NEUTRAL Unchanged Asia Ex-Japan Banks Sharnie Wong, CA +852 2903 3457 sharnie.wong@barclays.com Barclays Bank, Hong Kong Barclays | Hong Kong Banks 18 March 2014 2 Investment summary Greater RMB exchange-rate volatility in recent weeks has highlighted the risks to corporates of unhedged FX exposure and potential asset-quality issues arising from banks’ China exposure. While near-term uncertainty may prevail, RMB depreciation so far has been small (-1.5% ytd) and our fixed-income strategist, Rohit Arora, still expects gradual appreciation of the RMB, forecasting USDCNY to reach 5.95 in 12 months (6.15 spot), as policymakers will be wary of sustained CNY depreciation expectations, which could increase the risk of significant capital outflows. Moreover, banks are benefiting from greater FX hedging business as corporates increasingly hedge their RMB positions in light of potentially greater exchange-rate volatility. Hong Kong’s banking system has HK$3.5trn of exposure to China (including both on and off-balance-sheet), equivalent to 21% of Hong Kong’s system banking assets but only 1.8% of China’s system banking assets. We estimate this consists of HK$1.9trn of loans (including trade finance) and the remainder of HK$1.55trn in other debt investments, letters of credit, guarantees, undrawn commitments and derivatives. Hong Kong supplies HK$2.2trn of liquidity to China on a net basis, based on the HKMA’s net external claims data. This is small in the context of China’s large banking system (1.7% of China’s system deposits), but is very material for Hong Kong, equivalent to 24% of system deposits. We believe asset quality overall is a key risk to the banks, not only that relating to their Mainland China exposure, given that credit costs and NPLs are at record lows system-wide. If there is a sharp downturn in the Chinese economy and a squeeze on funding for Chinese corporates, we believe domestic Hong Kong loans will also be affected due to the Hong Kong economy’s reliance on China for growth. Moreover, the eventual normalisation of interest rates in Hong