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Morningstar | 601288 Updated Forecasts and Estimates from 19 Feb 2019

Following the People's Bank of China's announcement that it will launch central bank bill swaps to improve the liquidity of banks' perpetual bonds, we’re maintaining our fair value estimates for the Chinese banks we cover. According to the central bank’s statement, primary dealers engaged in an open-market operation are allowed to swap the perpetual bonds they hold for the central bank bills. Banks' perpetual bonds with ratings no lower than AA will be included as qualified collateral for a medium-term lending facility, a targeted medium-term lending facility, a standing lending facility, and relending. This essentially provides cheap funding for financial institutions to buy perpetual bonds. Though such a measure could alleviate the market’s concern about  banks’ capital replenishing pressure and limited loan growth potential due to capital constraints, we expect a neutral impact on banks. The launch of the swaps will effectively lower funding costs as a result of improved liquidity of perpetual bonds. Loan growth will see a modest pickup after banks’ capital positions are strengthened. However, such benefits will be largely offset by lower returns on equity, given increased interest payments and reduced financial leverage.

Our top picks are Agricultural Bank of China and Industrial & Commercial Bank of China, which are trading at 23% and 21% discounts to our fair value estimates, respectively. Assuming other assumptions are unchanged, we believe current prices imply bad-debt ratios of about 13% and 10% for these two banks. We believe risks for these banks are manageable, as their prudent operations and cheap funding costs enable high profitability and thus strong ability to absorb credit losses gradually. Furthermore, solid progress as witnessed during the two-year financial deleveraging campaign mitigates our long-term credit quality concerns for banks.

We believe this measure was launched in response to rising capital refinancing needs for Chinese banks both to increases in on-balance-sheet lending to fill the funding gap left by shadow bank contractions and to meet higher capital requirements associated with the total loss-absorbing capacity buffer. As global systemically important banks, the big four banks are required to hold TLAC instruments to no less than 16% of risk-weighted assets by 2025 or 2022 if China’s outstanding financial and nonfinancial corporate bonds reach the 55% trigger for an accelerated TLAC implementation timeline per the Financial Stability Board. The current total capital ratio for the big four banks ranges from 14% to 16%, and the potential funding gap is estimated to be CNY 100 billion-450 billion for each, or 50% to 1.9 times of their 2017 net profits. We expect the funding gap of the big four banks will be gradually closed by steady organic growth (above 12% over our five-year forecast) and the issuance of perpetual bonds, preferred shares, and Tier 2 capital bonds or TLAC bonds.

The Bank of China led the banks to issue CNY 40 billion in perpetual bonds in the interbank market. The bonds are priced at 4.5%, at the low end of the pricing band ranging from 4.5% to 5.2%. The funding cost is lower than the 5.5%-6.0% range for its domestic preferred shares issuance as early in 2013. The issuance is expected to boost the Tier 1 ratio by 0.3% to 12.3%.

Though the central bank bill swaps launch will encourage banks' perpetual bond issuance, we don’t expect the issuance will reach very large scale. The risk weighting of perpetual bond investment is likely to be around 100% despite the central bank’s credit backing, which is costly for banks suffering from capital constraints. Besides, we expect perpetual bonds will be priced at around 4.5%, much higher than the average 1.5%-3.0% for most listed banks. Thus, the issuance of other Tier 1 instruments is likely to be capped at around 1% of total RWA, and the issuance of perpetual bonds is likely to account for 0.3%-0.5% of total RWA for the big four banks.