Asian Banks: China Debt: Testing The "Impossible Trinity"

Deutsche Bank
Markets Research
Asia Industry Date

China 7 April 2017
Banking / Finance
Asian Banks
Banks Industry Update
Stephen Andrews, CFA
China Debt: Testing the "Impossible Research Analyst

(+852 ) - 2203 6191
Trinity" stephen-a.andrews@db.com
Balancing the "Impossible Trinity" becoming even harder Hans Fan, CFA
A shifting external environment is making China's task of balancing the Research Analyst
trilemma of independent monetary policy, freedom of capital flows & a stable (+852 ) 2203 6353
FX rate increasingly challenging. In this report, we look at how China lowered hans.fan@db.com
its total debt servicing cost via rate cuts/debt restructuring to cushion the
weight of a rising debt load. However, against a backdrop of rising US rates Top picks
this has come at the expense of increasing pressure on the capital account.
Our rate sensitivity analysis suggests that debt servicing costs are likely to be a ICBC (1398.HK),HKD5.01 Buy
real constraint on China ability to raise rates over the next 2-3 years. This lack China Merchants Bank Buy
(3968.HK),HKD20.45
of rate flexibility threatens to exacerbate capital outflows.
Source: Deutsche Bank
Financial stresses rise rapidly once debt servicing cost to GDP reaches 13-15%
Related recent research Date
Our analysis of a variety of different banking systems over the past 20-30 years
suggests that the level of financial stress in a banking system starts to increase PBOC liquidity facilities: Doing 23 Jan 2017
significantly if total debt servicing cost/GDP rises above c13-15%. China’s debt whatever it takes
Stephen Andrews
servicing cost peaked at 12.9% of GDP in 2014. Since that date through
China Banks & PPI: Timing is 02 Mar 2017
cutting interest rates and restructuring debt this has fallen back to 10.7% in Q4
everything
16. This gives China some head room but not much given China’s debt load Stephen Andrews
will need to continue to compound at 13-15% to meet a 6.5% GDP growth Chinese banks - Financial 23 Mar 2017
target. China therefore faces a policy dilemma – rising debt servicing burden deleveraging
that requires lower rates, and potentially higher inflation and higher US interest Hans Fan
rates that require high rates domestically. This dilemma will likely become Source: Deutsche Bank
more challenging in the next 2-3 years.
Valuation and Risks
Liquidity risk not credit risk: The capital account will remain in focus We value Chinese Banks using a 3-
A backdrop of higher US rates and flat to falling Chinese rates is likely to only
stage Gordon Growth Model (PV=
increase the propensity of the holders of RMB liquidity to convert it to US
dollars placing further downward pressure on China’s already depleted FX (ROE-g)/(CoE-g)with target prices
reserves. Despite the investor focus on bank asset quality we are of the based on 2017 book values (LT ROE
opinion that it is a change in the flow or cost of liquidity that actually precedes ranges from 10-13%, and COE 11-
rising stress in a financial system. In this regard we view the building pressure 13.5%) Downside risk is property price
on China’s capital account as a real and present danger for Chinese bank protection. Upside risk is removal or
investors over the next 1-2 years that receives far less attention than bank loan softening of GDP targeting, SOE
impairment charges (which continue to be actively “managed”). If US rates defaults.
rise as expect we see a further tightening of capital controls as a very real
possibility.
Cautious on China banks: A weaker credit impulse & fading reflation trade
The MSCI China banks index is now trading 1 standard deviation above its 5
year average 1 year forward P/E multiple and a 5 year low implied cost of
equity (i.e. expensive vs where it has traded for the past 5 years). We think the
risk reward profile now looks poor given the rising risks to what we believe
have been the core drivers of the re-rating (i.e. the China reflation trade).
Whilst we remain underweight the China banks in a regional context within
China we have a clear preference for the retail-orientated banks (ICBC and
CMB) over the more wholesale funded orientated bank (joint-stock banks and
some city commercial banks). The latter, we believe, would be more sensitive
to the current rise in market rates as we laid out in our recent report March
23rd “Chinese Banks – Financial deleveraging: Rising funding pressure”.
________________________________________________________________________________________________________________
Deutsche Bank AG/Hong Kong Distributed on: 07/04/2017 17:30:50 GMT
Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, 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. DISCLOSURES AND ANALYST
CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 057/04/2016.
0bed7b6cf11c
7 April 2017
Banks
Asian Banks
Investment summary
In this report, we analyze how China has looked to balance the “impossible
Trinity” or Trilemma of FX stability, independent/market driven monetary policy
and free movement of capital & its implication for Chinese banks. Over the
past 2-3 years China has managed down its debt servicing cost to cushion the
impact on the economy of its ballooning debt load. However, with US rates
now rising and capital outflow pressures more acute than in the past the ability
to continue to do this looks increasingly challenged. We model out 3 scenarios
looking at how China’s interest rate structure may evolve over the next 2-3
years and make the following observations in relation to balancing the
trilemma:
Monetary Policy: Financial stresses increase when total debt servicing cost to
GDP rises above 13-15%.... China has limited headroom to raise rates.
We estimate that China’s debt servicing cost expressed as a % of GDP peaked
at 12.9% in 2014. Since that date through cutting interest rates and
restructuring debt this has fallen back to 10.7% in Q4 16. Whilst this has
cushioned the banks from the worst of an impairment cycle it has come at the
expense of lower assets yields and hence lower NIMs and RoAs. Our analysis
of a variety of different banking systems over the past 20-30 years suggests
that the level of financial stress in a banking system starts to increase
significantly if total debt servicing cost expressed as a % of GDP rises above
c13-15%. This gives China some head room but not much given we estimate
China’s debt load will need to continue to compound at 13-15% over the next
2-3 years to meet the 6.5% GDP growth target. Under the 3 interest rate
scenarios laid out in this report if we cap China’s debt servicing cost/GDP ratio
at 13% then Chinese rates may in fact have to fall over the next 2-3 years.
China in our opinion may therefore have very little scope to raise interest rates
if inflation picks up or the external environment shifts adversely (e.g. US rates
rise sharply).
Figure 1: Modeling China’s Total debt servicing cost expressed as a % of GDP
Base case Maintain carry to US Cap at 13% of GDP

20.0%
18.0% For markets with high debt levels
financial stress increases above 13-15%
16.0%
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
Source: Deutsche Bank, BIS, CEIC
Page 2 Deutsche Bank AG/Hong Kong

7 April 2017
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Asian Banks
Capital Flows: The external environment is changing adding additional pressure

Ever since the GFC China has enjoyed positive carry from an interest rate
perspective relative to the US. However, US rate are now rising and our
analysis suggests China has limited scope to raise rates over the next 1-2
years. All else being equal, the propensity for RMB liquidity to want to convert
to US dollars looks set to increase adding additional pressure to China’s capital
outflows. With debt servicing costs increasingly being the primary constraint
on rising interest rates then to balance the impossible trinity the currency
would normally have to weaken or China faces further FX reserves depletion. If
we assume China will looks to maintain minimum FX reserves of say US$2trn
then the “available” reserves have fallen from c10-11% of M2 2-3 years ago to
just c3-4% of M2 today. With M2 still compounding at a double digit rate this
is not a lot of headroom to play with on a 2-3 year timeframe. Should US rates
continue to rise it seems likely we may see a further tightening of capital
controls to limit the pace of FX reserve depletion. If this does indeed happen it
will clearly be a further set-back of capital account reform which we would
view a negative for the banks in the medium to long-term.
A potential side effect of tighter capital controls is that we would expect HK If China further tightens
and Singapore loan growth to surprise positively as more Chinese corporate capital controls we may see
seek to borrow offshore to fund their regional expansion plan (as it becomes HK & Singapore loan growth
harder to move money offshore). Our preferred Singapore Bank is currently
surprise on the upside
DBS (Buy; SGD19.13).
Figure 2: China’s FX reserves (US$ bn) & FX reserves Figure 3: Rising US short term interest rates relative to
expressed as % of M2 Chinese rates is likely to put further pressure on Chinese
capital outflows
FX Reserves Fx Reserves as % M2 Cross border capital flows China 1yr gov yield less US
35.0% 4,500 600 4.50
Net
4,000 4.00
30.0% 400 inflows
3,500 3.50
25.0%
3,000 200 3.00
20.0% 2,500 2.50
0
15.0% 2,000 2.00
1,500 -200 1.50
10.0% ?
1,000 Net 1.00
5.0% -400
500 outflows 0.50
0.0% 0 -600 0.00
Source: Deutsche Bank, CEIC Source: Deutsche Bank, CEIC
China bank investors are still looking in the wrong place for stresses to emerge
The Chinese bank investment community remains obsessed with non-
performing loans and asset quality of the China banks. In reality, we think that
by managing debt servicing costs and restructuring SoEs/migrating credit risk
towards the central government balance sheet that credit risk will continue to
be “managed” from a P&L impairment perspective (at the expense of gradual
asset yield/RoA erosion). It is however the change in flow and cost of liquidity
that typically causes a banking crisis, ample liquidity can hide a range of
underlying ills. In this regard the rapid expansion of the PBOC domestic
balance sheet that we have seen over the past 12-18 month is we think of
particular note. We continue to believe that the chance of an uncontrollable
domestic liquidity event remains remote unless we see a major policy mistake.
Deutsche Bank AG/Hong Kong Page 3

7 April 2017
Banks
Asian Banks
As we wrote in our January report “PBOC liquidity facilities: Doing whatever it

takes” we believe if necessary the PBOC will provide as much liquidity is
required to meet the goals of the Chinese leadership, even if this involves a
degree of “Moral hazard”. However, it is the cross border capital flows that
have been straining the system (& resulted in the PBOC liquidity injections to
date) and it is here that we believe the flows have now structurally reversed.
China’s more significant liquidity risk appears to us to be cross border in
nature with pressure on the capital account and diminishing inflows from a
current account surplus that is now dwarfed by an RMB liquidity base that
continues to compound at a double digit pace per annum. The conundrum of
the impossible trinity is becoming ever more pressing.
Figure 4: Liquidity support to the banking system from Figure 5: Who owns China’s M2? (H1 16E)
the PBOC has increase dramatically over the past 12-18
months (RMB bn)
OMO/ Other PSL MLF Corporate Foreign, 1% Cash in
10,000 deposits - bill circulation, Corporate -
collateral, 3% 4% excl. bill
9,000
deposits, 28%
8,000 Non-bank fins,
9%
7,000
6,000
5,000 Gov
Departments,
4,000 15%
3,000
2,000
Retail - rest,
1,000 Retail - HNWI, 22%
17%
0
Source: Deutsche Bank, CEIC Source: Deutsche Bank, BCG, CEIC, Wind.
Figure 6: Over the past 12 month the drag on China bank Figure 7: China 10 year government bond yield less US
returns has come more from asset yield compression 10 year government bond yield Vs RMB/US$ FX rate
(rate cuts/debt restructuring) than from impairments
1.20%
China 10yr less US 10 yr Dollar per RMB
3.00 0.17
1.00%
2.50 0.17
0.80% 2.00 0.16
1.50 0.16
0.60% 1.00 0.15
0.50 0.15
0.40%
0.00 0.14
0.20% -0.50 0.14
-1.00 0.13
0.00%
-1.50 0.13
-2.00 0.12
Source: Deutsche Bank, Company accounts (includes Big 4 + listed JSBs) Source: Deutsche Bank, CEIC

7 April 2017
Banks
Asian Banks
We remain cautious on the China banks in a regional context

Our cautious stance on China banks in a regional context is not just predicated
on the longer-term thematic discussed in this report but also the shorter term
headwinds we see developing over the next 3-6 months which we laid out in
our piece “China banks & PPI: Timing is everything” published in early March.
This highlighted that we now believe China is late in the current reflation cycle
rather than early. As such, we expect both a downturn in the “credit impulse”
and a tightening of market orientated rates in an attempt to de-lever parts of
the shadow banking sector to weigh on bank share price performance. Whilst
we remain underweight the China banks in a regional context within China we
have a clear preference for the retail orientated banks (ICBC and CMB) over the
more wholesale funded orientated bank (joint-stock banks and some city
commercial banks). The latter, we believe, will be more sensitive to the current
rise in market rates as we laid out in our recent report “Chinese Banks –
Financial deleveraging: Rising funding pressure”
Figure 8: China credit impulse looks to be fading Figure 9: PPI could be close to a peak if commodity
prices do not rise further
60.0%
400 MSCI China Banks China PPI 13.0%
55.0%
18th National 19th National
50.0% Congress Nov Congress Oct- 350
17th National 2012 8.0%
Nov 2017
45.0% Congress Oct
2007 300
40.0%
3.0%
35.0% 250
30.0% ? -2.0%
25.0% 200 ?
20.0% Reflation
Deflation -7.0%
150
15.0%
10.0% 100 -12.0%
TSF rolling 3 mth (SA) Average +1SD -1SD

7 April 2017
Banks
Asian Banks
Testing interest rate gravity

Can China afford higher rates?
China’s growing debt load is the elephant in the room of the China “reflation”
story that we believe can only be ignored for so long. In this report we model
out the evolution of China’s debt servicing costs against the backdrop of the
current economic model that still relies on GDP targeting/credit to drive growth.
Over the past 2-3 years China has employed a strategy of lower interest rates
and significant debt restructuring to managed debt servicing costs. This is
evident in falling bank interest income as well as lower total debt servicing
costs expressed as a % of GDP (see charts below). In essence despite total
debt in China increasing by 1/3rd in the 2 year period YE2014-16 the economy
did not feel the extra burden of this debt as rate cuts more than offset the
additional debt load in terms of the absolute level of interest burden. This has
led to a steady fall in China’s debt funding cost as a % of GDP (note this chart
assumes no principal repayment, it simply looks at the annual interest costs).
Figure 10: China’s estimated total debt servicing cost Figure 11: China YoY Change in joint stock bank and Big
expressed as % of GDP 4 reported interest income
30.0% Big 4 JSBs Big 4 + JSBs
14.0%
Govt Household Corporate 25.0%
12.0%
20.0%
10.0% 15.0%
8.0%
10.0%
5.0%
6.0%
0.0%
4.0% -5.0%
2.0% -10.0%
-15.0%
0.0%
Mar-07
Mar-08
Mar-09
Mar-10
Mar-11
Mar-12
Mar-13
Mar-14
Mar-15
Mar-16
Sep-07
Sep-08
Sep-09
Sep-10
Sep-11
Sep-12
Sep-13
Sep-14
Sep-15
Sep-16
Source: Deutsche Bank, BIS, CEIC Source: Deutsche Bank, Company data
Figure 12: Absolute change in estimated China rolling 12 Figure 13: YoY Change in China estimated debt servicing
month debt servicing cost (US$bn) costs
250 40%
200
30%
150
20%
100
10%
50
- 0%
(50)
-10%
(100)
-20%
(150)
Source: Deutsche Bank, BIS, CEIC Source: Deutsche Bank, BIS, CEIC

7 April 2017
Banks
Asian Banks
How fast does China’s debt need to grow?
Two important aspects of the Chinese financial system are the still relatively
low level of disintermediation (that makes it heavily reliant on bank funding)
and the requirement to supply enough credit to meet the leadership’ stated
GDP target of at least 6.5% for the current 5 year plan (which runs 2015-2020).
When trying to estimate the weight of the interest burden on the economy
from China’s growing pile of debt it is, therefore, important to estimate
approximately how fast credit (and hence bank assets) will need to grow over
the next 3 years. For the purpose of this exercise we show some broad
estimates of this in the table below. This demonstrates that even with an
improving credit multiplier (credit growth divided by nominal GDP growth) that
absent a downward revision in the GDP growth target China is likely to require
at least a 13-14% CAGR in credit over the next 3 years. Note in this analysis we
are using total credit as per the BIS (Bank of International Settlements)
disclosed data. We note that the pace of credit growth the BIS reports is
towards the lower end of the spectrum in the market (c14.7% yoy for 2016 Vs
our own estimate of 16-17%). Nevertheless we use the BIS data as it is widely
available but we would stress this is likely in our opinion to represent a
minimum level of credit growth if the GDP target is to be achieved. Total debt
to GDP will as is widely expected move through the 300% barrier over the next
2-3 years although with a greater emphasis on leveraging up the household &
government balance sheet rather than corporate.
Figure 14: To achieve China’s national GDP target will require 13-15% credit growth for 3 years 2017-2019
2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E
Nominal GDP 41,303 48,930 54,037 59,524 64,397 68,905 74,413 80,961 87,762 94,958
Nominal growth rate 18.3% 18.5% 10.4% 10.2% 8.2% 7.0% 8.0% 8.8% 8.4% 8.2%
US$ bn 6,268 7,774 8,673 9,695 10,380 10,611 10,727 11,733 12,719 13,762
Total Credit Assets (BIS data) 74,487 88,100 104,829 125,287 145,134 168,614 193,426 221,498 252,729 286,954
YoY 21.6% 18.3% 19.0% 19.5% 15.8% 16.2% 14.7% 14.5% 14.1% 13.5%
US$ bn 11,304 13,997 16,826 20,407 23,394 25,966 27,883 32,101 36,627 41,588
Credit/GDP 180% 180% 194% 210% 225% 245% 260% 274% 288% 302%
Credit multiplier 1.18x 0.99x 1.82x 1.92x 1.94x 2.31x 1.84x 1.65x 1.68x 1.65x
Total Bank assets 96,161 113,787 133,686 152,475 172,203 199,156 230,376 263,810 301,008 341,770
YoY growth 18.8% 18.3% 17.5% 14.1% 12.9% 15.7% 15.7% 14.5% 14.1% 13.5%
US$ bn 14,593 18,079 21,457 24,835 27,757 30,670 33,210 38,233 43,624 49,532
Total credit (RMB bn)
Corporates 49,687 58,497 70,404 83,556 96,382 111,997 125,996 141,116 157,485 174,809
Households 11,209 14,020 16,019 19,686 22,922 26,733 32,614 39,300 46,767 55,184
Government 13,590 15,582 18,405 22,045 25,830 29,885 34,816 41,082 48,477 56,961
Implied total credit 74,487 88,100 104,829 125,287 145,134 168,614 193,426 221,498 252,729 286,954
YoY
Corporates 19.2% 17.7% 20.4% 18.7% 15.4% 16.2% 12.5% 12.0% 11.6% 11.0%
Households 37.4% 25.1% 14.3% 22.9% 16.4% 16.6% 22.0% 20.5% 19.0% 18.0%
Government 11.6% 14.7% 18.1% 19.8% 17.2% 15.7% 16.5% 18.0% 18.0% 17.5%
Total 21.6% 18.3% 19.0% 19.5% 15.8% 16.2% 14.7% 14.5% 14.1% 13.5%
As % of GDP
Corporates 120.3% 119.6% 130.3% 140.4% 149.7% 162.5% 169.3% 174.3% 179.4% 184.1%
Households 27.1% 28.7% 29.6% 33.1% 35.6% 38.8% 43.8% 48.5% 53.3% 58.1%
Government 32.9% 31.8% 34.1% 37.0% 40.1% 43.4% 46.8% 50.7% 55.2% 60.0%
Implied total credit.GDP 180.3% 180.1% 194.0% 210.5% 225.4% 244.7% 259.9% 273.6% 288.0% 302.2%

7 April 2017
Banks
Asian Banks
Figure 15: Forecasting China’s total debt to GDP: Expected to continue to rise
sharply so long as GDP targeting remains in place
350
300
250
200
150
100
50
0
Mar-08
Mar-09
Mar-11
Mar-12
Mar-13
Mar-15
Mar-16
Mar-17
Mar-19
Mar-20
Mar-07
Mar-10
Mar-14
Mar-18
Sep-07
Sep-08
Sep-09
Sep-11
Sep-12
Sep-13
Sep-15
Sep-16
Sep-18
Sep-19
Sep-20
Sep-10
Sep-14
Sep-17
Govt Household Corporate

Figure 16: Our credit growth estimates imply an Figure 17: China total credit growth yoy as measured as
improving credit multiplier which may prove optimistic by reported total social financing plus local govt bonds
issued.
4.00x 40.0%
3.50x 35.0%
20yr avg credit
3.00x multiplier - c1.5x 30.0%
2.50x 25.0%
2.00x 20.0%
1.50x 15.0%
10.0%
1.00x
5.0%
0.50x
0.0%
0.00x

7 April 2017
Banks
Asian Banks
Testing the “impossible trinity”…
We think it is important to link China’s growing debt burden, interest rates, FX

rates and capital flows together as they are all interrelated and of extreme
importance for investors. The famous “impossible trinity” or (trilemma) reflects
that it is impossible for a country to have all three of the following….
1) A fixed/stable exchange rate
2) Independent monetary policy (i.e. market derived/inflation targeting

rate structures)
3) Free movement of capital (e.g. an open capital account)
According to the well-known theory a government can only pursue 2 of these

policies at the same time. We believe that events in China over the past 3-6
months are increasingly testing this hypothesis and asking the questions
which of the three gives? In the face of a rising external interest rates
environment if China wishes to maintain a stable RMB/US$ FX rate then either
domestic rates have to rise or the capital account has to be closed. In reality
we think we are seeing interesting shifts in all three legs of the China
“Trilemma”…
Capital controls have increased….

Towards the end of 2016 as rate expectations in the US rose China’s capital
account came under severe pressure as outflows accelerated (see charts
below). As China has taken steps in recent years to defend the RMB its FX
reserves have depleted significantly falling from a peak of US$4trn to cUS$3trn
today. If we assume China will looks to maintain minimum FX reserves of say
US$2trn then the “available” reserves have fallen from c10-11% of M2 2-3
years ago to just c3-4% of M2 today. With M2 continuing to compound
domestically at a double digit rate (and the propensity of holders of RMB
liquidity wanting to switch to US dollars rising as US rates rise) it is not hard to
see why the pace of FX reserve depletion remains a key China talking point.
To combat these outflows over the past 3-6 months we have seen much more
stringent Chinese enforcement of cross border capital controls. We also sense
greater reluctance from multi-national corporations to move capital into China
whilst the desire for Chinese corporates to invest overseas remains at close to
record levels. This we believe is resulting in a structural shift in China’s direct
equity investment capital flows (unimpeded outward direct investment flows
are now higher than China’s foreign direct investment capital inflows for the
first time). Very rarely do you see “healthy” economies and financials system
put in place increasingly draconian capital controls.

7 April 2017
Banks
Asian Banks
Figure 18: China’s FX reserves have dropped significantly Figure 19: Tightening capital controls is likely to have
slowed outflows but not stopped then completely
FX Reserves Fx Reserves as % M2 Cross border capital flows China 1yr gov yield less US
35.0% 4,500 600 4.50
Net
4,000 4.00
30.0% inflows
400
3,500 3.50
25.0%
3,000 200 3.00
20.0% 2,500 2.50
0
15.0% 2,000 2.00
1,500 -200 1.50
10.0% Net
1,000 1.00
outflows
5.0% -400
500 0.50
0.0% 0 -600 0.00
It is not clear to us how aggressively capital controls can be enforced without

starting to severely impact on China’s trade balance and its important current
account surplus (CAS). This is especially true if domestic policies continue to
encourage consumption and a leveraging up of the household balance sheet).
From a banking sector financial stability perspective we believe it is a change in
the flow and/or cost of liquidity then tends to cause credit stresses to rise to the
surface. In this regard we view the change in capital flows across the Chinese
border as extremely significant (and the tightening of capital controls evidence
that this is an issue). As China’s economic model requires credit/money
creation to grow at a mid-teens CAGR (to meet the GDP target) the pool of
domestic liquidity continues to expand rapidly. If we look at the size of the
current account surplus relative to the size of this liquidity pool (i.e. M2 or total
bank assets, see chart below) it has shrunk meaningfully over the past 5-10
years from over 6% a decade ago to less than 1% today. So vulnerability to
cross border capital flight and FX reserves depletion continues to build.
Figure 20: China’s current account surplus as % of Figure 21: China current account surplus is likely to be
domestic liquidity (taken as M2) has dropped down significantly YoY in Q1 17 (US$ mn)
significantly
CAS as % GDP CAS/M2 CAS/ Bank assets 140,000
12.0%
120,000
10.0%
100,000
8.0%
80,000
6.0%
60,000
4.0%
40,000
2.0%
20,000
0.0%
0

7 April 2017
Banks
Asian Banks
China rates have started to move….

In recent weeks, we have seen Chinese rates start to rise. Whilst benchmark
lending rates have remained anchored at current levels for over a year an
ongoing shift towards greater reliance on wholesale funding is leading to
greater sensitivity to market rates in China (see our recent piece “China banks:
Financial deleveraging: Rising funding pressure”). Whilst credit in different
parts of the financial system is linked to different interest rates and re-prices at
a different pace (but most sub-1year) if market rates rise the weight of China’s
enormous debt load increases over time. As we show in the charts below since
Q4 lows the 5 year MoF bond yield has moved up 70bps to 3.13% and the 5
year CDB bond yield c120bps to 4.13%. More recently we have also seen the
PBOC pushing up the cost of its liquidity facilities the SLF and MLF and CD
rates rise, all of this is likely to squeeze banks with weaker funding franchises
and impact on credit growth and ultimately asset quality. In the remainder of
this report we look to test the extent to which China interest rates can move
up and scale the incremental debt servicing burden under different scenarios.
This is not an exact science but we do believe it is important to get a feel for
the magnitude of the changes that we may see. We believe in reality China has
very little scope to see interest rates rise significantly whilst still pursuing a
credit driven growth model.
Figure 22: China 5 year government bond yield and Figure 23: China’s short term interest rates have spiked
Policy bank bond yield have risen recently again (7 day REPO rate)
MoF 5 year CDB 5 year 12.00
6.0
10.00
5.0
8.00
4.0
6.00
3.0
4.00
2.0
2.00
1.0
0.00
0.0
Figure 24: China benchmark lending rates are unchanged Figure 25: Asset mix of Big 4 banks Vs JSBs (H1 16_
for over a year
9.00 Within 1 yr 1-5yr Over 5yr Other Net loans AFS Securities HTM Securities
8.00 Receivables REPO Interbank RRR
100%
7.00
90%
6.00 80%
5.00 70% 44.6%
52.5%
4.00 60%
3.00 50% 5.6%
2.00 40% 6.5% 6.9%
1.00 30% 20.5% 12.8%
20% 2.4%
0.00
10%
7.8% 11.2%
0%
JSB Big 4
Source: Deutsche Bank, CEIC Source: Deutsche Bank, Company data

7 April 2017
Banks
Asian Banks
Joining the dots: US interest rates expectations:
As the Trilemma laid out above suggests, the issue with continuing to manage
China’s debt servicing cost via lower rates and debt restructurings is that it is
encouraging greater levels of capital flight. The picture is complicated by
external factors that are both beyond China’s control and more pressing than
in the past given a more challenging backdrop for cross-border capital flows.
We view the movement in the US yield curve as a key driver of the propensity
for RMB liquidity to flow into US dollars. As such we use this to “anchor” our
different scenarios for where China rates may move. If Chinese rates stay
low/continue to decline against a back drop of rising US rates then the outflow
pressure on the capital account we believe is likely to only increase from here.
Conversely over reliance fiscally on property/land prices makes too much
monetary policy tightening difficult. Popping the property bubble would also
blow a huge fiscal hole in government budgets that are overly dependent on
the property/construction sectors for revenues. So the direction of travel and
scale of rate moves in China is a vital component in considering the longevity
of the current economic model.
For the sake of simplicity, we have assumed that the short end of the US yield
curve moves largely as the famous Federal Reserve “Dot Plot” suggest over
the next 2-3 years. We then assume 3 China rate scenario based on the degree
of Carry between China and the US yield curve…
1) Base case: China yield curve steadily converges with US over next 3-4
years. As US rates rise China’s rate rise too but at a much slower pace
2) Maintain positive carry at current levels: To limit capital outflows we

assume China has to raise rates more aggressively to defend the
currency. This results in the spread between US and Chinese yield
curves remaining broadly constant
3) Manage debt servicing cost in China flat as % of GDP: We assume the

overwhelming driver of policy is maintaining China’s debt servicing
costs at affordable levels. As such we set China rates so that total
debt servicing cost as a % of GDP remains relatively constant. This
does however mean that Chinese rates have to fall further and end up
with negative carry relative to US rates. This will lead to building
pressure from a capital outflow perspective.

7 April 2017
Banks
Asian Banks
Figure 26: The US Federal Reserve “Dot Plot” chart for rate expectations
Source: Deutsche Bank, US Federal Reserve
Figure 27: An estimate of US yield curve vs the Fed Dot Figure 28: China 5 year government bond yield Vs the US
Plot charts
Fed funds 1 year 5 year China 5yr US 5 yr
6.00% 5.00
4.50
5.00%
4.00
4.00% 3.50
3.00
3.00% 2.50
2.00% 2.00
1.50
1.00% 1.00
0.50
0.00%
0.00
Source: Deutsche Bank, CEIC, US Federal Reserve Source: Deutsche Bank, CEIC

7 April 2017
Banks
Asian Banks
Scenario 1: A Base case
Our base case scenario assumes that Chinese 1yr rates largely converge with
the US over the next 2-3 years as the US yield curve rises. This in the context
of China is actually a relatively mild interest rate scenario with rates moving up
just 60-70bps. It also leaves rates well below the levels we saw in previous
rates rise cycles in 2009/10 and 2013 as we show in the chart below.
Figure 29: China interest rate moves Figure 30: China government yields assumed spread to
US rates
Short rates 1 Year 5 Year 1 Year 5 Year
6.00% 4.50%
4.00%
5.00% 3.50%
4.00% 3.00%
2.50%
3.00% 2.00%
1.50%
2.00%
1.00%
1.00% 0.50%
0.00%
0.00%
In our model of total debt servicing cost we have to make some assumptions
for the sake of simplicity. This is not an exact science but we assume that the
debt servicing cost on government debt is the same as the 5 year government
bond yield. We then assume a spread above this for the Corporate and
Household debt burdens. As we show below, we have matched up this cost of
borrowing historically to the household loan and corporate loan yield reported
by China’s biggest banks over the past 5-10 years to arrive at an appropriate
spread. We show this in the charts below but note that currently reported bank
corporate and Household loan yields sit 150-200bps above the government 5
year government bond rate.
Figure 31: Matching our estimated household debt Figure 32: Matching our estimated corporate debt
servicing yield to bank reported household loan yields servicing yield to bank reported corporate loan yields
Household Loan yield Est Household yield Corporate loan yield Est corp yield
7.00%
6.50%
6.50%
6.00%
6.00%
5.50%
5.50%
5.00%
5.00%
4.50%
4.50%
4.00% 4.00%
3.50% 3.50%
3.00% 3.00%
Source: Deutsche Bank, China Bank financial reports, CEIC Source: Deutsche Bank, China bank financial reports, CEIC

7 April 2017
Banks
Asian Banks
Even under this relatively benign base case scenario China’s debt servicing
cost expressed as a % of GDP still starts to rise sharply from a current low of
10.8% of GDP up to a level of close to 16% of GDP in 2019/20. This is well
above the high of 12.9% seen in 2014 and would indeed be high by
international standards (we benchmark China debt servicing cost historical
ranges elsewhere in the world towards the back of this report).
Figure 33: Total China debt servicing cost expressed as a % of GDP under our
base case scenario
18.0%
16.0%
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
Jun-18
Jun-09
Jun-12
Jun-15
Mar-07
Mar-16
Mar-19
Mar-10
Mar-13
Dec-07
Dec-16
Dec-19
Dec-10
Dec-13
Sep-08
Sep-17
Sep-20
Sep-11
Sep-14
When it comes to debt levels, it is often argued that it is rates of change that
matter more than absolute levels. So in the charts below we show the rolling
12 month change in total debt servicing cost in absolute terms (in US$bn) and
also the year on year change. Even this relatively mild level of rates rises when
coupled with China’s required 13-14% credit growth rate leads to a sharp rise
in total interest burden of cUS$300-400bn over the next 12 months.
Figure 34: Absolute change in debt servicing in US$bn Figure 35: Year on year change in total debt servicing
for our base case scenario cost
400 50%
300 40%
30%
200
20%
100
10%
-
0%
(100)
-10%
(200) -20%

7 April 2017
Banks
Asian Banks
The charts above are we believe useful in that they illustrate how over the past
2-3 years via lowering interest rates and debt restructuring China has managed
to minimize the impact of its rising debt burden on the broader economy. In
fact our model indicates that in Q4 16 the total debt servicing cost for the
economy was little changed in absolute terms from that 2 years before in H2
‘14. However a rise in interest rates rapidly reverses this change. Just the mild
rises we have modeled above represent a c20% swing in to debt servicing
costs. To put this in the context of GDP this is equivalent to about 2-3% of GDP
on a rolling 12 month basis. This is likely to be a significant drag on growth
and risks rapidly reversing an improvement in cash flows at China’s weakest
borrowers. From an FX perspective a movement in China’s 1 year interest rates
to match a rising US rate over the next 2-3 years is also unlikely in our opinion
to be sufficient to stop the current issue of capital outflows impacting the
balance of FX reserves.
Figure 36: Rolling 12 month increase in debt servicing Figure 37: Assumed change in Chinese interest rates
cost expressed as % of GDP over the next 2-3 years built in to base case.
4.0% 0.80%
3.0% 0.70%
2.0% 0.60%
0.50%
1.0%
0.40%
0.0%
0.30%
-1.0%
0.20%
-2.0% 0.10%
-3.0% 0.00%
Short rates 1 Year 5 Year
Source: Deutsche Bank, CEIC Source: Deutsche Bank
Figure 38: The reported interest income of China’s big 4 Figure 39: Aggregate interest income of China Big 4
banks is down meaningfully yoy banks plus Joint stock banks
30.0% Big 4 JSBs Big 4 + JSBs JSBs Big 4
25.0% 1,200,000
20.0%
1,000,000
15.0%
10.0% 800,000
5.0%
600,000
0.0%
-5.0% 400,000
-10.0%
200,000
-15.0%
0
Source: Deutsche Bank, company accounts Source: Deutsche Bank, Company accounts

7 April 2017
Banks
Asian Banks
Scenario 2: Maintaining positive carry to the US
With the current focus on limiting capital outflows and tightening of capital
controls it seems likely any rise in US rates relative to China will only
exacerbate downward pressure on the RMB. Our second scenario therefore
seeks to maintain the current level of positive carry between the US yield curve
and Chinese yield curve to limit the impact on capital outflows of higher US
interest rates. This would obviously lead to a more meaningful upward shift in
the Chinese yield curve and a higher resulting debt servicing cost as US rates
rise. As we show in the chart below this could move the total debt servicing
cost expressed as a % of GDP up as high as 18-19% over the next 3 years or so.
This would be considerable higher than anything China has experienced in its
modern history. A move of this quantum would in our opinion most likely trigger
a serious correction in real asset prices. Given China’s heavy reliance on real
estate/infrastructure for economic growth and banking/land sales/construction
for its fiscal revenues this we believe is unlikely to be an acceptable scenario
for China’s leadership.
Figure 40: Total China debt servicing cost as % of GDP (interest only) if US
rates rise and China maintains current level of positive carry
20.0%
18.0%
16.0%
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
Mar-07
Mar-08
Mar-09
Mar-10
Mar-11
Mar-12
Mar-13
Mar-14
Mar-15
Mar-16
Mar-17
Mar-18
Mar-19
Mar-20
Sep-07
Sep-08
Sep-09
Sep-10
Sep-11
Sep-12
Sep-13
Sep-14
Sep-15
Sep-16
Sep-17
Sep-18
Sep-19
Sep-20
Source: Deutsche Bank, BIS, CEIC,US Federal Reserve
Interestingly interest rate rises of this magnitude only moves the yield on
corporate and household lending back to similar levels seen 3-4 years ago as
we show in the charts below. So whilst this level of interest rates would not be
viewed as “unusual” the additional debt that China has taken on over the past
3-4 years and the rise in Chinese real estate prices inherently makes the
economy more vulnerable to the sudden rise in rates this scenario models.

7 April 2017
Banks
Asian Banks
Figure 41: Maintaining positive carry with the US: Figure 42: Maintaining positive carry with the US:
Matching household debt yield with household loan yield Matching corporate debt yield with corporate loan yield
reported by banks reported by banks
7.00%
6.50%
6.50%
6.00%
6.00%
5.50%
5.50%
5.00%
5.00%
4.50% 4.50%
4.00% 4.00%
3.50% 3.50%
3.00% 3.00%
Source: Deutsche Bank, Company accounts Source: Deutsche Bank, Company accounts
In terms of the rates of change under this scenario the absolute increase in
debt servicing cost would rise to an eye-catching increase of US$400-500bn
dollars on a rolling 12 month basis, a c25-30% rise yoy at its peak. A rise of
this magnitude is an increase in debt servicing cost equivalent to 3-4% of GDP
per annum. It would also of course dramatically add to the current cost of
ever-greening Chinese problem debt which our China banks team has already
estimated could be as higher as 5-10% of total China debt. This scenario we
believe highlights China’s dilemma if US rates rise sharply based on a US
domestic reflation trade. The analysis suggests that China has limited scope to
raise rates at a similar pace to the US given its current credit driven GDP
growth model without causing serious debt servicing problems.
Figure 43: Absolute rolling 12 month change in debt Figure 44: Year on year change in total debt servicing
servicing cost (US$bn) cost if China maintains current level of carry against
rising US yield curve
500 50%
400 40%
300 30%
200 20%
100 10%
- 0%
(100) -10%
(200) -20%

7 April 2017
Banks
Asian Banks
If the debt servicing cost is increasingly becoming a primary constraint on

Chinese interest rate structures then domestic returns assumptions (especially
amongst retail investors) are likely to be out of line with what is likely to be
achievable. This of course also has significant implications for a financial
system where “guaranteed” risk free return expectations are arguably now out
of line with the significant burden the debt load now places on the economy.
cost expressed as a % of GDP built in to maintaining the same level of positive carry Vs
the US.
5.0%
3.00%
4.0%
3.0% 2.50%
2.0%
2.00%
1.0%
0.0% 1.50%
-1.0%
1.00%
-2.0%
-3.0% 0.50%
0.00%
Source: Deutsche Bank, BIS, CEIC Source: Deutsche Bank, CEIC

7 April 2017
Banks
Asian Banks
Scenario 3: Managing debt servicing costs to GDP
Our third scenario for Chinese rates factors in a much more benign interest
rate evolution that is governed primarily by a need for China to keep rates low
to manage debt servicing costs. This we have modeled by running total debt
servicing costs flat expressed as a percentage of GDP at roughly 13%. This
corresponds to the peak China saw back in 2013/14 where stresses really
started to appear in the economy as shown in the chart below.
Figure 47: Scenario 3: Maintaining China’s total debt servicing cost stable as a
% of GDP
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
Mar-07
Mar-08
Mar-09
Mar-10
Mar-11
Mar-12
Mar-13
Mar-14
Mar-15
Mar-16
Mar-17
Mar-18
Mar-19
Mar-20
Sep-07
Sep-08
Sep-09
Sep-10
Sep-11
Sep-12
Sep-13
Sep-14
Sep-15
Sep-16
Sep-17
Sep-18
Sep-19
Sep-20
Relative to China’s current level of interest rates this actually implies a

declining yield structure as the debt load increases over time (we show China 1
year rates under our 3 scenarios below). It may also lead to US rates moving
above Chinese rates on a 2-3 year timeframe (if rates rise as per the Fed dot-
plot chart).
Figure 48: China’s 1 year interest rates under our 3 Figure 49: China 1 year interest rates positive/negative
different rates scenarios carry Vs US interest rates (as per Fed Dot plot)
Base Case Maintain Carry Maintain debt servicing to GDP Base Case Maintain Carry Maintain debt servicing to GDP
5.00% 4.50%
4.50% 4.00%
4.00% 3.50%
3.50% 3.00%
2.50%
3.00%
2.00%
2.50%
1.50%
2.00%
1.00%
1.50%
0.50%
1.00%
0.00%
0.50% -0.50%
0.00% -1.00%

7 April 2017
Banks
Asian Banks
Our view would be that this is hard to do without exacerbating capital out flow
issues pressuring the RMB. Essentially this would represent a headwind if not
complete reversal of the policy of gradual opening of the capital account and
internationalization of the RMB. It would however most likely lead to a steady
decline in household and corporate lending yields (see below) which would be
supportive to real asset prices which remains a vital element of China’s current
growth model. This scenario however would likely to lead to a steady erosion
of bank asset yields, NIMs and hence RoA over time, similar to the evolution
we have seen in other more developed markets with growing total debt
problems (Japan, Korea etc).
Figure 50: To maintain debt servicing cost stable as a % Figure 51: To maintain total debt servicing costs stable
of GDP household loan yields would have to fall as a % of GDP total corporate loan yields will have to
steadily decline
7.00%
6.50%
6.50%
6.00%
6.00%
5.50%
5.50%
5.00%
5.00%
4.50%
4.50%
4.00%
4.00%
3.50%
3.50%
3.00%
3.00%
Source: Deutsche Bank, Company data Source: Deutsche Bank, company data
It is worth noting that even capping the total debt servicing cost at 13% of
GDP would still result in a rise in the total debt servicing cost in the short term.
This would be an unhelpful headwind for the economy as a whole.
Figure 52: Absolute rolling 12 month change in debt Figure 53: Year on year change in total debt servicing
servicing cost (US$bn) cost if China maintains total debt service cost as % of
GDP stable at c13%
350 50%
300
40%
250
200 30%
150 20%
100
10%
50
- 0%
(50)
-10%
(100)
(150) -20%

7 April 2017
Banks
Asian Banks
cost expressed as a % of GDP over the next 2-3 yrs built in to hold debt servicing cost
to GDP at c13%.
5.0%
0.00%
4.0%
3.0% -0.05%
2.0%
-0.10%
1.0%
-0.15%
0.0%
-0.20%
-1.0%
-2.0% -0.25%
-3.0% -0.30%
The most pressing issue of declining Chinese interest rates relative to the US
related to the impossible trinity in that it would most likely lead to further
pressure on the RMB. As we show in the chart below under our 3rd scenario
Chinese rates may drop below US rates on a 2-3 year timeframe. This would
only serve to further increase the attractiveness to Chinese
investors/depositors of holding US dollars. Given the dwindling capital inflows
expressed as a percentage of China’s growing domestic liquidity pool this is
likely to lead to further falls in FX reserves and potentially additional tightening
of capital controls.
Figure 56: China interest rates positive/negative carry Figure 57: Rising US short term interest rates relative to
relative to the US yield curve Chinese rates is likely to put further pressure on Chinese
capital outflows
4.50% Cross border capital flows China 1yr gov yield less US
1 Year 5 Year
4.00% 600 4.50
3.50% Net
4.00
400 inflows
3.00%
3.50
2.50%
200 3.00
2.00%
2.50
1.50% 0
1.00% 2.00
0.50% -200 1.50
0.00%
?
Net 1.00
-0.50% -400
outflows 0.50
-1.00%
-600 0.00
Source: Deutsche Bank, CEIC Source: Deutsche Bank, CEIC, SAFE

7 April 2017
Banks
Asian Banks
Benchmarking Vs International peers
China is now one of the most indebted nations in the world with total debt to
GDP sitting at c270% (according to the Bank of International Settlements, BIS).
As we show in the chart below this is in line with many more mature
developed markets. A key difference is the level of corporate debt which
remains much higher in China (we believe it is deliberated left as opaque
where the SoE sector stops & government begins).
Figure 58: Estimated current total debt to GDP

400
350
300
250
200
150
100
50
Source: Deutsche Bank, BIS
With debt levels it is widely recognized that it is the rate of change that
matters often more than the absolute level of debt. As such in the chart below
we show that change in debt/GDP over the past 5 years for a variety of global
markets. Here again China stands out globally at a 70-80% increase.
Figure 59: Change in Debt to GDP over the past 5 years (Q1 2012-Q1 2017)

80
70
60
50
40
30
20
10
0
-10
-20

7 April 2017
Banks
Asian Banks
To put a rise of this magnitude into context in the chart below we show the
rise in debt in China expressed as a % of GDP over the past 5 years (Q1 12 to
Q1 17) relative to that seen in a number of different markets in the 5 years
leading up to the Global Financial Crisis (taken as Q1 2012 to Q1 2007). Again
China’s pace of debt accumulation matches the fastest levels seen in almost
any market pre-GFC. However China is doing this on a much large scale given
we estimate it is currently creating 40-50% of the world’s net new money
supply. Back in the lead up to the GFC not individual market could claim such
a dominant position in terms of money creation. So the fact that China’s debt
burden is growing at a pace not seen historically is not in doubt… but how
does its debt servicing cost now compare vs other markets both today and
relative to history?
Figure 60: The rate of change in debt to GDP in China over the past 5yrs
matches the highest levels seen in the 5 year leading up to the GFC

80
60 Change in debt GDP 5 years leading up to

GFC Q1 2002 -Q1 2007
40
20
-20
-40
A look at current debt service cost to GDP…

As the analysis shows earlier in this report, we estimate that China’s debt
servicing cost expressed as a % of GDP peaked at c13% in H2 2014 and
subsequently dropped to c10.7% in Q4 16 as rates have been cut and debt
restructured to support the economy. How however does this level compare to
other banking systems around the globe over time and are there any lessons
that we can learn as to potential “stress points” above which financial risks
start to rise rapidly? In the chart below, we show our estimate for debt
servicing cost as a % of GDP for a variety of different markets in Asia and
around the world as of Q1 2017. Our methodology for each is the same as for
that we have employed for China in that we use the benchmark 5 year
government bond yield as a proxy for the government debt funding cost and
then assume a spread above this for both household and corporate debt
(typically c200bps for corporate debt and 150bps for household which if often
dominated by mortgages.. We appreciate this may not be 100% accurate but
this is not an exact science. This shows that China’s total debt servicing cost
to GDP ratio is still amongst the highest in the world. This in part of course
related the central bank policy in other parts of the world that have led to a
record period of low rates. As such, to get an idea of where we may see debt
servicing cost/GDP start to threaten financial stability we need to look back at
history in other markets.

7 April 2017
Banks
Asian Banks
Figure 61: Total debt servicing cost expressed as a % of GDP for a variety of
different banking markets
12.0%
Corporate Household Govt
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
How has the US looked over the past 30-35 years?

In the chart below we show our estimate of the US total debt servicing
cost/GDP ratio over the past 30-35 years. Over this time frame it has averaged
about 11% however this was during a period where the average 5 year
government bond yield has been a little under 5% (so much higher than today).
Interestingly if we focus specifically on 3 period of elevated financial stress we
note that these typically occurred when the debt servicing cost to GDP ratio
rose above the 13-14% range. For example during the Savings and Loans crisis
when hundreds of banks/thrifts in the US went bust the ratio stood at 16-18%.
More recently as debt levels have risen the LTCM/Asian crisis/ TMT bubble &
GFC saw the ratio rise to c13-14% before falling away as rates were cut
aggressively as the economy slowed sharply.
Figure 62: US estimated debt servicing cost as % of GDP
Savings & Loan

16-18% GFC debt
LTCM/ Asia
20.0% servcing/GDP 12.0%
crisis 13%
18.0% TMT bubble 14%
16.0% 14% 10.0%
14.0% 8.0%
12.0%
10.0% 6.0%
8.0%
6.0% 4.0%
4.0% 2.0%
2.0%
0.0% 0.0%
Debt servicing cost/ GDP (LHS) 5yr Gov yield (RHS)


7 April 2017
Banks
Asian Banks
When does debt/servicing cost/GDP get too high?

A key question is obviously when does the debt servicing cost/GDP ratio rise to
levels that start to significantly increase systemic financial risk. There is no
exact answer to this as each market is different but in the chart below we
show a range of estimated total debt servicing cost to GDP over the past 20-25
years for a variety of global markets. As a rough rule of thumb we think it is fair
to say that if this ratio reaches 13-15% then the chances of significant stresses
starting to appear in the financial system starts to increase rapidly. This is vitally
important for investors in Chinese banks to understand given our 3 scenarios
above saw debt servicing costs to GDP rise to up to 18% of GDP 2-3 years out,
and even with rate decline (& resulting FX pressures) still at the lower end of
this “stress range” of 13%.
Figure 63: Range of estimated total debt servicing cost/GDP over the past 20-
25 years for a variety of global markets
30.0%
Max Min Current
Financial stress
25.0% seems to
increase as you
pass 13-15%
20.0%
15.0%
10.0%
5.0%
0.0%
Readers will no doubt see the higher levels recorded by Korea, Thailand and
Malaysia. However, as we show in the chart below, these were only ever seen
at the peak of the Asian financial crisis. Elevated debt servicing levels led to a
complete collapse of many of these banking systems so we believe should not
be viewed as part of a normal “cyclical” range.

7 April 2017
Banks
Asian Banks
Figure 64: Estimated ASEAN debt servicing costs expressed as % of GDP

30.0%
Thai Malay Korea
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%

7 April 2017
Banks
Asian Banks
China bank valuations
Over the past 12 months since the end of Q1 16 the MSCI China banks index
has risen c30%. This has been sufficient to out-perform many of its Asian
peers although it has marginally under-performed the MSCI World Banks index
by c1% (Europe remains the laggard up 24% whilst Latam Banks are up 47% &
the US banks +%). Year to date however, the China banks are up c8% which
has lagged the regional by 3-4% but nevertheless out-performed the global
banks index which is up 5-6% with the US banks up just 1-2% in 2017 after a
very strong 2017.
Figure 65: MSCI Asia banks index performance over the Figure 66: MSCI Asia banks index performance year to
past 12 months date
45.0 30.0
38.7 25.7
40.0 37.1
25.0
35.0 32.0
30.4 30.3
28.8
30.0 Simple average = 23% 20.0 Simple average = 12.3%
23.7 17.3
25.0 22.1
18.8 18.5 15.0 13.5 13.3 12.9
20.0 12.7 12.1 11.7 11.1
15.0 10.0
10.0 8.2
10.0 5.8
5.0 5.0
0.0
0.0
-5.0 -0.4
-4.8
-10.0 -5.0
Source: Deutsche Bank, Factset Source: Deutsche Bank, Factset
Figure 67: MSCI Asian banks index performance relative Figure 68: MSCI Asian banks index performance relative
to MSCI global banks over the past 12 months to MSCI global banks year to date
10.0 7.4 25.0
5.9
5.0 20.1
0.7 20.0
0.0
-0.9 -1.0 15.0
-5.0 -2.5
11.7
-10.0 -7.6
-9.2 10.0 7.9 7.7 7.3 7.1 6.5
-15.0 -12.4 -12.8 6.1 5.5
4.4
5.0 2.6
-20.0
-25.0 0.0
-25.5
-30.0
-5.0
-35.0
-6.0
-36.1
-40.0 -10.0
From a valuation perspective, the rise in Chinese bank share prices has left
them trading 1 standard deviation above their 5 year average consensus 1 year
forward P/E. The P/B multiple remains relatively depressed but this largely
reflects the ongoing decline in RoE that the sector has experienced as asset
yields/NIMs have fallen to manage the rising debt servicing cost highlighted in
this report. If we look on an implied cost of equity basis that better reflects the
decline in RoE that we have seen the sector is now trading close to a 5 year
low (i.e. expensive vs its 5 year trading range).

7 April 2017
Banks
Asian Banks
Figure 69: MSCI China banks index 1 year forward P/E Figure 70: MSCI China banks index PB Vs RoE trading
trading range is now 1 standard deviation above its 5 range over the past 5 years
year average
7.0 1.5 24%
1.4
6.5 22%
1.3
1.2
6.0 20%
1.1
5.5 1.0 18%
0.9
5.0 16%
0.8
4.5 0.7
14%
0.6
4.0 0.5 12%
Nov-12
Nov-13
Nov-14
Nov-15
Nov-16
May-12
May-13
May-14
May-15
May-16
May-17
Nov-12
Nov-13
Nov-14
Nov-15
Nov-16
May-12
May-13
May-14
May-15
May-16
May-17
MSCI China / Banks -IG Avg +1SD -1SD MSCI China / Banks -IG Avg +1SD -1SD ROE
Source: Deutsche Bank, MSCI, Factset Source: Deutsche Bank, MSCI, Factset
Figure 71: MSCI China banks implied cost of equity is Figure 72: MSCI China banks index dividend yield is now
back close to a 5 year low (i.e. expensive) c5%
23%
7.5%
22% 7.0%
21% 6.5%
20% 6.0%
5.5%
19%
5.0%
18%
4.5%
17%
4.0%
16% 3.5%
15% 3.0%
Nov-12
Nov-13
Nov-14
Nov-15
Nov-16
May-12
May-13
May-14
May-15
May-16
May-17
Nov-12
Nov-13
Nov-14
Nov-15
Nov-16
May-12
May-13
May-14
May-15
MSCI China / Banks -IG Avg +1SD -1SD MSCI China / Banks -IG Avg +1SD
May-16 -1SD
Source: Deutsche Bank, MSCI, Factset Source: Deutsche Bank, MSCI, Factset
At current valuations, we remain unconvinced that the Chinese financial

system has dealt with the significant structural issues it is facing. To our mind
there has been no systemic de-leveraging, credit growth is running at c16%
and nominal GDP 8-9%. We do recognize that certain parts of the corporate
sector (manufacturing for example) has been undergoing a notable credit
cycle. Indeed the impairment charge at the joint stock banks has risen to
c150bps of loans + receivables (the big 4 banks are currently at c80bps, see
charts below). We also believe that we are seeing an ongoing migration of
credit risk towards the central government balance sheet, whilst lowering
credit risk this is likely to lower returns via low asset yields. This is in line with
our core hypothesis in this report that China will have to continue to actively
manage its debt servicing cost in coming years limiting its capacity to raise
interest rates.

7 April 2017
Banks
Asian Banks
Figure 73: China joint stock banks P&L impairment Figure 74: China big 4 banks P&L impairment charge as
charge as % of loans & loans plus receivables (rolling 12 % of loans & loans plus receivables (rolling 12 month
month basis) basis)
As % of average loans As % of average loans + receivables As % of average loans As % of average loans & receivables
2.50% 2.50%
2.00% 2.00%
1.50% 1.50%
1.00% 1.00%
0.50% 0.50%
0.00% 0.00%
Source: Deutsche Bank, Company accounts Source: Deutsche Bank, Company accounts
Our cautious stance on China banks in a regional context which we laid out in
our piece “China banks & PPI: Timing is everything” published in March 2, is
predicated on the theme that we now believe China is late in the current
reflation cycle rather than early. As such, we expect both a downturn in the
“credit impulse” and a tightening of market orientated rates in an attempt to
de-lever parts of the shadow banking sector to weigh on bank share price
performance. Whilst we remain underweight the China banks in a regional
context within China we have a clear preference for the retail-orientated banks
(ICBC and CMB) over the more wholesale funded orientated bank (joint-stock
banks and some city commercial banks). The latter we believe will be more
sensitive to the current rise in market rates as we laid out in our recent report
“Chinese Banks – Financial deleveraging: Rising funding pressure”.
Figure 75: Summary China bank valuation table

(Local currency) Share Rec P/E 17 P/E 18 P/B 16 P/B 17 RoE 16 RoE 17 RoA 16 RoA 17 2016 2017
price yield yield
Agri. Bank of China 3.65 Hold 5.8x 5.5x 0.84x 0.76x 15.0% 13.8% 0.96% 0.90% 5.2% 5.3%
China Construction Bank 6.35 Buy 6.0x 5.9x 0.89x 0.81x 15.3% 14.0% 1.20% 1.12% 4.9% 5.0%
ICBC 5.11 Buy 5.7x 5.6x 0.85x 0.77x 15.2% 14.0% 1.20% 1.14% 5.2% 5.3%
Bank of Communications 6.01 Hold 5.8x 5.7x 0.70x 0.64x 14.5% 11.4% 1.05% 0.82% 5.1% 5.1%
China Merchants Bank 20.9 Buy 6.7x 5.9x 1.15x 1.02x 16.3% 16.2% 1.10% 1.14% 4.0% 4.5%
China CITIC Bank 5.19 Sell 5.3x 5.2x 0.64x 0.59x 12.6% 11.5% 0.76% 0.68% 4.7% 4.7%
China Minsheng 8.24 Sell 5.6x 5.4x 0.78x 0.70x 14.5% 13.3% 0.97% 0.89% 3.2% 3.3%
CEB 3.80 Sell 5.2x 5.1x 0.70x 0.64x 13.9% 12.8% 0.88% 0.78% 5.7% 5.7%
Bank of China 3.77 Buy 5.9x 5.8x 0.74x 0.68x 13.1% 12.0% 0.94% 0.86% 5.2% 5.2%
H-share Banks (HK$) 5.8x 5.6x 0.81x 0.73x 14.5% 13.2% 1.00% 0.93% 4.8% 4.9%
Industrial Bank 16.3 Sell 6.0x 5.9x 0.89x 0.73x 15.6% 13.4% 0.93% 0.84% 3.9% 3.9%
Shanghai Pudong Bank 16.2 Sell 6.6x 6.4x 1.01x 0.90x 16.4% 14.4% 0.96% 0.88% 2.9% 2.9%
Bank of Ningbo 18.4 Sell 9.5x 8.8x 1.57x 1.40x 16.8% 15.6% 0.89% 0.77% 2.7% 2.8%
China Everbright Bank 4.11 Sell 6.4x 6.2x 0.85x 0.78x 13.9% 12.8% 0.88% 0.78% 4.7% 4.7%
Bank of Beijing 9.9 Buy 6.7x 5.9x 0.99x 0.88x 15.0% 15.3% 0.91% 0.93% 2.3% 2.5%
Bank of Nanjing 12.0 Sell 9.6x 8.8x 1.38x 1.23x 14.5% 13.5% 0.78% 0.64% 1.9% 2.0%
A-share Banks (RMB) 7.5x 7.0x 1.12x 0.99x 15.4% 14.2% 0.89% 0.81% 3.1% 3.1%
Simple average 6.5x 6.1x 0.93x 0.84x 14.8% 13.6% 0.96% 0.88% 4.1% 4.2%
Source: Deutsche Bank, Factset priced on 5 April
th

7 April 2017
Banks
Asian Banks
Figure 76: Chinese H-share bank consensus 1 year Figure 77: Chinese H-share bank consensus 1 year
forward P/B trading range for the past 5 years forward P/E trading range for the past 5 years
1.6x 9x 8.4x
1.4x 8.2x
1.4x 7.7x 7.8x
1.4x 1.3x 1.3x 8x 7.4x
1.3x 7.1x 7.2x 7.2x
6.7x 6.9x
1.2x 7x 6.3x
1.2x 1.1x
1.0x 1.0x 6x
1.0x 0.9x 0.9x
5x
0.8x
4x
0.6x 4.1x 4.0x 4.1x 4.1x 4.2x 4.2x
0.7x 3.9x
3x 3.5x 3.5x 3.6x
0.5x 0.5x 0.6x 0.6x 0.5x
0.4x 0.5x 0.5x 0.5x 2.9x
0.5x 0.5x 2x
0.2x
1x
0.0x 0x
Historical range Current Average Historical range Current Average
Figure 78: H-share Chinese bank consensus 1 year Figure 79: H-share Chiense bank consensus 1 year
forward RoE trading range for past 5 years forward implied cost of equity trading range
25% 35%
31.5%
20.7% 20.1% 20.4% 20.2% 30%
19.4% 19.4%
20% 18.0% 25.9%
17.4% 24.3% 25.1%
16.7% 16.3% 25% 22.7% 21.8% 22.7% 23.6%
15.9% 21.7% 21.9% 22.0%
15%
20%
13.0% 12.6% 13.5%

12.0% 12.1% 12.7% 12.0% 15%
10% 11.2% 11.5% 15.3% 14.9% 14.9% 14.7% 15.0%
10.3% 10.3% 13.6% 13.1% 14.5%
10% 12.6% 13.4% 13.2%
5%
5%
0% 0%
Average Average
Historical range Current Historical range Current

7 April 2017
Banks
Asian Banks
Appendix 1
Important Disclosures
*Other information available upon request
Prices are current as of the end of the previous trading session unless otherwise indicated and are sourced from local
exchanges via Reuters, Bloomberg and other vendors . Other information is sourced from Deutsche Bank, subject
companies, and other sources. For disclosures pertaining to recommendations or estimates made on securities other
than the primary subject of this research, please see the most recently published company report or visit our global
disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr. Aside from
within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the
"Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing.
Analyst Certification
The views expressed in this report accurately reflect the personal views of the undersigned lead analyst about the
subject issuers and the securities of those issuers. In addition, the undersigned lead analyst has not and will not receive
any compensation for providing a specific recommendation or view in this report. Stephen Andrews/Hans Fan
Equity rating key Equity rating dispersion and banking relationships

Buy: Based on a current 12- month view of total 500
share-holder return (TSR = percentage change in 450
53 %
share price from current price to projected target price 400
350 36 %
plus pro-jected dividend yield ) , we recommend that 300
investors buy the stock. 250
200
Sell: Based on a current 12-month view of total share- 150
17 % 10 %
100 16 % 19 %
holder return, we recommend that investors sell the 50
0
stock
Buy Hold Sell
Hold: We take a neutral view on the stock 12-months
out and, based on this time horizon, do not Companies Covered Cos. w/ Banking Relationship
recommend either a Buy or Sell.
Asia-Pacific Universe
Newly issued research recommendations and target
prices supersede previously published research.

7 April 2017
Banks
Asian Banks
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Asian Banks: China Debt: Testing The "Impossible Trinity"

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Asia Industry Date

Stephen Andrews, CFA

China Debt: Testing the "Impossible Research Analyst

Figure 1: Modeling China’s Total debt servicing cost expressed as a % of GDP

Base case Maintain carry to US Cap at 13% of GDP

Source: Deutsche Bank, BIS, CEIC

Page 2 Deutsche Bank AG/Hong Kong

Capital Flows: The external environment is changing adding additional pressure

Source: Deutsche Bank, CEIC Source: Deutsche Bank, CEIC

Deutsche Bank AG/Hong Kong Page 3

As we wrote in our January report “PBOC liquidity facilities: Doing whatever it

Page 4 Deutsche Bank AG/Hong Kong

We remain cautious on the China banks in a regional context

10.0% 100 -12.0%

TSF rolling 3 mth (SA) Average +1SD -1SD

Source: Deutsche Bank, CEIC Source: Deutsche Bank, CEIC

Deutsche Bank AG/Hong Kong Page 5

Testing interest rate gravity

Page 6 Deutsche Bank AG/Hong Kong

How fast does China’s debt need to grow?

Deutsche Bank AG/Hong Kong Page 7

Govt Household Corporate

Source: Deutsche Bank, CEIC Source: Deutsche Bank, CEIC

Page 8 Deutsche Bank AG/Hong Kong

Testing the “impossible trinity”…

We think it is important to link China’s growing debt burden, interest rates, FX

1) A fixed/stable exchange rate

2) Independent monetary policy (i.e. market derived/inflation targeting

3) Free movement of capital (e.g. an open capital account)

According to the well-known theory a government can only pursue 2 of these

Capital controls have increased….

Deutsche Bank AG/Hong Kong Page 9

Source: Deutsche Bank, CEIC Source: Deutsche Bank, CEIC

It is not clear to us how aggressively capital controls can be enforced without

Source: Deutsche Bank, CEIC Source: Deutsche Bank, CEIC

Page 10 Deutsche Bank AG/Hong Kong

China rates have started to move….

Source: Deutsche Bank, CEIC Source: Deutsche Bank, CEIC

Deutsche Bank AG/Hong Kong Page 11

Joining the dots: US interest rates expectations:

2) Maintain positive carry at current levels: To limit capital outflows we

3) Manage debt servicing cost in China flat as % of GDP: We assume the

Page 12 Deutsche Bank AG/Hong Kong

Source: Deutsche Bank, US Federal Reserve

Deutsche Bank AG/Hong Kong Page 13

Scenario 1: A Base case

Source: Deutsche Bank, CEIC Source: Deutsche Bank, CEIC

Page 14 Deutsche Bank AG/Hong Kong

Source: Deutsche Bank, BIS, CEIC

Deutsche Bank AG/Hong Kong Page 15

Source: Deutsche Bank, CEIC Source: Deutsche Bank

Page 16 Deutsche Bank AG/Hong Kong

Scenario 2: Maintaining positive carry to the US

Source: Deutsche Bank, BIS, CEIC,US Federal Reserve

Deutsche Bank AG/Hong Kong Page 17

Page 18 Deutsche Bank AG/Hong Kong

If the debt servicing cost is increasingly becoming a primary constraint on

Deutsche Bank AG/Hong Kong Page 19

Scenario 3: Managing debt servicing costs to GDP

Source: Deutsche Bank, BIS, CEIC

Relative to China’s current level of interest rates this actually implies a

Source: Deutsche Bank, CEIC Source: Deutsche Bank, CEIC