>CHINESE BANKS (CITI)

Next Phase: NIM and Profitability Expansion

■ Profitability over volumes – Chinese banks have underperformed lately due to concerns over slowing loan growth. We see this current negative sentiment as a buying opportunity. Despite slowing loan growth, we believe the earnings trend remains positive due to improving loan and deposit mix, and higher rates. We see expanding NIMs as a healthier earnings driver than surging loan volumes.

■ Improving loan mix – 2H09 loan mix should improve lending shifts from discounted bills to regular loans, for an estimated yield differential of 250-300bps. This process has already begun in July with Rmb198bn contraction in discounted bills.

■ Improving deposit mix – An active A-share market should support a shift in deposits from time to demand (~150bps yield differential), helping to lower funding costs.

■ Rising interest rates – Recent increases in repo/interbank rates and bond yields are positive for NIMs across the sector. Interest rates are likely to head higher as our economists now expect lending and deposit rate hikes to begin in 2Q10.

■ Smaller banks bigger beneficiaries – Given their higher proportion of discounted bills (up to 30-40% of 1H09 loan growth), historically greater deposit mix volatility, and greater gearing to symmetrical rate hikes, smaller banks are bigger beneficiaries. We now expect NIMs for the sector to recover 10-20bps hoh in 2H09E, followed by 5-20bps yoy expansion in FY10E (no rate increase assumed), with smaller banks leading the recovery.

■ Raise TPs, Upgrade CMB to Buy – CMB and CNCB are most geared to these themes and our top picks among smaller banks. Top picks among big banks: CCB, ICBC.

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