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A lose-lose situation



10 October 2011

HONG KONG BANKS A lose-lose situationHong Kong banks are facing unprecedented risks from the development of the offshore RMB market. We see rising foreign exchange risk, liquidity risk, operational risk, and regulatory risks. Asset quality risks are also rising. Regardless of the direction of the RMB/USD exchange rate, we believe Hong Kong banks lose. We see either pressure from continued HK$ liquidity tightening, or asset quality deterioration. We maintain our cautious view on the sector and prefer the international banks HSBC (1-OW) and Standard Chartered (1-OW). Hang Seng Bank (2-EW) is our preferred local exposure. Offshore RMB drag: The offshore RMB market has created new business opportunities for Hong Kong banks. However we believe these are being rapidly overshadowed by rising risks and unintended consequences associated with offshore RMB development. HK$ liquidity has continued to tighten, despite a slowdown in offshore RMB deposit growth. RMB product development has been largely dependent on RMB appreciation. More recently, RMB deposit growth has moderated after increasing regulatory tightening on so called arbitrage lending. Leakage of RMB back to China and competition from regional peers is a risk to RMB liquidity accumulation in Hong Kong. Ultimately, we believe Hong Kong banks will be under pressure regardless of FX currency movements: RMB appreciation vs USD (China growth intact) = Tighter HK$ liquidity USD appreciation vs RMB (China hard landing) = Higher credit costs Asset quality risk rising: Hong Kong banks are highly exposed to Mainland-related lending (e.g. 42% of loans for BEA). Our base case is for a soft landing in China and a gradual uptick in credit costs to 7 bps, 19bps and 26bps for FY11/12/13E. In a bear case scenario for FY13E, where credit costs reach long-term historical average levels of 100bp, we expect downside from our base case of -38% for earnings, -4% for book value and -3% for ROE (pg29). We believe Hang Seng Bank is most defensive against a potential deterioration in asset quality due to its strong risk management track record (peak credit cost of 121bps during 1998 Asian financial crisis) and high breakeven credit cost (due to its high pre-provision return on assets, ignoring contribution from Industrial Bank). Cut FY11/12E earnings by up to 15% and lower PTs by 13% on average. This reflects pressure on funding cost, credit growth and market-related fee income. We prefer the bigger, liquid international banks HSBC and Standard Chartered. Among the local banks, we like Hang Seng Bank (2-EW) for its strong, proven risk management track record. BOCHK (2-EW) is more susceptible to the risks of offshore RMB, in our view. Key risks include: 1) pace of global economic recovery; and 2) sector corporate action.Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. This research report has been prepared in whole or in part by research analysts based outside the US who are not registered/qualified as research analysts with FINRA. PLEASE SEE ANALYST(S) CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 50.

SECTOR UPDATE Asia ex-Japan Banks 2-NEUTRAL Unchanged For a full list of our ratings, price target and earnings changes in this report, please see table on page 2. Asia Ex-Japan Banks Sharnie Wong +852 290 33457 Barclays Bank, Hong Kong Tom Quarmby +852 290 33053 Barclays Bank, Hong Kong Leon Qi +852 290 33994 Barclays Bank, Hong Kong

Barclays Capital | Hong Kong Banks

Summary of our Ratings, Price Targets and Earnings Changes in this Report (all changes are shown in bold)Company Rating Old Asia ex-Japan Banks Bank of China (Hong Kong) Ltd. (2388 HK / 2388.HK) Bank of East Asia Ltd. (23 HK / 0023.HK) Dah Sing Banking Group Ltd. (2356 HK / 2356.HK) Dah Sing Financial Holdings Ltd. (440 HK / 0440.HK) Hang Seng Bank Ltd. (11 HK / 0011.HK) Wing Hang Bank Ltd. (302 HK / 0302.HK) Price Price Target Old New EPS FY1 (E) EPS FY2 (E)

New 07-Oct-11

%Chg Old New %Chg Old New %Chg

2-Neu 2-Neu 2-EW 2-EW 3-UW 3-UW 2-EW 2-EW 2-EW 2-EW 2-EW 2-EW 3-UW 3-UW 16.76 24.95 6.92 20.60 92.75 61.50 20.90 29.60 9.30 37.40 20.00 21.70 7.80 31.60 -4 1.93 1.92 -1 -2 -4 -3 -1 1.80 1.70 -6

-27 2.33 2.29 -16 0.91 0.91 -16 3.58 3.42 -6 8.70 8.40

2.19 1.93 -12 0.96 0.82 -15 3.89 3.35 -14 10.00 8.62 -14 5.99 5.64 -6

123.30 115.70 68.90 61.40

-11 6.91 6.84

Source: Barclays Capital Share prices and target prices are shown in the primary listing currency and EPS estimates are shown in the reporting currency. FY1(E): Current fiscal year estimates by Barclays Capital. FY2(E): Next fiscal year estimates by Barclays Capital. Stock Rating: 1-OW: 1-Overweight 2-EW: 2-Equal Weight 3-UW: 3-Underweight RS: RS-Rating Suspended Sector View: 1-Pos: 1-Positive 2-Neu: 2-Neutral 3-Neg: 3-Negative

10 October 2011


Barclays Capital | Hong Kong Banks

INVESTMENT SUMMARYThe potential return on investment from future offshore RMB business opportunities is subject to a high degree of risk and regulatory uncertainty, in our opinion. In this report, we discuss the potential risks and unintended consequences of RMB internationalisation. In light of uncertainty over the global economic outlook, we also look at sensitivities to deterioration in asset quality and exposure to European countries.

Risks of RMB internationalisationWe believe that the market has underestimated the risks associated with RMB internationalisation.

Liquidity risk HK$ and offshore RMB leakageThe first negative consequence was partial cannibalisation of the HK$ deposit base (flat YTD 2011) by rapid offshore RMB deposit growth (+93% ytd). Next, we believe the offshore RMB deposit base is under threat due to:

Tough regulatory stance on repatriation of funds to mainland China, which may dampen corporate demand for offshore RMB. This is already evident through the moderating offshore RMB deposit growth in the past few months, since the Peoples Bank of China (PBOC) and Hong Kong Monetary Authority (HKMA) voiced concerns on arbitrage lending in June. Gradual leakage to mainland China (onshore RMB) through corporate trade-related remittances and individual transfers (limit of HK$80,000/day).

Macro riskThe growing pool of offshore RMB has been partially driven by underlying business justifications (e.g. genuine trade in RMB), but to a larger extent has been driven by customer expectations on RMB appreciation, in our view. The events of recent weeks highlight that RMB appreciation may not be a certainty and may be subject to high market volatility.

Asset quality issues may arise if there is uncertainty over local and Mainland economic growth (potentially resulting in RMB depreciation vs the USD). Customers and potentially banks may suffer losses on products structured on RMB appreciation. These sophisticated products could well be highly geared and have long tenors.

Regulatory risk unknown return on investmentThe scope and pace of offshore RMB development is driven by the regulators in mainland China. This uncertainty makes it difficult for the banks to calculate or estimate a return on investment despite making heavy investments in IT and human resources.

Asset quality risksMarkets are increasingly pricing in higher credit costs on the back of European debt concerns and fears of a China hard landing. Our base case is on the assumption of a soft landing in China, and we expect a gradual normalisation of sector credit costs to 7bps, 19bps and 26bps for FY11/12/13E (from 3bps in FY10).

10 October 2011


Barclays Capital | Hong Kong Banks

If credit costs normalize from the current lows to the long-term historical average credit cost levels for each bank by FY12E (by FY13E for BOCHK, after de-risking its loan book from the very high credit losses in 1999), we estimate that in FY12E and FY13E:

Earnings will be lower by 16% and 38%, respectively Book value will be lower by 2.1% and 4%, respectively Return on equity will be lower by 1.1% and 3.1%, respectively

Hang Seng Bank is most defensive against a potential deterioration in asset quality, in our view, due to its strong risk management track record (peak credit cost of 121bp, lowest among peers) and high earnings buffer, with a break-even credit cost of 278bps. Hang Seng Banks FY12E pre-provision profit (which excludes contribution from Industrial Bank) is enough to withstand a seven-fold increase in its long-term historical credit cost of 28bps. Hong Kong banks risk to claims on Western European countries (ex-UK) is limited to 4.3% of assets, on average, on our estimates. All banks in our coverage universe have immaterial exposure to peripheral European countries. For BOCHK, we estimate that a worse-case scenario where a 100% writedown is taken on Euro-denominated trading and AFS securities would result in a 13.3% hit to equity.

Earnings revision and valuationWe lower our earnings forecasts for the Hong Kong banks by up to 15% for FY11-13E, on the back of lower credit growth and margin and slightly higher credit cost assumptions. Our estimates are 2-20% below Bloomberg consensus profit estimates on average. Based on our blended valuation methodology approach, the sector offers 22% absolute upside potential based on fair value. However, in the near term, share price performance may be affected by market volatility. We estimate there is still 46% potential downside for Hong Kong bank shares vs historical t