October 2016 banking volume –Continued build-up of leverage

Deutsche Bank Markets Research Asia China Banking / Finance Banks Industry Chinese Banks Date 14 November 2016 Industry Update October 2016 banking volume – Continued build-up of leverage Credit growth stayed strong at 17%, leading to higher system leverage ________________________________________________________________________________________________________________ Deutsche Bank AG/Hong Kong Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, 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. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 057/04/2016. Hans Fan, CFA Research Analyst (+852 ) 2203 6353 hans.fan@db.com Stephen Andrews, CFA Research Analyst (+852 ) - 2203 6191 stephen-a.andrews@db.com Jacky Zuo Research Associate (+852 ) 2203 6255 jacky.zuo@db.com Vincent Gu Research Associate (+852 ) 2203 6185 vincent.gu@db.com Top picks ICBC (1398.HK),HKD4.60 Buy China Merchants Bank (3968.HK),HKD18.32 Buy Source: Deutsche Bank Companies Featured ICBC (1398.HK),HKD4.60 Buy China Construction Bank (0939.HK),HKD5.52 Buy Agri. Bank of China (1288.HK),HKD3.16 Hold Bank of China (3988.HK),HKD3.42 Buy Bank of Communications (3328.HK),HKD5.90 Hold China Merchants Bank (3968.HK),HKD18.32 Buy China CITIC Bank (0998.HK),HKD4.91 Hold China Minsheng Bank (1988.HK),HKD8.74 Hold CEB (6818.HK),HKD3.50 Hold Shanghai Pudong Bank (600000.SS),CNY16.60 Sell Industrial Bank (601166.SS),CNY16.29 Sell Ping An Bank (000001.SZ),CNY9.18 Hold Bank of Beijing (601169.SS),CNY9.56 Buy Bank of Nanjing (601009.SS),CNY10.64 Sell Bank of Ningbo (002142.SZ),CNY17.26 Sell Source: Deutsche Bank We value Chinese banks using a three-stage Gordon Growth Model (PV= (ROE-g)/(COE-g)), with target prices based on 2016E book values. The PBOC reported new RMB loans and TSF of Rmb651bn and Rmb896bn, respectively, both below consensus. Adjusting for Rmb475bn municipal bonds, system credit growth in Oct stayed strong at 17.1% yoy (Sept: 17.0%). This points to continued build-up of system leverage. Credit mix-wise, all sectors, including the government, household and corporate, are leveraging up. Mortgages continued to be the biggest driver, contributing 75% of new loans. We expect credit growth to soften modestly in Nov-Dec 2016, but we see low visibility in 2017E. If China boosted fiscal and monetary stimulus in 2017E, it is a short-term positive but long-term negative for banks. Who is borrowing? All sectors are leveraging up The new credit was more equally allocated among the three sectors in Oct. We estimate governments took the largest share of 39%, while corporates and the household sector made up 29% (Sep: 40%) and 33% (Sep: 27%) respectively. The pace of mortgage growth showed few signs of slowdown, contributing 75% of total new loans. As a further step toward tightening, banking regulators are requiring banks to extend fewer new mortgage loans on a month-on-month basis, as reported by Shanghai Securities. As such, we expect mortgage growth to gradually soften in the next two months. Who is lending? City/rural commercial banks and policy banks On the lending side, smaller city/rural banks and policy banks, whose combined assets made up 32% of system total, remained the major lenders, with asset growth of 17-28% yoy (Figure 3). In contrast, the asset growth of the big-five banks (38% of banking assets) and joint-stock banks (18%) remained slow at 8.1% and 14.6%. In addition, we estimate policy banks’ new lending made up 24% of system new loans in 9M16 (18% in 2015), suggesting stronger fiscal stimulus (see Policy banks – driving growth and restructuring). System deposit growth improved but M2 growth still low System deposits grew by 11.5% yoy (September: up 11.1%), supported by new fiscal deposits (up Rmb682bn MoM) and non-bank FI deposits (up Rmb523bn), partly offset by outflows of retail deposits (down Rmb468bn) on strong property purchases. However, due to continuing shrinking FX reserves in October (down US$45.7bn vs. down US$18.8bn in September), M2 growth remained uninspiring at 11.6% yoy (Aug: 11.5%). M1 growth fell to 23.9% from 24.7% in Sept, resulting in a narrower M1-M2 gap of 12.3ppt (Aug: 13.2ppt). Expecting slower credit growth in Dec, but further stimulus is ST upside risk We expect credit growth to soften over the rest of the year, given: 1) tightening property policies in top-tier cities; 2) less municipal bond issuance, with total issuance in 10M16 reaching Rmb5.56tr, vs. the whole-year quota of Rmb6.2tr, implying less