The Financial Crisis and China's Banking Industry

The ongoing financial crisis has had a significant impact on the global financial services industry and caused serious damage to the global economy. Although China's banking industry has limited direct exposure to the subprime crisis, it is facing a difficult road ahead, as the crisis has been deepening China's economic slowdown. However, we're optimistic about the ability of Chinese banks to withstand the difficulties ahead, and we maintain our confidence in their long-term prospects.

Less Sensitive to the Global Crisis--But Fundamentals Are Weakening
China's banking industry has strengthened considerably in recent years. Since 2004, China has been reforming its banking industry by allowing the banks to issue publicly traded shares and implementing market-driven business practices to improve the banks' management ability and form a business-oriented banking industry. These reforms have been fairly successful--many banks have accumulated significant equity market funding and grown their earning assets rapidly, thanks in part to China's strong economic growth for the past several years. The rapid growth of banks' earning assets, combined with the favourable interest-rate environment and the increase of noninterest income from a low base, have contributed most to the banks' earnings growth for 2006 and 2007. The enterprise income tax rate cut (to 25% from 33%) and the changes in tax-deductible items in 2008 extended the strong momentum of earnings growth. In the third quarter, the tax changes in 2008 contributed 22% to the net income growth on a year-over-year basis.

Moreover, China's banking industry is not deeply integrated with the global financial market yet, and therefore it has had limited direct exposure to the subprime crisis. As of midyear 2008, the listed banks' combined exposure to dollar-denominated bonds was around $123 billion and accounted for less than 3% of the banks' total assets. As a result, subprime-related write-downs have not had a significant negative impact on banks' earnings. To the contrary, the listed banks had an average net income growth of 53% in the third quarter this year, compared with the same period last year.

After reviewing their fundamentals, you might guess that the share prices of Chinese banks would hold up better than those of their peers in other countries during this crisis. However, the share prices of the six major Chinese banks listed in Hong Kong dropped more than 33% on average in October, and declined almost 50% on average since the beginning of August. What has caused the sharp decline in share prices--panic or fundamental concerns? We think that fundamental concerns are the major reason driving this correction. Taking a closer look at the banks' fundamentals, we find that they are not as strong as they may initially appear.

The Financial Crisis May Deepen China's Economic Slowdown
The financial crisis came at difficult time for China, as it will likely deepen the already-expected slowdown in China's double-digit economic growth. Strong growth in exports and investments in real estate have played crucial roles in China's growth, but neither was without cost and neither appears sustainable.

Because China's export market is driven by low-end goods, export growth came at the cost of poorly paid labor and a huge expenditure of natural resources. However, now that China's currency has appreciated significantly and labor costs have increased, the price advantage of "made in China" is unlikely to bolster further growth. While China intends to gradually shift its exports to higher value-added products and to stimulate domestic demand to reduce the economy's reliance on exports, this transformation will be a long and painful process for many small and medium-sized enterprises. The damage to the world economy caused by the financial crisis is likely to materially shrink international demand for China's goods, which would be a double blow to China's slowing exports. In the coming year, we may see China's exports growth decline to less than 10%, and some enterprises may go bankrupt.

Another issue for China's economy is the sluggish real estate industry. Excessive speculative investments in China's real estate over the last several years--which were stimulated by the appreciation of China's currency--have created a housing price bubble. The ongoing decline in transaction volumes and investment confidence signal that China's real estate bubble may be bursting. Although countrywide housing prices were still at a high level at the end of September, we may see the price correction in the real estate industry through 2009, which also poses a material challenge to China's economy.

And a Slowdown Would Challenge China's Banks
These internal and external economic issues increase the threat of a "hard landing" for China's economy, which will impact the banks in various ways, in our opinion. First, the growth in banks' earning assets is likely to decelerate because of tighter credit control from the banks and lower demand for credit. Second, nonperforming loans (NPLs) may increase as some productive assets become idle. Third, as the central bank cuts interest rates to fight against the economic slowdown, net interest margins for banks are also likely to shrink. These rate cuts have already begun. On Sept. 29, the central bank reduced both its benchmark one-year lending and savings rates by 0.27%, to 6.66% and 3.60%, respectively--the third interest-rate cut within two months. We think these rate cuts are unlikely to be the last. During the 1997-98 Asian financial crisis, China dramatically cut the benchmark one-year saving rate by 5.49% to 1.98%. As the ongoing financial crisis seems likely to cause more damage than what happened 10 years ago, we project that the benchmark one-year savings rate could fall as low as 1.71%, and the benchmark one-year lending rate as low as 4.23%. In the coming year, we expect to see five to seven interest-rate reductions, which could collectively cause banks' net interest margins to drop over 0.50%. A drop of this magnitude would cut deeply into banks' profits. Based on those forecast estimates, we project that the average growth rate for net income of the listed banks in China could decline to less than 10% in 2009, and we would not be surprised if some banks have negative growth.

Long-Term Prospects Remain Strong
There are varying views regarding the length and depth of the economic slowdown, and the prospects of China's banks. However, we are optimistic about the long-term prospects of China's banking industry. It is hard to predict when the bad news will stop coming, but several things give cause for optimism. As a developing country, China still has a lot of potential for economic growth. The government's strong fiscal condition affords it a variety of weapons to fight against economic slowdown, such as its recent CNY 4 trillion (around $590 billion) stimulus package. Thanks to government intervention, the economic slowdown in China may not be as bad as initially feared.

We also think that China's banks' financial health is generally strong, benefiting from conservative lending policies and sufficient capital levels. At the end of September, the average capital adequacy ratio of all the listed banks was around 13%, compared with the minimum of 8%. Nonperforming loans were only 2% of total loans, and provisions for loan losses were sufficient to cover 123% of nonperforming loans. These figures reflect the banks' strong balance sheets, which we think will give them a cushion to help them through the tough time ahead.

China's banks have lots of room to increase their profitability, such as developing new revenue sources, operating more efficiently, and improving risk management, as they are still beginners in the global business world. China's banks partnered with many bigger players in the global financial markets as strategic investors several years ago, which gave the banks access to international management skills as well as new investors. We expect to see continuous improvement in management as a result. We also think China's banks are likely to find new areas for growth. To date, corporate lending has been the major source of revenue for China's banks. However, we see a huge potential for retail banking and service-related fee income, thanks to China's population of more than 1.3 billion and household savings deposits of over CNY 20 trillion (around $3 trillion) at the end of September 2008. As China's banks put more emphasis on retail banking and generating fee income, we expect these revenue streams to become the driving force behind their earnings growth.

Overall, we expect China's banking industry to have a difficult year in 2009. Recent share price drops reflected the dim fundamentals ahead to some degree, but may also provide a good long-term investment opportunity, given the upward trend of China's economy and assuming that the banking industry is not materially damaged by the crisis. But given the complexity of the economic uncertainties ahead, we recommend that investors seek a large margin of safety below conservative fair value estimates before investing in China's banks.