Asset quality series 1 - From the ground up, it is value, not a trap

Deutsche Bank Markets Research Asia China Banking / Finance Banks Industry Chinese Banks Date 23 September 2015 Coverage Change Asset quality series 1 - From the ground up, it is value, not a trap Stay positive; bottom-up studies show excessive negativity priced in ________________________________________________________________________________________________________________ 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) 124/04/2015. Hans Fan, CFA Research Analyst (+852) 2203 6353 hans.fan@db.com Tracy Yu Research Analyst (+852) 2203 6191 tracy.yu@db.com Jacky Zuo Research Associate (+852) 2203 6255 jacky.zuo@db.com Key Changes Company Target Price Rating 1398.HK 7.62 to 6.90(HKD) - 0939.HK 8.54 to 7.90(HKD) - 1288.HK 5.06 to 4.61(HKD) - 3988.HK 5.93 to 5.40(HKD) - 3328.HK 9.00 to 8.49(HKD) - 3968.HK 27.45 to 24.83(HKD) - 0998.HK 6.82 to 6.31(HKD) Hold to Buy 1988.HK 12.62 to 11.60(HKD) - 3618.HK 7.48 to 6.94(HKD) - 3698.HK 3.69 to 3.42(HKD) - 1963.HK 6.85 to 6.36(HKD) - 600000.SS 18.67 to 17.75(CNY) - 601166.SS 16.16 to 15.63(CNY) - 000001.SZ 17.61 to 16.68(CNY) - 601009.SS 16.00 to 15.40(CNY) - 002142.SZ 13.17 to 12.70(CNY) - 601818.SS 5.44 to 4.96(CNY) - 601169.SS 12.00 to 11.98(CNY) - Source: Deutsche Bank Top picks China Construction Bank (0939.HK),HKD5.53 Buy Bank of China (3988.HK),HKD3.53 Buy Source: Deutsche Bank Five interest rate cuts in 12 months and concerted efforts to improve liquidity do, after a while, begin to take effect. That is the evidence from analyzing the debt service ability of 7,500 companies in China which together account for 28% of corporate debt. The number of those companies with debt at risk is falling; EBIT coverage is improving; LGFV debt is covered by disposable assets and bond swap. Historic NPLs are rising but with provision cover of 191% already in place this can be absorbed far better than valuations of 0.7x 2016E P/B imply. Indeed, NPLs would have to reach 6% to match current valuations. We maintain a positive stance on the sector, with CCB and BoC our top picks. Mild NPAT recovery in 2016E, raising NPL forecasts to 1.7-2.1% in 2015-16E Our new NPLs are more cautious than before (1.7% in 2015E and 2.1% in 2016E, vs. 1.4% in 1H15) but the impact on NPAT estimates is minor, cutting 2016E 3.6%. This is due to the buffer of over-provisioning built up since 2007 as coverage is still at 191% as of 1H15. In aggregate, we now estimate sector 2016 ROE of 15%. Taken with our revised RMB forecasts, this leads to reductions of up to 10% in our target prices for Chinese banks. As part of the revisions, we upgrade CNCB-H from Hold to Buy on valuation. This report marks the transfer of coverage of ICBC, CCB, ABC, BOC, BoCom, CMB, MSB and CNCB in A- and H-share and CRCB in H-share from Tracy Yu to Hans Fan. A-share companies’ financials show signs of improvement in debt servicing Our proprietary studies show improving EBIT coverage and debt servicing ability for the 2,700 A-share listed non-financial companies and 3,500 SMEs listed on the NEEQ, mainly due to falling corporate financing costs on policy easing. In particular, the “debt at risk” ratio of 2,700 A-share companies, which we define as the percentage of debts of companies with an EBIT coverage ratio of less than one to total debts of all sampled companies, has fallen to 13% in 2Q15 from 15% in 1Q15 and 19% in 4Q14. With effects of policy easing continuing to show up and lower corporate financing cost, t his suggests banks’ NPL formation is likely to slow in the coming quarters as the economic situation in 2H15 improves as Deutsche Bank’s economist predicts. Weaker cash flows for LGFVs but debt swap cushions risks Another study into 1,300 LGFVs’ financials shows deteriorating cash flows (only 31% “fully/ basically” covered in 2014). However, we found total value of their disposable assets, such as land and SOE stakes, have covered their debts at about 100% during 2007-14. Moreover, with Rmb2.2tr municipal bonds issued YTD (58% of 2015 quota), we expect the local government debt swap to sufficiently finance near-term debt obligations and lower systemic risks. Stress test – what if NPL shoots up to 8.5%? While policy incentives to help loss-making SOEs repay debts stay high, under our stress situation where we assume China’s GDP to fall below 5% and the support to SOEs is removed, we