Banks navigate China slowdown with caution

If markets stabilise from their bout of volatility, wealth management income could rebound. Piyush Gupta, group CEO of DBS, says: “We’ve had a solid wealth management quarter because we’ve had a lot of new money flow. We’ve got over $10 billion of net new money [in 1HFY2022], which is double what we normally get.” For most private banks, AUMs are down because asset values fell. “We made up for it by getting new money into the system. Also, we have slightly more deposits in our wealth management base than a lot of other private banks. That part of the story is good,” adds Gupta.

The other part of the story, as he tells it, is that annuity income is quite low. “What we make through regular fees is not more than 10%. The bulk of the income we make is through trading activities. When clients are worried, they are not in the market trading. That activity is a function of market confidence and market data. So the underlying question is what happens to the markets at the end of the year?” If China has bottomed and the market recovers, the wealth part of the business could come roaring back, Gupta hopes.

China too big to fail

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For all the risks volatile markets and rising interest rates pose which include more expensive mortgages, higher credit costs and slowing economies, the elephant in the room is China indeed. Now accounting for almost a fifth of global GDP, China is the reason why DBS and OCBC acquired banks in Hong Kong. DBS bought Dao Heng Bank way back in 2002 for $10 billion. In 2014, OCBC acquired Wing Hang Bank for HK$38.7 billion which was equivalent to $6.2 billion at that time. Over the years, OCBC has built up a 20% stake in the Bank of Ningbo. In April 2021, DBS acquired a 13% stake in Shenzhen Rural Commercial Bank for RMB5.3 billion ($1.08 billion).

While DBS and OCBC reported sterling 2QFY2022 earnings on the back of NII gains, their Hong Kong subsidiaries reported y-o-y and q-o-q declines. DBS Hong Kong reported a net profit of $593 million, down 4% y-o-y. OCBC Wing Hang reported a 39% y-o-y decline in 1HFY2022 net profit to HK$590 million ($103.6 million) while 2QFY2022 earnings fell 5% q-o-q to HK$287 million. OCBC’s associates, mainly the Bank of Ningbo, contributed $254 million in 2QFY2022, up 15% y-o-y but down 4% q-o-q. In 1HFY2022, OCBC’s associates contributed $499 million, up 18% y-o-y.

“NIM has not increased because we are not a top-three player in Hong Kong. Our Casa [current account savings account] is not as high as what we have in Singapore. What this translates to is that for some of the loans we have on the market, we are a price-taker,” explains OCBC group CFO Darren Tan.

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“Even though we fund ourselves in the market at a higher rate, we will not be able to pass on completely to our customer base, which is why NII in OCBC Wing Hang has not increased as much,” Tan adds.

Property overhang

Just as China looms large for local banks, property looms large in China’s economy.

According to DBS Economics & Strategy, the uncertainty surrounding the asset quality of Chinese banks has increased amid a real estate downturn. The most consequential risk is the ballooning number of homebuyers refusing mortgage service given delivery concerns. “We estimate that RMB1.1 trillion to RMB1.8 trillion of mortgages are at risk. This could lower banks’ Tier 1 capital ratio by 40–80 bps in the worst-case scenario. Additionally, falling revenues related to land sales may lead to spending curbs by local governments. Our analysis shows that large banks will have ample capital to withstand such headwinds, and central government support could provide additional cushion,” says the team at DBS Economics & Strategy.

In an Aug 8 report by Fitch Ratings which cited the National Bureau of Statistics (NBS), China’s primary residential housing sales fell 32% y-o-y in 1HFY2022. Meanwhile, industry research by CRIC China indicates a sharper 50% decline in aggregate sales of the top 100 real estate developers. “State-owned developers outperformed private developers as homebuyers remained concerned about homebuilders’ financial stability,” Fitch Ratings notes.

As a rough guide, the People’s Bank of China (PBOC) indicated that direct investment in real estate in 2020 reached about RMB7.5 trillion or 7.4% of GDP. Data from NBS shows that the construction industry, which is directly related to real estate, contributed RMB7.3 trillion or 7.2% of GDP while property-related financial services contributed 8.3%. In the same year, some 51.5% of investments in fixed assets involved real estate.

“Private developers’ weak sales and muted access to financing will hamper their ability to launch new projects. This will further pressure their liquidity in the longer term and lead to more defaults and restructuring in their capital-market debt,” Fitch Ratings says in the Aug 8 report.

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Fitch believes the recent rise in the number of homebuyers suspending mortgage payments over stalled projects underlines the potential for China’s property crisis to deepen, as diminishing confidence could stall the sector’s recovery, which will eventually ripple through the domestic economy. The boycott has driven policy intervention to shore up the property market. For example, the central government has urged banks to support unfinished projects by collaborating with local governments and asset management companies.

“A failure to stop the spread of mortgage payment boycotts will add pressure on banks, dampen homebuyers’ sentiment and further squeeze the funding and liquidity positions of developers, many of which are already in severe liquidity distress,” Fitch Ratings says.

Whether these dire warnings pan out remains to be seen. When asked about its exposure to China property, the management of each bank was quick to point out that it has a small onshore presence in China. Helen Wong, group CEO of OCBC, says that the bulk of its NPLs or non-performing loans in China is not real estate. “Yes, we do have real estate exposure but it is not substantial. Overall, onshore China loans make up just 2% of our book,” she adds.

Wong acknowledges that OCBC has a “small” portfolio of onshore mortgages which are predominantly in Shanghai and the Pearl River Delta for completed projects. “The LTV (loan-to-value) is particularly low for this portfolio as of June, so we’re pretty comfortable with this portfolio, but it is indeed a very small portfolio,” she says.

Similarly, Gupta says DBS’s main exposure to Chinese property is through network customers from Singapore. UOB’s NPLs for Greater China increased by $524 million h-o-h in 1HFY2022 due to the downgrade of a major real estate corporate account. According to UOB group CFO Lee Wai Fai, the rest of its China real estate exposure is via network customers out of Singapore.

Fitch Ratings warns that an extended housing slump in China would contain growth in overall fixed-asset investment, decelerating the expansion of engineering and construction (E&C) companies. “The sector, in general, has been in difficulty since 2021. With halted projects and delays in receivable payments, local state-owned and privately owned E&C companies and contractors with high exposure to property projects are under pressure from weak cash flows and a drain on their liquidity,” Fitch cautions.

GBA strategy still core and key

Previously, OCBC’s management had identified China as a megatrend and had articulated a Greater Bay Area (GBA) strategy.

Wong, who became CEO in April 2021, remains committed to the GBA strategy and China. “Our strategy is very much supporting the flow between China and Asean, on the investments that come this way, I think there is still quite a lot of business to do. Many Chinese customers or MNCs have started operations for some time now, in some of the Asean countries,” Wong indicates.

For example, Wong cites companies that have invested in Penang, and fintech companies from China based in Singapore. In addition, on the sustainability front, Chinese companies big on electric vehicles (EV) and batteries are sourcing commodities from the region.

OCBC’s onshore presence in China is limited. “You have to think about the competitive positioning of us as a banking group in China. Of course, it is very competitive with the big Chinese local banks. So to compete by lending in China alone is not a good strategy. But to help Chinese companies going to other parts of the world where we have a good presence, that is something we want to do,” Wong says.

At present, travel between the GBA and Asean is curtailed to contain the spread of Covid-19. Chinese customers who want to travel out of the GBA into Hong Kong or vice versa are very much limited, Wong points out.

“But in the longer run, the flow [of trade and investment] within Asia, demand for banking, wealth management and insurance products will also increase as the market becomes more affluent. And I think the important thing is putting our act together as one group and as one bank to capture and serve our customers on a regional basis,” Wong says.

Tan Teck Long, executive vice-president and head of global wholesale banking, reiterates Wong’s view of how OCBC positions itself in the GBA. “As a foreign bank, the strategic positioning for China is really about delivering our network outside Mainland China. Basically, there are two flows which are important to us. One is the Mainland China and Hong Kong flow. The other is the flow between the Greater China and Asean.”

Growth in other regions

Back in 2011, UOB set up the Foreign Direct Investment (FDI) Advisory unit to assist and enable the flow of trade and investment between other parts of the world including North Asia, Asean and within Asean.

For the first five months of 2022, cross-border wholesale banking income rose by 13% y-o-y, and in 1HFY2022, cross-border income formed 29% of wholesale banking income. In addition, income from cross-border suppliers and distributors within UOB’s Financial Supply Chain Management (FSCM) solution rose by 69% y-o-y in 1HFY2022.

While UOB’s retail banking operating profit fell by 10% y-o-y in 1HFY2022 to $820 million, Asean’s economies have started to reopen.

“Asean countries benefit from easing of safe distancing measures and resumption of air travel. In particular, Malaysia and Indonesia gain from the recovery in domestic consumption and higher energy and commodity prices. Asean countries benefit from the ongoing disruption to the global supply chain. Many multinational companies have adopted the China + 1 strategy and have plans to set up alternative production facilities within the Asean region,” says Jonathan Koh, an analyst at UOB Kay Hian.

Since its launch in 2019, UOB TMRW, UOB’s digital bank, has added one million active customers. UOB’s group CEO Wee Ee Cheong says UOB TMRW expects to acquire a further half a million customers this year.

In January, UOB announced it is acquiring Citigroup’s retail portfolio in Malaysia, Thailand, Vietnam and Indonesia for around $4.9 billion, which is equivalent to 1.2x book. This comprises Citi’s NAV of $4 billion and a premium of $915 million. The acquisition almost doubles UOB’s regional retail customers from 2.9 million to 5.3 million, assuming a 10% attrition rate.

“We are happy with the progress,” Wee says of the Citi acquisition. “We are targeting legal closing for Thailand and Malaysia by the end of this year, Vietnam by the first quarter, and Indonesia by the fourth quarter next year. Citibank staff have given us a strong vote of confidence, and 90% of the staff in Thailand, Malaysia and Vietnam have agreed to join us. In Indonesia, 75% of the leadership team will come on board,” he adds.

“[The Citi acquisition] will add 3% to loans and 5% to AUM and around 5% to EPS in steady state. The deal is in commercial banking, one of UOB’s core strengths, providing a clear path to integration,” says a JP Morgan update on Aug 1.

Elsewhere, OCBC’s earnings were boosted by an 82% y-o-y and 35% q-o-q rise in contributions in 2QFY2022 to $374 million, thanks to 88%-owned insurance company Great Eastern Holdings (GEH).

“The strength in GEH earnings was led by non-operating profit from the insurance business, which was likely the result of an asset-liability mismatch from higher interest rates. This more than offset losses from the shareholders’ fund, due to mark-to-market losses in equities and collective investment schemes,” says JP Morgan in an update on OCBC’s results.

For GEH, total weighted new sales grew 9% q-o-q and 3% y-o-y. New business embedded value rose 6% q-o-q and 3% y-o-y. “These results affirm the positive impact of higher rates to insurance companies, which should sustain in the next few quarters. However, growth could slow on weaker GDP,” JP Morgan notes.

So far, so good

Taimur Baig, chief economist at DBS Economics & Strategy, says in a report dated Aug 8, that aggregate exports out of Asia were up 13.1% y-o-y through June. The figure is even more promising for Asia ex-China at 20.6% y-o-y. At this time last year, Asia’s exports rose 35% y-o-y on the back of a post-lockdown rebound so a double-digit growth at this current juncture is indicative of sustained strength of the exports cycle, Baig notes.

The US and China represent two sides of the same coin, and US demand is keeping China afloat. Despite the woes of its property sector, China’s factories have been humming along, allowing exporters to keep their operations going because of external demand. The cost of shipping a container from Shanghai to Los Angeles has declined by over 40% since 4Q2021. This suggests some of the supply-side frictions related to ports have eased considerably, helping trade.

“China’s strong exports also reflect resilient demand from its largest importer, the US. With jobs and wages showing continued strength, American consumers have so far shrugged off the challenges posed by a high cost of fuel and food, keeping retail sales growth in high single digits,” Baig says in his Aug 8 note.

On the other hand, China’s domestic demand is weak and imports have slumped. However, other Asian economies are picking up the slack. For instance, South Korea’s July exports rose 9.4% y-o-y.

Trade between the US and Asia is good for the local banks which have managed to muscle in on the European banks’ stranglehold on trade loans some 10–15 years ago. Trade loans are short-term and increasing digitalisation has mitigated many of the risks.

“Asia’s exports have begun the second half of the year still in good shape. Chances are the going may get tough as demand in the US, EU and China soften further but it is heartening to see that export earnings have not yet been hit as much as we had feared given the plethora of outstanding headwinds,” says Baig.

On the other hand, as consumers pay more for food and fuel, discretionary demand could fall if inflationary pressures do not abate. “As interest rates go up across countries, the rising cost of financing should have a dampening impact on consumer and business spending, affecting the demand for goods produced in Asia,” Baig cautions.

The flip side of constrained consumer demand could be a fillip for bank investors as profits and dividends rise. According to UOB Kay Hian’s Koh in a roundup of the banks, the local lenders benefited from an almost total pass-through of interest rate hikes in US Federal Funds Rate to Singapore domestic rates. Sora (Singapore overnight rate average) and three-month Sibor increased by 105 bps and 112 bps q-o-q respectively to 1.66% and 1.91% during the quarter, Koh says.

Banks have also strengthened their funding franchise with DBS, OCBC and UOB improving their Casa ratio by 13.6 percentage points (ppt), 13.0 ppt and 11.5 ppt respectively to 72.3%, 60.9% and 54.7% over the past three years, Koh says. These underpinnings provided the local banks with strong uplifts in their NII (see Table 1).

Credit costs have normalised and writebacks are unlikely in the second half of the year. UOB has guided 25 bps in credit costs, DBS is expecting 20 bps while OCBC’s guidance has been less clear but Wong guided relatively lower credit costs. JP Morgan has built 26 bps at OCBC in its forecast for FY2022 and FY2023.

Who will outperform?

In terms of dividend payout ratio and dividends, DBS has generally been the most generous. DBS pays dividends quarterly, and in 2QFY2022, the dividends of 36 cents per share worked out at $826 million or a payout ratio of 51%.

UOB comes second with a payout ratio of 50% or 60 cents per share. OCBC has traditionally been the most parsimonious of the three, with a payout ratio of just 44% in 1HFY2022. As a counterpoint, OCBC did increase its 1HFY2022 dividends by three cents compared with 1HFY2021.

In terms of valuation, DBS trades comfortably above its mean. This is most likely a reflection of its parentage and the capable leadership of Gupta in charting the bank’s current course. The focus on digitalisation and launching a digital bank as far back as 2016 is likely to pay off as more expensive money is likely to keep the challengers — new digital banks — at bay.

During a results briefing, Gupta sounded somewhat cautious about the outlook. Despite what he says is a strong pipeline of loans, the bank’s franchise in Hong Kong, China and Taiwan may have given him cause for concern.

Despite a strong NII outlook, and benign credit environment, valuations appear to be disconnected from the rate outlook, says a UBS report. “We think [this] is driven by the macro front and its implications on asset quality,” UBS says.

Looking at earnings and cost of equity make it more clear that a relatively deep slowdown and a significant pickup in credit costs are already priced in. “The market is pricing in 70 bps increase in credit costs over normalised levels,” UBS suggests.

As an observation, the book value of all three banks fell in 2QFY2022 from 1QFY2022 which in turn was lower than 4QFY2021. This is because their securities portfolios, which form part of their high-quality liquid assets, declined as interest rates rose.

In terms of price-to-book ratios, OCBC is the cheapest among the three but it has traditionally traded at lower multiples versus peers. For instance, OCBC’s mean is 1.1x book value while DBS’s mean is 1.3x book value. UOB is somewhere in the middle.

For most of this year, OCBC has traded below its mean while DBS has traded well above its mean. This is probably because DBS is viewed as less risky and is a greater beneficiary of the rate hike cycle. Whether this will persist for the rest of the year and into next year remains to be seen. But, over a five-year period, DBS is the clear outperformer.