China Banking Sector
Earnings downgrade due to
more bearish macro forecasts
Lucy Feng
Research Analyst
(+852) 2203 6251
lucy.feng@db.com
David Chung
Research Associate
(+852) 2203 6136
david-hk.chung@db.com
Revising down our earnings and TP, CMB downgraded to HOLD
We have lowered earnings by 13-38% for 2009E and 12-40% for 2010E and target
prices by 4-8% for the six H-share banks under our coverage to reflect the more
bearish economic forecasts from our China economist. Additionally, we have
downgraded CMB to a HOLD following our TP revision. Our lowered earnings
forecast is driven by higher credit costs of 135-180bps in 2009E and 150-180bps
in 2010E. We have also lowered NIM assumptions by 4-30bps in 2009E and 3-
26bps in 2010E to reflect the expected further 135bps PBOC benchmark rate cuts.
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LOCATED IN APPENDIX 1.
Forecast change
Top picks
ICBC (1398.HK),HKD4.46 Buy
Companies featured
ICBC (1398.HK),HKD4.46 Buy
2007A 2008E 2009E
P/E (x) 19.9 10.9 12.1
Div yield (%) 0.3 4.6 4.2
Price/book (x) 3.4 2.0 1.9
China Construction Bank (0939.HK),HKD4.88 Hold
2007A 2008E 2009E
P/E (x) 18.6 9.8 11.6
Div yield (%) 4.0 4.1 3.4
Price/book (x) 3.6 2.0 1.8
Bank of China (3988.HK),HKD2.60 Hold
2007A 2008E 2009E
P/E (x) 17.7 8.7 9.2
Div yield (%) 1.0 4.3 3.8
Price/book (x) 2.2 1.3 1.2
Bank of Communications (3328.HK),HKD5.80 Sell
2007A 2008E 2009E
P/E (x) 21.0 8.9 13.7
Div yield (%) 1.1 4.5 2.9
Price/book (x) 3.9 1.7 1.7
China Merchants Bank-H (3968.HK),HKD16.04 Hold
2007A 2008E 2009E
P/E (x) 23.7 10.2 12.0
Div yield (%) 1.1 2.9 2.5
Price/book (x) 6.7 2.5 2.2
China CITIC Bank (0998.HK),HKD3.03 Hold
2007A 2008E 2009E
P/E (x) 24.1 7.5 8.6
Div yield (%) 0.3 4.0 4.1
Global Markets Research Company
Balance sheet strength intact despite lack of earnings growth
In our view, Chinese banks have no solvency risks, and balance sheets remain
strong when compared to other banks in the region. We emphasize that despite
the aggressive earnings downgrade from much lower NIM and significantly higher
credit costs assumptions, all six of our H-share banks still have positive earnings.
We have already factored in a very severe interest rate and asset quality
environment, so we believe Chinese banks are very unlikely to report significant
losses that would negatively impact book value. Additionally, all of the H-share
listed banks -- with the exception of CMB, which has significant goodwill following
its acquisition of WLB -- have equities that are not artificially increased by goodwill
or property revaluations.
New government policies would imply upside risks to our current estimates
We believe there could be upside risks to our gross NPL formation, credit costs
and earnings estimates due to new government policies. The China Securities
Daily reported on Dec 5 that the business tax rate imposed on banks’ gross
income could be reduced from the current 5% to 3% and applied on a net rather
than gross basis. Based on our estimates, the combined effects of a 2% business
tax rate cut and the change from gross to net basis would increase FY09E after-tax
earnings by c.5-10% for the six H-share banks under our coverage. In addition,
local media recently reported that China will set up institutions dedicated to
providing small enterprises improved access to loans. We believe such a
mechanism, if implemented properly, will significantly reduce commercial banks’
credit risks from failing SMEs. However, we have yet to include these potentially
positive developments into our forecasts because the business tax rate cut has
yet to be confirmed and the actual implementation of the institutions for SMEs
remains unclear.
Valuation – ICBC now the only Buy in the sector and remains our top pick
We reiterate ICBC as our sector top pick given its more balanced inland and
coastal loan portfolio and well-controlled growth pace (11% loan CAGR from 05 to
07). A sharp economic slowdown remains the key downside risks and earnings
swing factor. We estimate 6-7% GDP growth as a safe threshold for the banking
sector. Below this level, banks would see a significant increase in non-performing
loans. Key upside risk is that the fiscal stimulus package from the Chinese
government could significantly boost credit demand and internal consumption. If
the economy recovers much faster-than-expected, loan growth could revive and
margins could expand again.

Executive summary
Earnings lowered 12-40% in 2009-10E
We have lowered earnings estimates and refined target prices of the six H-share banks under
our coverage to reflect more bearish economic forecasts from our China economist. Due to
New GDP growth assumptions of 7.0% for 2009E and 6.6% for 2010E we have increased
2009E and 2010E gross NPL formation by another 50-100bps to 2.5% and 3.0%,
respectively. Credit cost estimates have therefore been increased to 135-180bps in 2009E
and 150-180bps in 2010E.
Additionally, our China economist expects another 135bps PBOC benchmark rate cut, so we
have lowered our NIM assumptions by 4-30bps in 2009E and 3-26bps in 2010E to reflect
lower spreads from the lending business, lower interest rates from the central bank
requirement reserve and significantly lower bond yields from reinvestments. As a result, we
have lowered earnings estimates 13-38% for 2009E and 12-40% for 2010E for the six Hshare
banks under our coverage.

Target prices adjusted slightly by 4-8%, CMB downgraded to Hold
We have fine-tuned our target prices as a result of the earnings cut, but we believe the
current lackluster earnings do not reflect longer-term margins given the current financial
crisis, so we have only cut our sustainable ROE assumptions by 0.2-0.5pct.

CMB has risen by over 30% (vs Hang Seng Index’s 8.7%) following its 3Q08 result on Oct.
30, but we believe further upside is limited, as reflected in our earnings and target price
revisions, and hence have downgraded CMB to Hold. We continue to believe the upcoming
4Q results could negatively affect share performance.
Key upside risks from new government policies
As top policy makers discuss ways to ensure GDP growth remains at a relatively high level,
the government is likely to initiate a cut in the business tax to add a stimulus to the slowing
economy. The Three-Day Annual Central Economic Work Conference in Beijing in December
will likely set the tone for next year’s policies.
Potential business tax rate cut is earnings accretive
The China Securities Daily reported on Dec 5 that the business tax rate imposed on banks’
gross income could be reduced from the current 5% to 3% and applied on a net rather than
gross basis. Note that the business tax is currently imposed on gross interest income from
loans and advances to customers (i.e. it excludes other interest income from government
bonds or interbank loans) and gross fee and commission income.
Based on our estimates, the combined effects of a 2% business tax rate cut and change
from gross to net basis would increase FY09E after tax earnings by c.5-10% for the six Hshare
banks under our coverage.

New institutions for SMEs will help ease asset quality issues
Local media recently reported that China will set up institutions dedicated to providing small
enterprises, which are suffering the most from the global financial crisis, better access to
loans. According to the China Banking Regulatory Commission (CBRC), the move is intended
to help avoid widespread bankruptcies and lay-offs. Small- and medium-sized enterprises
(SMEs) in China -- labour-intensive enterprises vulnerable to fluctuations in domestic and

external demand -- have been particularly badly hit by the global financial crisis. In the first
half of the year, 67,000 SMEs shut down and laid-off millions of employees, as calculated by
the National Development and Reform Commission. The CBRC said the institutions would be
established by commercial banks as quasi-corporate bodies or subsidiaries that would be
independently run. The institutions are expected to have a system for the provision of bad
loans that is separate from their parent banks. They will apply a different mechanism for
writing off bad loans, making it easier for them to get rid of the NPLs on their books. We
believe such a mechanism, if implemented properly, would significantly reduce commercial
banks’ credit risks from failing SMEs and partially address investors’ concerns about Chinese
banks providing national services in order to bailout the overall economy.
New government policies would imply upside risks to our current estimates
We see the above two developments as potential positive catalysts, but we have not yet
built them into our forecasts because the business tax rate cut has yet to be confirmed by
the regulators and there is still a lot of uncertainty regarding how the institutions for SMEs
would operate. Since SMEs are widespread throughout the country, there is a significant risk
that these institutions will not be set up in time for the SMEs in need to obtain the required
funding.
Nevertheless, if these developments do take place, we believe there could be upside risks to
our gross NPL formation, credit costs and earnings estimates.