China Bank: Downgrade ICBC, CCB and BOC to U-PF; SELL CMB, Bocom, CNCB.

We lower ICBC, CCB from BUY to Underperform, BOC from Outperform to Underperform, reinitiate coverage on CNCB with a SELL and maintain SELL on CMB and Bocom. While heavy NIM pressure should offset the boost of strong loan growth, provision charges will rise sharply and NPL balance should double in FY09-10. Regulators are also likely to tighten provisioncoverage requirement from 100% to 130% for large banks and to 150% forsmaller ones. H-share banks will see disappointments in 4Q08 earnings and EPS decline in FY09, with the exception of ICBC.

Provisions - The verdict is out. We see gross NPL balance for H-share banks to increase 110% in FY08-10CL, with most of the NPLs coming from manufacturers and property developers. ICBC (1398 HK - HK$3.45 - BUY) and CCB (939 HK - HK$3.94 - BUY) should see the least impact, but CNCB (601998 CH - Rmb4.08 - BUY), Bank of Comm (3328 HK - HK$5.14 - SELL) and CMB (3968 HK - HK$12.60 - SELL) will be most affected. Guidance from CNCB shows that regulators in China may have tightening provision-coverage requirements from 100% to 150% for CNCB and Bocom. We believe the requirement for ICBC, CCB and BOC is set at 130%. This supports ourlongholding views that investors should avoid small banks.
NIM pressures. We see NIM pressures not only from falling interest rates, but also weakening pricing power. We see a further 108bps rate cuts in FY09.Most of the lending in FY09-10CL should go to government departments and stated-owned enterprises, which are low-margin lending. Strong loan growth not sufficient to sustain EPS. Despite slowing economy, loan growth should be sustained by aggressive infrastructure spending. For example, the Ministry of Railways has secured loan commitment of Rmb2tn. However, most of the positive impact should be offset by NIM pressure.

Underweight H-share banks. Large banks should see less pressure on NIM and lower provision requirements. ICBC should be the only bank that can achieve modest EPS growth, but valuation is not appealing. BOC is the cheapest large bank, but overhang from US mortgages-backed securities remains. CCB should see more NIM and NPL pressure than ICBC. Small banks - Bocom, CMB and CNCB - will be hit the hardest.

ICBC - Fairly valued. With our more cautious outlook on NPLs and NIM in the sector, we have cut ICBC FY08-10CL EPS by 5-9% and hence downgraded it from BUY to U-PF. Despite that, we continue to see ICBC as the top pick. We believe ICBC will see the least NIM pressure, due mainly to its fixedinterest-rate bonds. The bank’s prudent growth policy in the past four years suggests relatively low NPL risks. Longer-term, we believe ICBC’s leading position in China banking should remain unparalleled. However, trading the 1.6x FY09 PB, valuation seems to have priced in the resilience.

CCB - Second to ICBC. Our more cautious sector stance has led us downgrade CCB FY08-10CL EPS by 19-42% and our rating from BUY to U-PF. Nevertheless, CCB remains a preferred stock in the sector. Given its historical niche in infrastructure financing, low loan/deposit ratio and strong capitaladequacy ratio, we see CCB as the prime beneficiary of infrastructure-related lending boom. Furthermore, though CCB’s NIM may contract due to falling interest rates, we believe the pressure should be second-lightest in the sector. Like ICBC, CCB should be less affected by rising NPLs, given itshigh exposure to SOE lending.

BOC - MBS overhang remains. Poor performance from BOCHK and more writedown from its US-dollar mortgages-backed-securities (MBS) portfolio point to downside risks in earnings and we see consensus estimates as too high. In FY09-10CL, we see BOC’s ROE to remain at about 12-13% and EPS to be flat, as removal of currency-translation loss due to renminbi appreciation should help offset NIM pressures and rising credit costs. Unless US credit market stabilises, deteriorating domestic fundamentals mean that conditions for ROE improvement are lacking. While we are getting cautious on H-share banks as a whole, we downgrade to U-PF from O-PF.

CMB - Capital constraints. Despite the 16.1% underperformance in the past three months, we continue to see downside at CMB. In addition to NIM pressure from falling renminbi interest rates, CMB’s integration with Wing Lung Bank (96 HK - HK$153.50 - N-R) will further drag NIM. We see CMB’s NIM to contract by 79bps from 1H08 to FY10CL - the most pronounced in the sector. While its sector-highest exposure to property and SME loans remain concerns, we flag the risks of goodwill writedown and capital constraint. Our target price of HK$8.83 implies 30% downside. Reiterate SELL.

Bocom - Stuck in the middle. We continue to see severe NIM pressures on Bocom, given its sector-fastest deposit migration. While Bocom’s assetliability structure is similar to its smaller competitors, it is classified as a large bank by regulators, which means the benefit from lower required-reserve ratio is not applicable to the bank. All in, NIM pressure at Bocom should be higher versus ICBC and CCB. Bocom is more exposed to rising NPLs and our analysis shows that Bocom should be hit the second-hardest in the sector, although its coverage requirement only increases to 130%. Maintain SELL.

CNCB - Main victim of NPLs. While removal of the 75% loan/deposit-ratio cap bodes well for CNCB, it should see strong NIM pressure, as it may need to raise more high-cost deposits to support loan growth. Meanwhile, aggressive growth (loans; risky exposures) over the past few years buoys credit risks. Our analysis shows that CNCB could be hit the hardest amid rising NPLs. Though the stock is trading below book, we see little catalysts to drive a rerating. Reinitiate coverage with a SELL call.

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