China banks:Be not a lender, but be a borrower

Event

The PBOC has cut China’s benchmark interest rates. Our initial thoughts onthe impact on the banks are that the move will put further pressure on NIMswhile alleviating – but not resolving – the trend of rising NPLs and thereforecredit cost pressures. We think there are better ways to play this, asborrowers rather than lenders are likely to be the real winners from this move.

Impact

The PBOC cut the benchmark rates. It cut the one-year lending rate by40bps to 5.6%. The adjustment in yields should take place over the next 3months, into 1Q15. While the central bank also cut the one-year deposit rateby 25bps to 2.75%, it also increased the range for differentiating deposit ratesfrom 1.1x benchmark to 1.2x benchmark.

Spreads and NIMs will fall (that’s bad). What this means is that banks willstill be able to pay as much as 3.3% -- exactly the maximum on a one-yeartime deposit that they already could pay before this rate cut. In our view,spreads and NIMs will inevitably fall as a result. As usual, banks with betterCASA deposit franchises, ie, the larger banks, should face less NIM pressurethan smaller competitors.

So will credit costs (that’s good). Lower borrowing costs are a gift to ChinaInc, which will face less cash flow pressure as a result. This should accrue toa slower trajectory of increasing NPLs, and thus cap the increase in banksector credit costs in 2015. Estimating the reduction in the peak NPL ratio ishard given that we are far from convinced that reported NPL ratios reflect thereality of the health of China’s corporate borrowers. However

But asset quality issues won’t be entirely resolved. Our team’s proprietarywork on the 858 bond issuers (which together account for RMB21trn or 28%of total corporate debt) indicates that RMB4.1trn or 20% of their debt can becategorized as “uncovered” on an EBIT basis in 2013. Cutting bond issuers’implied debt costs by 40bps would reduce EBIT-uncovered debt to RMB3.3trnor 16% of their total debt. So while the rate cut should alleviate the trend ofrising credit costs, China Inc’s underlying debt problems will very likely remain.

Outlook

On balance, the rate cut doesn’t change our cautious view on the Chinabanks. The move may be a short-term positive for sentiment on the entiremarket, but we don’t suggest that investors chase a possible bank rally onMonday. We retain ICBC (1398 HK, HK$4.94, O/P, Tgt: HK$5.44) and CCB(939 HK, HK5.58, O/P, Tgt: HK$6.41) as relatively conservative top picks,although admittedly ABC (1288 HK, HK$3.47, Neutral, Tgt: HK$3.47) has thebest funding franchise. BoCom (3328 HK, HK$5.72 , U/P, Tgt: HK$4.36) isour top Underperform.

We think there are better plays than the banks on the rate cut event. Thewinners should include stocks in sectors on which we have a more positivefundamental view. These include basic materials companies (see MattyZhao’s report titled Quality SOEs to win on debt theme for details) andproperty stocks (see David Ng’s recent sector note: China property:Recovery in progress).