Government to support economic revival. At the close of the National People’s Congress, the newly appointed Premier Li Qiang announced a GDP growth target of 5% for 2023; this came on the heels of a 3% growth recorded by the world’s second largest economy in 2022.
The government’s commitment to spur growth is evident from the sharp increase in new loans of CNY5.8t between December 2022 and February 2023, representing a 98% y/y increase.

Source: Bloomberg, DBS

China financials as a sector plays an important role in the CIO Barbell strategy construct as it delivers attractive and sustainable dividend yields (Figure 2). The total return from investing in China financials has been resilient during last year’s market rout as it concluded the year flat (Figure 3) despite declines in global equities (-18%) and Asia ex-Japan equities (-21%).

Source: Bloomberg, DBS

Source: Bloomberg, DBS

Unscathed by banking debacle in developed markets

We maintain our stance that China’s large State-owned Enterprise (SOE) banks are substantially insulated from external shocks currently faced by banks in the developed markets, owing to the former’s traditional business models.
The majority of China banks’ revenue and balance sheets are domestic centric, anchored by conventional deposits and loans. Notably, China SOE banks are known for their strong local branding and nationwide branch networks with access to cheap Current Account Savings Account (CASA) funding, and the discipline to stay away from exotic deposits and loans. As such, they are unscathed by the debacles affecting Western financial institutions.

Our constructive stance on China large financials rests on the following fundamentals:

1. Strengthening regulatory oversight. The government announced the establishment of a new financial regulatory agency—National Financial Regulatory Administration (NFRA)—to consolidate regulatory oversight of the world’s largest banking sector by asset value, bridging the gaps between multiple financial sector agencies which currently oversee different areas. As at 3Q22, China’s banking sector’s total assets stood at c.USD52t, an exceedingly important element in China’s economic ambitions (Figure 4).
   
   Figure 4: A sector too important to fail

    
   

   Source: Bloomberg, DBS

2. Loan growth. The government has set a growth target for total social financing in 2023 to be in line with nominal GDP growth estimated at around 7%-8% where large commercial banks will play pivotal roles to supply the necessary funding. This bodes for a better outlook for loan growth and net interest income. As at February 2023, China’s total social financing had grown 9.9% y/y.
3. Loan quality. Large state banks and the broad financial sector have their balance sheets predominantly anchored within China with minimal exposure to overseas assets and liabilities. The large banks have extended loans mainly to SOEs, government-linked projects, local large private sector enterprises, and consumer mortgages. These loans are usually of better quality and face low default risks even during past crises. The sector’s non-performing loan (NPL) ratio has stayed low at the range of 1.6%-1.7% over the past few years and is likely to remain (Figure 5).
   
   Figure 5: Non-performing loans in check

    
   

   Source: Bloomberg, DBS

   
   
   Figure 6: Strong balance sheet

    
   

   Source: Bloomberg, DBS

4. Capital base. Between 2010 and 2022, the combined capital of China’s six largest banks had increased four-fold (Figure 6) and their loan loss provisions reached 250% (Figure 7). The banking sector’s capital adequacy ratio and tier-1 capital adequacy ratio improved further, registering 15.2% and 12.3% respectively as at 3Q 2022 (Figure 8). These figures reflect the sector’s resilience.
   
   Figure 7: Buffered for loan losses

    
   

   Source: Bloomberg, DBS

   
   
   Figure 8: Well capitalised

    
   

   Source: Bloomberg, DBS

5. Yields. At the current price, China’s large SOE banks are rewarding investors with attractive and sustainable dividend yields of 7-8%. Over time, they have delivered appealing cumulative total returns to investors (Figure 9).
   
   Figure 9: The power of dividends (2010 = 100)

    
   

   Source: Bloomberg, DBS

6. Property loan exposure. China banks’ loan exposure to real estate developers declined to 5.9% at the end of 2022, a significant improvement from the peak of 7.6%. Exposure to mortgage loans have likewise declined to 18.9% from the peak of 21.8% (Figure 10). Using Hong Kong as a reference where residential mortgage NPL among commercial banks have remained low during past crises ((a) 2000 dot.com bubble, b) 2003 SARS pandemic, c) 2008 GFC, d) 2020 Covid pandemic (Figure 11)), we reckon the NPL of mortgages among China’s large banks should remain stable and low.
   
   Figure 10: Exposure to property loans manageable and declining

    
   

   Source: Bloomberg, DBS

   
   
   Figure 11: Referencing Hong Kong banking sector as a guide for NPL outlook

    
   

   Source: Bloomberg, DBS

7. Valuations. China financials trade at floor valuations. At a historical price-to-book ratio of 0.5x (Figure 12), the sector is valued at -1.5 standard deviation to historical mean. Similarly, the forward P/E ratios of 5x-6x against projected earnings growth of 11% over the next two years indicate that the market is pricing in a lot of pessimism which we believe is unjustified. These risk-reward metrics appear attractive by any standard.
   
   Figure 12: Compelling valuations

    
   

   Source: Bloomberg, DBS

Recommendations
China’s large SOE banks are well positioned as income generators in the CIO Barbell Strategy for their attractive and sustainable dividend yields of 7-8%. This is supported by the sector’s compelling valuations on the back of stable earnings growth of 5-6% over the next two to three years. As such, we continue to advocate China financials as part of a holistic portfolio strategy construct.