Chinese Banks: Financial Impact of Rising LGFV Default Risks Is Manageable to Large Banks

The Hang Seng Mainland Banks Index has declined 11% from its recent peak in early May. We attribute the decline to increasing concerns about downward pressure on banks’ net interest margins, or NIMs, and growing risks related to debts of local government financing vehicles, or LGFVs, amid a weak economic recovery and struggling land sales. We believe SOE banks have smaller exposures to LGFV debt and that their credit quality is better than peers given strong bargaining power to implement prudent borrower selection. Monetary and fiscal easing and the government’s strong support for troubled regional banks also limit systemic risks, in our view. That said, we believe the ongoing LGFV loan restructuring is likely to weigh on banks’ NIMs and the classification of restructured loans as special-mentioned loans will also increase provision expenses for banks. We maintain our fair value estimates for Chinese banks as we already factored in a NIM reduction of 10-25 basis points this year and expect credit costs to trend in line with our existing forecasts.

Our preferences for investment among Chinese bank stocks are Agricultural Bank of China, or ABC, and China Merchants Bank, or CMB. We expect the market will continue to favor state-owned banks for their defensive qualities of cheap valuation, high dividend yield, and favorable base effect for revenue growth in the third quarter of 2023. However, if further economic weakness triggers broad-based interest rate cuts or service fee cuts to support the economy, SOE banks will be more adversely affected by such changes. We have seen mild recoveries in auto sales, credit card transactions, issuance of bank wealth management products, and sales of fixed-income fund products continue. We expect investor preference for Chinese banks will rotate back to retail-focused banks in the fourth quarter of 2023 on recovery in consumer and investment activities and a favorable base effect in noninterest income.