The author is Bernstein Research senior analyst Mike Werner
Since the peak of the SHIBOR (Shanghai Interbank Offered Rate) crisis in late June, the Chinese banks have staged a mini-rally as their shares are up 13%, on a weighted-average basis, outperforming the regional MXAPJ Index by 840bp over this period.
Despite this, the Chinese banks continue to trade at very undemanding price-to-book multiples of just 1.06 times.
Based on the strong correlation between ROEs (return on equity) and P/B (price to book) ratios for the top 100 global banks, the Chinese banks are trading at a sizable 50% discount to their global peers.
The low valuation tells us the market is pricing in a sustainable ROE of 9.4% for the Chinese banks. This is well below the 21.2% they reported in 2012. It is also below the 18.0% that the market expects from the group in 2014.
For the Chinese banks to achieve a 9.4% sustainable ROE, net interest margins would have to decline 90 basis points (one percentage point equals to 100 basis points) to 1.75%, or annual credit costs would have to rise 145bp to 1.90%. A combination of the two scenarios would also suffice.
These scenarios imply that the Chinese banks’ risk-adjusted net interest margins will fall to 1.40%, lower than most major countries in the world, even the over-banked Taiwan.
We forecast the banks will face a 30 basis points decline to their net interest margins and a 40 basis points increase to credit costs from current levels to sustainable levels where they will generate 14% to 15% ROEs.
Another explanation for the low valuations is that the market believes the book value of the Chinese banks is inflated by 50%. The market is pricing in a scenario where the Chinese banks’ book value is half of its reported value.
For this to occur, 15% of the banks’ loan books would have to deteriorate into non-performing loans immediately.
Our forecast is that the Chinese banks will face non-performing loan formation of 9% (cumulatively) over the coming 3 to 4 years, much lower than the scenario currently being priced into the Chinese banks.
As a result, we view the valuation of the group as attractive and prefer the large banks.
(The article has been edited for clarity)
