China strikes first in 2019 with RRR cut

We reaffirm our Overweight call on China Financials.
Chief Investment Office07 Jan 2019
Photo credit: AFP Photo

In 4Q18 and 1Q19’s CIO Insights, we highlighted our Overweight calls on China and its Financials sector, on expectations of pro-growth policy stimulus, improving earnings fundamentals, compelling valuations, and sound balance-sheet quality. With the latest measure from the People’s Bank of China (PBOC), we reaffirm our constructive stance.

The PBOC announced last Friday (4 January) to cut its reserve requirement ratio (RRR) by 100 bps, to be applied in two equal moves on 15 and 25 January. The main purposes are to replace the maturing of medium-term loan facilities (MLF) in 1Q19 and supply liquidity to the economy ahead of the Lunar New Year. At 3.30%, the 1-year MLF cost of funds is significantly higher than the 1-year savings deposit rate of 1.50%. Consequently, the repayment of MLF will immediately ease banks’ funding costs. The RRR cuts will free up longer-lasting liquidity at lower costs, compared with MLF.

Once the cut is fully implemented, the RRR for large banks will be reduced to 13.5% and should restore monetary conditions (Figure 1). This will also boost lending activities and change the current market perception that the private sector and small-and-medium enterprises (SME) are facing tight liquidity.

Improving China Financials’s operating environment. In its official announcement, the PBOC reiterated its stance of “targeted easing” and maintaining a stable monetary policy. The easing could boost money supply against the backdrop of a manageable non-performing loan (NPL) ratio of 1.5% among large banks and the sector’s average of 1.9% (Figure 2). Combining the RRR adjustment and targeted MLF, this will release a net CNY800b (USD117b, after factoring in the repayment of some maturing MLF) of liquidity into the system, equivalent to 0.9% of gross domestic product (GDP) value..

The banking sector looks promising, with underlying fundamentals improving consistently, as evidenced from the recovery in net interest margins (NIM) and mortgage rates (Figure 3). Such stability in NIM and lending rates is a prelude to the rerating of the sector’s investment outlook.

Moreover, the sector still boasts ample capacity to expand its loan book. At a loan-to-deposit ratio of 74%, banks’ balance sheets are still a distance away from reaching their optimal level (Figure 4). The positive yield curve will be another supportive factor for banks’ NIM on favourable maturity transformation and asset/liability management (Figure 5).

Figure 1: China RRR and monetary conditions

Source: Bloomberg, DBS

Figure 2: Striking a balance between asset quality and liquidity growth

Source: Bloomberg, DBS

Figure 3: Net interest margins and mortgage rates on the rise

Source: Bloomberg, DBS

More room for policy to offset external headwinds. The government has expedited credit support to the private sector and SMEs which have faced credit tightening amid the deleveraging measures in early 2018. As such, there is high likelihood policymakers will continue to provide support and incentives in the coming quarters, resulting in a rebound in capital investment and other economic activities. Together with the government-led infrastructure spending, these measures should offset external headwinds and set the economy back on the path of stable quality growth.

After the Global Financial Crisis, the correlation between GDP-to-loan growth was at a range of 0.5-0.6x (Figure 6) where every percentage point of new loan granted added 0.5 percentage points of GDP growth. Based on the total banking sector’s local currency loan value of CNY135.2t, the CNY800b released by the RRR cut is equivalent to an additional 0.6 percentage points of new liquidity, and could sequentially add 0.3-0.4 percentage points of GDP growth over the coming 12 months. We foresee the Chinese authorities continuing to remain practical and prudent in implementing monetary easing to ensure its effectiveness and avoid volatility in CNY exchange rates.

Figure 4: Capacity to lend more

Source: Bloomberg, DBS

Figure 5: Bank profitability will sustain

Source: Bloomberg, DBS

Figure 6: Bank loans have positive effect to GDP growth

Source: Bloomberg, DBS

Economic transformation for the win. China’s monetary easing is timely, in tandem with the US Federal Reserve hinting at slowing down rate hikes. This clearly shows Beijing’s commitment to spur its economy, which is increasingly powered by domestic services and consumption – the result of the government’s economic transformation efforts to develop its tertiary industries (Figure 7). Notably, the tertiary industries’ contribution to GDP has consistently expanded and reached 51.6% in 2017 from 32.4% in 1990, and has outstripped the secondary industry since 2012.

The size of China’s economy, on a purchasing-power-parity-adjusted basis, reached 18.2% of global share in 2017, and is projected to reach 18.7% in 2018 and 21% by 2023, respectively. This is a massive leap from a mere 2.3% in 1980 (Figure 8).

Constructive on China Financials. We remain constructive on China Financials and favour large banks and insurance companies, on improving fundamentals, earnings stability, compelling valuations, and attractive dividend yields. Upon the announcement of the RRR cut, there was an immediate spike in the sector’s earnings forecast, reflecting the positive impact on profitability (Figure 9). The sector is trading at forward price-earnings ratio of 6x and forward price-to-book ratio of 0.7x, on 10% earnings growth in 2019 (Figure 10), while the sector dividend yield of >5% is sustainable on a contained payout ratio of 30%.

Figure 7: Services sector taking the lead

Source: Bloomberg, DBS

Figure 8: China’s GDP increasing influence globally

Source: Bloomberg, DBS

Figure 9: Immediate spike in earnings outlook

Source: Bloomberg, DBS

Figure 10: Price-to-book at floor valuation

Source: Bloomberg, DBS

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