The outlook for China's big four banks

The Empire state building dressed up in red and yellow to celebrate the official opening of ICBC's branch in New York on October 15, 2008

Record profits for Chinese banks

China's "big four" commercial banks have posted record profits in H1 08 reflecting the resilience of the Chinese economy which grew by 10.4% in the first half of the year. َ

As a matter of fact, the operating profit of Industrial and Construction Bank of China (ICBC, HKG:1398), China Construction Bank (CCB, HKG:0939), Bank of China (BOC, HKG:3988) and Bank of Communications (BOCOM, HKG:3328) grew on average by 35% in H1 08 from the same period a year ago. After-tax profit jumped on average by 62% , BOCOM leading the way with an 81% increase and BOC lagging behind with a mere 38% . In addition, the return on equity of the four largest chinese commercial banks reached a stunning 23% up from 19% a year ago.

With an after-tax profit of RMB 64.9 billion yuan ($9.57 billion) in H1 08, ICBC, which is already the bank with the biggest market capitalization in the world, became the world's most profitable bank, largely ahead of follower HSBC which posted a profit of $7,7 billion.

At a time when the United States face their worst financial crisis since the Great Depression, these figures signal a shift of financial power to China and reward the prudent policies put in place by the Chinese authorities over the last expansion cycle to reign in credit and avoid the accumulation of bad loans that clogged the banking system in the late nineties.

In a context of increased competition from both domestic and foreign players, China's "big four" banks have achieved a dramatic transformation over the last five years moving from an administrative culture to a customer-centered culture, extensively diversifying their offering of products and services, and opening up their capital to global financial institutions such as Citigroup, HSBC, and Bank of America.

Preparing for the downturn

Ironically the exceptionnal H1 profit figures have been permitted to a large extent by the PBOC's six consecutive hikes of interest rates in 2007/2008 which boosted the commercial banks interest margin, before the central bank reversed its policy in September, amid growing concerns over the economy. In fact, interest income still contributes between 75% and 85% to the operating profit of the big four, although the contribution of net fee and commission income has steadily increased over the last few years. If the PBOC lowers by 100 bp its benchmark rate in the coming months, this could cut off roughly 20% to 30% of the banks operating income.

In addition, the fee and commission income comes in part from wealth management services can be significantly impaired if the stock market does not stabilize in the coming months.

Finally, although there should be no hard landing of the chinese economy in 2009 if domestic demand remains strong enough to compensate for reduced external demand, any slowdown will impact heavily the most exposed sectors of the economy : small private export firms mostly based in the Pearl River delta, and property developers which will be hurt by the falling property prices in some of the country's major urban hubs (Shenzen, Shanghai, Hanzhou,...). Hence, credit losses are likely to rise over the next few quarters, therefore negatively impacting the commercial banks operating income.

All in all, H2 profits figures are likely to bring more sobering news than the skyrocketing H1 figures. However, with an average capital adequacy ratio of 13, with a geographically diversified business across all the major provinces of China, with a stable funding made up mostly of corporate and individual deposits, the Big Four are relatively well prepared for the downturn. Besides, the valuation of their shares is now exceptionnally attractive given their high return on assets, their low cost-to-income ratio (around 35%) and their long term growth potential.

Bottom line : if you want to make a bet on China's long term growth story then make a bet on China's big four banks !