China Financials – Dividend Narratives

Share prices of China banks have experienced volatility over the past months (Figure 1). This is primarily due to news regarding certain groups of homebuyers’ refusal to service their mortgage ...
Chief Investment Office04 Aug 2022
Photo credit: AFP Photo

Share prices of China banks have experienced volatility over the past months (Figure 1). This is primarily due to news regarding certain groups of homebuyers’ refusal to service their mortgage obligations on unfinished residential projects amid suspension of construction works and delayed deliveries by a number of cash-strapped developers.

Investors may be wondering what the impact of the boycott in mortgage repayments are on the banking sector as these repayments are used to fund the working capital of real estate developers. Headline news have painted a cautious picture of the impact to real estate and its related sectors. However, the direct real estate sector as a percentage of China GDP is low at 6%-7% since 2010 (Figure 2).

Our fundamental investment thesis on China banks is predicated on their ability to provide steady income through attractive yields of 6-7% which fit well on the income side of the CIO Barbell Strategy. Over the past few years, China banks have endured economic challenges brought about by the pandemic and have maintained dividend payments. It remains a strategically important sector to the government.

Figure 1: China banks

Source: DBS

We believe the recent issue of select homebuyers’ refusing to service their mortgages should not pose any inherent long-term risk to China’s overall economic trajectory and the banking sector.

Figure 2: Real estate as a percentage of GDP (1995 – 2021)

Source: DBS

While the list of halted projects as at the end of 2021 was estimated at CNY466b (USD70b), this value is a manageable 0.4% of China’s gross domestic product. These projects would have reached a certain level of construction progress and we believe they are mostly commercially viable for developers and relevant parties to resume construction in order to realise full project payment and entice homebuyers to continue servicing their loans.

Figure 3: Value of halted projects (CNYb)

Source: China Real Estate Information Corp, Bloomberg Intelligence, DBS

Knowing the importance of the real estate sector to the local economy and the implications to consumer confidence, China is likely to introduce government-driven solutions to resolve the stalemate. Possible resolutions include:

  1. Special purpose bond issuance by local or provincial governments
  2. Banks to extend loans at specific project levels
  3. Regulators to work with creditor banks to restructure the outstanding developer loans
  4. Local authorities and industry peers to take over the completion of these projects

It is important that the gridlock is ultimately resolved, given the wide range of stakeholders involved – local government bodies, commercial banks, building contractors, construction firms, material suppliers, real estate developers and their employees, as well as homebuyers. Nonetheless, we believe these homebuyers will eventually resume the mortgage servicing so as not to impact their domestic personal credit rating which was implemented since 2014. From the banking sector standpoint, non-performing loans (NPL) ratio has stayed at 1.7% over the past 5 – 6 years (Figure 4) and is likely to stay within a manageable range as banks take prudent steps to maintain asset quality. Take the four largest banks as example. They have set aside loan loss provisions of 250% as at the end of March 2022 (Figure 5), amounting to CNY2.8t collectively. This will play a pivotal role for banks in maintaining stable balance sheet quality, cushioning the impact of economic volatility.

Figure 4: China banking sector NPL ratio (December 2006 – June 2022)

Source: DBS

Figure 5: Average loan loss provision of China’s 6 largest banks (December 2010 – 1Q22)

Source: DBS

Among China financials, our preference remains with large state-owned banks that have strong balance sheets with higher loan loss provisions, NPL ratios lower than industry average, and large capital bases. Large banks can tap cheaper funding from their larger current-account-saving-account (CASA) deposit base, have more diversified loan book composition and lower percentage of exposure to real estate mortgages.

Large state banks in China distribute 30% of their net profit after tax in the form of dividends (Figure 6), which we think is sustainable as evidenced over various cycles. The following chart (Figure 7) shows the four largest state banks offer average dividend yield of 8%-9% based on current share prices; admirable dividend returns by any standard.

Figure 6: Consistent and sustainable dividend payout ratio at 30%

Source: DBS

Figure 7: Attractive dividend yield of 8%

Source: DBS

To put things into perspective, investments in China H-shares listed banks since 2010 would have generated a total return of 60% contributed by accumulation of dividend income (Figure 8), in spite of prices remaining flat.

Figure 8: The power of dividend accumulation (2010 = 100)

Source: DBS

The recent selloff was primarily due to investors’ concerns about NPLs caused by the mortgage boycotts, but the scenario should reverse once resolutions are reached.

The sector’s price-to-book multiples corrected further to 0.5x (Figure 9) after the recent selloff, although the sector’s fundamentals remain largely intact. While near-term volatility is likely to persist, investors should not be demoralised by the recent chain of events as we expect upcoming policy initiatives.

As such, we advocate our constructive view on China large banks for their attractive dividend yield, balance sheet strength, and the government’s unwavering commitment to maintain the wellbeing of the world’s second largest economy, including the stability of its banking sector.

Figure 9: China banks at steep valuation discount

Source: DBS

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