Debt threats: China’s alarming credit-to-GDP ratio jumps from 120% to 166% in March 2011

Analysis by our China strategist Vincent Chan shows that during 2009 and 2010, total system credit financing totalled Rmb26.7 tn, representing a 71% jump in total system credit from an estimated Rmb37.8 tn in end-2008 over a twoyear-period. The credit-to-GDP ratio jumped by 46 p.p. from 120% in end-2008 to 166% by Mar-11.

Such a dramatic jump in credit-to-GDP raised a red flag as this is what BIS and the Basel
Committee is most concerned about. In a report Countercyclical capital buffer proposal
published by the Basel Committee on Banking Supervision in July 2010, it is recommended that banking regulators should gradually raise the capital buffer when the credit-to-GDP ratio is 2 p.p. above the long-term trend, and if the gap exceeds 10 p.p., the banking system could be quite vulnerable to financial system risks.

■ Asset quality the key variable: Connecting the new lending data with decelerating GDP growth, tight liquidity (authorities trying to control inflation) and higher interest rates form the recipe for loan-book stress. We are revising down our loan growth and margin assumptions while ratcheting up credit costs significantly in 2012-13E. Hence, our projected profits are 22% and 38% below consensus and show nil earnings growth for the next three years with ROEs declining to mid-teen levels from 18-21% now.

■ Downgrading China banks to UNDERWEIGHT, ABC to UNDERPERFORM and BOC to NEUTRAL (from OUTPERFORM): ABC has outperformed and has the potential for greater impairment on its county lending book. BOC may also suffer a larger impairment due to the scorching 49% loan growth (domestic loans up 56%!) in 2009. We have revised down our target prices using average 2012-13E ROEs, which are now lower. ICBC remains our top pick among China banks. While the anticipated supply of equity would be a dampener to bank stocks, a government carve-out of LGFV bad loans would be positive.