Hong Kong Banking Outlook 2014: China Risk Remains, U.S.

Taper Holds Some Uncertainty For Margins

Primary Credit Analyst: Joseph M Leung, Hong Kong 852-2533-3553; joseph.leung@standardandpoors.com Secondary Contacts: Qiang Liao, PhD, Beijing (86) 10-6569-2915; qiang.liao@standardandpoors.com Ryan Tsang, CFA, Hong Kong (852) 2533-3532; ryan.tsang@standardandpoors.com

Table Of Contents
Bank Interest Margins Are Likely To Widen But U.S. Taper And Domestic Competition Hold Uncertainty Rising Exposure To China Is A Key Risk For Hong Kong Banks Credit Losses From Mortgages In Hong Kong Banks Are Likely To Be Small Factors That May Trigger Rating Actions Related Criteria And Research

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Hong Kong Banking Outlook 2014: China Risk Remains, U.S. Taper Holds Some Uncertainty For Margins
The credit profiles of Hong Kong banks hinge mainly on their exposure to China and the performance of the economy there. Standard & Poor's Ratings Services believes Hong Kong banks will maintain their credit profiles in 2014. The interest margin of Hong Kong banks could widen because of the U.S. Federal Reserve's downsizing of its monthly bond buyback, but domestic competition for deposits holds some uncertainty. On the other hand, property prices in Hong Kong are softening. We expect property prices to decline 10% in 2014 and the impact on credit quality of mortgages to be limited. In our assessment, the economic and industry risk trends for Hong Kong's banking sector are stable. Standard & Poor's assumes in its base case that Hong Kong's economy growth will remain stable. We also believe the banks will continue to manage their exposure to China conservatively. Overview Hong Kong's financial markets may become more volatile as the U.S. Federal Reserve reduces its bond-buying program. Bank exposure to China continues to be a risk to credit quality. We project Hong Kong's property prices to fall by 10% in 2014, and the impact on credit quality of mortgages to be limited.

Bank Interest Margins Are Likely To Widen But U.S. Taper And Domestic Competition Hold Uncertainty
We expect Hong Kong banks' interest margins to rise gradually in 2014, despite some uncertainty from the U.S. Federal Reserve's reduction in monthly bond buybacks (commonly called tapering) and Hong Kong's domestic competition on deposits. Our base-case assumption is that the Fed will end its asset purchase in the third quarter of 2014. We expect U.S. dollar liquidity condition to tighten, which may raise long-term interest rates, depending on market expectations. This could boost Hong Kong banks' lending rates and, thus, their interest margins. However, the competition for deposit in the industry may lead to higher deposit rates, thus offsetting some of the benefit on margins. A more visible improvement in interest margin could come in 2015 on a full-year basis if the rising rate trend continues. Nevertheless, we caution that higher market volatility during the U.S. Fed's tapering may introduce some uncertainty to the interest margin of Hong Kong banks.

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Hong Kong Banking Outlook 2014: China Risk Remains, U.S. Taper Holds Some Uncertainty For Margins

Rising Exposure To China Is A Key Risk For Hong Kong Banks

We believe loans will grow slower than they did in 2013 but faster than nominal GDP; loans grew by about 16% in 2013. Our base-case assumption is for 3.4% real GDP growth in Hong Kong and 3.9% inflation in 2014. Credit demand from China will depend on the liquidity condition in the financial system there and, to a lesser extent, the difference in borrowing costs between China and Hong Kong. We expect liquidity could remain tight in China in 2014, and that could spur loan demand in Hong Kong. We expect Hong Kong banks to have limited appetite for loan growth. The banks are likely to balance credit growth with funding when interest rates rise and credit quality deteriorates, to meet liquidity requirement of Basel III, in our opinion. We therefore project the industry's loan-to-deposit ratio to remain largely stable. Hong Kong banks' loan quality is likely to deteriorate modestly in 2014. In particular, China-related loan quality deteriorated in 2013, and we expect this to continue this year. In our view, the Chinese corporates with weakening financial strengths include those in trade, manufacturing, and property development. The companies are facing higher borrowing cost and slower economic growth in China. Our base-case assumption is for 7.4% real GDP growth in China in 2014. We expect credit losses for domestic loans to stay low in our base-case scenario, given that Hong Kong's unemployment rate has been stable and corporate leverage remains healthy. Hong Kong banks' increasing exposure to China remains a key risk. Loan use outside Hong Kong amounted to about 30% of total loans, and trade finance accounted for about 9% of total loans as of Dec. 31, 2013. We expect the Chinese economy to be steady, and project total credit growth of 15%-16% in China in 2014. However, in the unlikely event of a hard downturn in China (GDP growth below 5%), Hong Kong's economy and its banking sector will suffer severely because of the close ties between the two systems. Banks in Hong Kong could suffer significant credit losses on their Chinese exposures. In addition, Hong Kong's economy could go into a recession, imposing another layer of pressure on these banks' creditworthiness.

Credit Losses From Mortgages In Hong Kong Banks Are Likely To Be Small
Residential property prices in Hong Kong started softening, after the U.S. Fed first announced plans for tapering and the Hong Kong government implemented a series of counter-cyclical prudential measures, which included lowering the loan-to-value ratio and imposing special stamp duties. As of Jan. 26, 2014, the Centaline leading property price index was down about 5% from the 2013 peak (recorded March 17, 2013); the index gained about 3% in 2013. Our base case is a 10% decline in residential property prices in 2014, and we expect the impact to the credit quality of mortgages to be limited. The risk of a 20%-30% weakening is low, in our view, because of the relatively tight supply condition. In an unlikely event that residential property prices fall 20%-30%, we expect potential credit losses from the residential mortgage portfolio in Hong Kong banks to be small. Our view considers the regulator's supervisory measures, including prudent limits on loan-to-value ratios of 50%-70% at origination in most cases. The Hong Kong government has proposed a resolution plan for financial institutions in distress. This plan could reduce the potential need of digging into public coffers to support such distressed institutions, in our view. We will assess the

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Hong Kong Banking Outlook 2014: China Risk Remains, U.S. Taper Holds Some Uncertainty For Margins

tendency of the government to provide support, the systemic importance of specific banks, and the relevant ratings when more details on the resolution regime at a later stage. At this stage, we assess the government to be "highly supportive" of systemically important banks and maintain our assessment of individual banks' importance to the system.

Factors That May Trigger Rating Actions

Our outlook on all our ratings on Hong Kong bank is stable, mainly reflecting our view that potential credit risks remain manageable and the banks are likely capable of maintaining their capitalization over the next two years. We expect the performance of the banking industry in Hong Kong to remain stable. In our view, the economic risk trend of the banking sector is stable. This reflects our view that Hong Kong banks' exposure to China continues to be managed conservatively and residential property prices in Hong Kong weaken 10% this year. A change in the exposure to China, credit growth acceleration or a sudden and wide fluctuation of property prices could prompt us to review our overall risk assessment of the system. Hong Kong's industry risk trend for banking sector is stable. The industry's market share is likely to remain similar; with the implementation of Basel III, we expect banks to restrain their risk appetite. Again, if their exposure to China grows substantially or Hong Kong subsidiaries of China banks have a substantially higher risk appetite, rational pricing within the industry could be threatened and funding could tighten. This is likely to lead us to review our assessment.
Table 1

Key Indicators Of Selected Hong Kong Banks

Return on average assets (%) 2Q 2013 Bank of China (Hong Kong) Ltd. DBS Bank (Hong Kong) Ltd. Fubon Bank (Hong Kong) Ltd. Hang Seng Bank Limited Standard Chartered Bank (Hong Kong) Ltd. The Bank of East Asia Limited A+/Stable/A-1 a+ 1.2 Gross NPAs/customer loans + other real estate owned (%) Net NPAs/customer loans + other real estate owned (%) Total loans/customer deposits (%) 2Q 2013 70.3

Issuer rating

SACP

Tier 1 capital ratio (%) 2Q 2013 11.2 2012 A 12.3

2012 A 2Q 2013 1.2 0.2

2012 A 2Q 2013 0.3 (0.2)

2012 A (0.2)

2012 A 66.8

AA-/Stable/A-1+

1.5

1.1

0.8

0.8

0.0

(0.1)

12.9

14.3

92.2

82.7

BBB+/Stable/A-2

bbb

0.7

0.5

0.1

0.1

(0.1)

(0.1)

10.6

12.1

66.6

66.5

AA-/Stable/A-1+ AA-/Stable/A-1+

a+ a-

3.4 1.2

1.9 0.9

0.2 0.3

0.3 0.3

(0.0) 0.1

(0.0) 0.1

13.6 11.3

12.2 10.4

70.9 58.7

66.6 55.6

A/Stable/A-1

bbb+

1.0

0.9

0.4

0.3

0.1

0.1

11.2

10.7

77.0

70.4

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Hong Kong Banking Outlook 2014: China Risk Remains, U.S. Taper Holds Some Uncertainty For Margins

Table 1

Key Indicators Of Selected Hong Kong Banks (cont.)

The Hongkong and Shanghai Banking Corp. Ltd. AA-/Stable/A-1+ a+ 2.7 1.4 0.5 0.6 0.1 0.1 14.2 13.7 65.9 60.9

SACP--stand-alone credit profile. NPAs--nonperforming assets.

Table 2

Banking Industry Country Risk Assessment

Country Government support Hong Kong Highly supportive BICRA group Anchor rating Group 2 a-

Economic risk factors and descriptors Economic risk Economic resilience Economic imbalances 3 Very low risk High risk

Industry risk factors and descriptors Industry risk 1

Institutional framework Very low risk Competitive dynamics Systemwide funding Low risk Very low risk

Credit risk in the economy Low risk

Related Criteria And Research

Related Criteria
Banks: Rating Methodology And Assumptions, Nov. 9, 2011 Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011

Related Research
Hong Kong Property Developers Brace For A Weaker Market In 2014, Jan. 12, 2014 Banking Industry Country Risk Assessment: Hong Kong, Dec. 17, 2013 Asia-Pacific Credit Outlook 2014: A Sigh Of Relief As Growth And Market Risks Subside, Dec. 10, 2013 Credit Conditions: North America's Credit Conditions Remain Favorable Despite The U.S. Government Shutdown, Dec. 9, 2013 2014 U.S. Banking Industry Outlook: Mostly Stable Ratings As The Credit Cycle Nears A Turning Point, Dec. 9, 2013 U.S. Economic Forecast: Two Economies Diverged In A Wood, Dec. 5, 2013 Resolution Plans For Global Banks May Eliminate government Support For Some, But Progress Is Varied, Dec. 4, 2013

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