In-depth report 17 May. 10

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1 In-depth report 17 May. 10 Financial Services Sector Policy Liquidity is King The Chinese government is, again, trying to implement mutually contradictory economic policies. It is in the process of tightening money supply in order to prevent inflation and housing price bubbles, which has had a knock-on effect of causing the slump in the stock market. At the same time, it needs the stock market to remain buoyant in order to support the potential 287bn yuan of bank capital raisings and the bn yuan IPO of Agricultural Bank of China. Without these, the banks cannot continue to lend sufficient amounts to support economic growth. This means the government is searching for other sources of non-inflationary liquidity to support the market, including directing banks to the H share market, and expanding margin trading and index futures to both domestic institutional investors and QFII. In tandem with investors switching out of property investments into stocks, Central Huijin buying bank shares and NSSF pledging support for index futures, this potentially puts a floor under the market at current levels. Financials Sectors Banks Policy: Negative Outlook: Negative Insurance Policy: Neutral Outlook: Neutral Securities Policy: Positive Outlook: Positive To ebb In response to the April economic data showing increased bank lending, higher property prices and rising inflation, the government is likely to continue to increase credit controls, enhance the implementation of property policies, and resume RMB appreciation in the near future to head off inflation. However, before adjusting the exchange rate, PBOC will continue to control the pace and direction of bank lending and use open market operations and adjustments to the reserve requirement ratio to remove liquidity from the banking system. These efforts, combined with a switch in investment from stocks to property market, have contributed to the 20% drop in the CSI 300 in the year-to-date. While this in itself would not be a major issue, and possibly even beneficial in the long term, the problem is that the government needs to pump the market back up again in order to complete the bank s capital raisings. and flow There is the potential that some of the money being forced out of the property market may feed its way back into stocks, as there are few other avenues for investment, particularly against the current environment of negative real interest rates on deposit accounts. On the policy side, however, the two responses appear to be: a) To increase liquidity at the domestic stock market through margin trading and stock index futures. Extending the market from retail investors to funds, QFII and securities houses in the near future should boost the market. b) To tell the banks to raise cash through the H share, rather than A share market. While in the short term, this is likely to push shares down further, the result of all this is that H share investors are effectively buying Chinese government debt through equities. Published by FCI for distribution by North Square Blue Oak outside PRC A307, Guanghua ChangAn Plaza, No.7 Jianguomennei Avenue, , Beijing China Tel: Fax:

2 China Policy In-depth Further tightening to come April economic data painted a negative picture for inflation, with CPI and PPI rising faster than expected, bank lending increasing ahead of expectations and property prices continuing to rise, so continued monetary tightening is firmly on the cards. With increased liquidity withdrawals through open market operations since the Spring Festival (removing 1.1trn yuan from the banking system through last week see chart 2) and the recent 50bp hike to the reserve requirement ratio, PBOC has brought M2 growth down from a high of 29.6% yoy in November to 21.5% yoy in April (see chart 1). PBOC has targeted 17% growth for the full year, so further tightening is likely to come in order to meet this target and head off inflation expectations. Chart 1: Money supply growth (% chg yoy) 45% 40% 35% M2 M1 M0 30% 25% 20% 15% 10% 5% 0% -5% -10% Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Source: PBOC Chart 2: PBOC weekly net injections/withdrawals from the banking system RMBbn /09/ /09/ /09/ /10/ /10/ /11/ /11/ /12/ /12/ /01/ /01/ /02/ /02/ /03/ /03/ /04/ /04/ /05/2010 Another 50bp hike to the RRR likely As part of the general tightening of monetary policy, it is likely that the reserve requirement ratio will be raised again by another 50bps in the near future, bringing the RRR to 17.5%, the same as the peak level in H2 08. PBOC is also likely to continue to withdraw money from the banking system using open market operations. Since the beginning of the year, PBOC has removed 679bn 2

3 Financial Services Sector Policy yuan from the banking system, and this is likely to continue in order to slow the growth in M2. If the three reserve requirement ratio hikes are factored in, PBOC has removed roughly 1.6trn yuan from the banking system in Bank lending to be tightened In addition to general tightening of monetary policy, the implementation of credit controls will become stricter, particularly where it relates to lending for second and third-home mortgages. This is likely to take the form of stricter implementation of previously announced policies, as opposed to new policies. In April, new long-term household lending reached 230bn yuan, up 134% yoy, contributing to the 12.8% yoy increase in house prices in April across 70 major cities, which in turn made housing costs in the CPI figure increase to 4.3%. Chart 3: Long-term household lending and % of total lending LT Household lending % of total lending 80% 70% 60% 50% RMBbn % 30% 20% 10% 0 0% Jan-2009 Feb-2009 Mar-2009 Apr-2009 May-2009 Jun-2009 Jul-2009 Aug-2009 Sep-2009 Oct-2009 Nov-2009 Dec-2009 Jan-2010 Feb-2010 Mar-2010 Apr-2010 Source: PBOC Mortgage lending likely to decrease from current levels Switch between property and stock investment At the beginning of H2 09 banks significantly increased long-term lending to the household sector, the vast majority of which is mortgage lending, with long-term household lending accounting for 50% of total lending in H2. While the share of longterm household lending has fallen to around 30% in Q1 10, it is still much higher than the 8% of total lending seen in H1 09. As the government wants to see house prices growth slow to below 10% from the current 12.8% growth, the current high level is unlikely to be maintained as the implementation of the current restrictions on mortgage lending is expected to become stricter. Liquidity and the stock market The tightening of liquidity will be a necessary step for the Chinese government to reduce inflation expectations and cool property price growth. The problem with the tightening is its effect on the stock market, as stock market movements in China can be roughly correlated with the growth of the money supply (see chart 4), meaning monetary policy tightening may continue to have a negative effect on the stock market. The correlation is not perfect, with other factors such as QFII funds and investor s preference from property investment over stock investment playing a factor. Chart 5 shows other deposits in H2, which are essentially stock market accounts, and property deposits. At end-08, the increase in other deposits drove the stock market higher, while starting in H2 09 when other deposits began to fall, property deposits increased. This also means that the current round of tightening in the property sector could increase stock market liquidity, given the lack of other investment channels in China. 3

4 China Policy In-depth Chart 4: The stock market and money supply growth 45% 40% 35% 30% 25% 20% 15% 10% M2 M1 CSI300 (RHS) 7,000 6,000 5,000 4,000 3,000 2,000 1,000 Index 5% 0 Feb-05 May-05 Aug-05 Nov-05 Feb-06 May-06 Aug-06 Nov-06 Feb-07 May-07 Aug-07 Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Source: PBOC Chart 5: Deposits and the stock market RMBbn M2: Quasi money: Other deposits Property deposits CSI300 (RHS) Index -800 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 0 Source: PBOC From 2005 to 2008, new increased property deposits averaged 76bn yuan per month, while new monthly inflows into other deposits averaged 37bn yuan. In H1 09, when money was being directed towards the stock market other deposits increased by an average of 328bn yuan per month, partly reflecting the use of bill financing for stock market investment, as highlighted in our report, Chinese A-Shares, The Liquidity is Repaid 11/08/10. Then, in H2 09, when bill financing was being repaid and investment in the property sector was being further encouraged, other deposits fell by an average 125bn yuan per month, while new property deposits increased by an average 169bn yuan per month. Now, with funding channels for property investment being shut off and investment in the sector being discouraged, it is possible that some of the extra money that has gone into the property sector over the past year may find its way back into the stock market. 4

5 Financial Services Sector Policy Table 1: Average monthly new property and other deposits RMBbn Property Other deposits H H Oct 09 Mar Funding in addition to / less than trend amount H H Oct 09 Mar Source: CEIC, FCI Research Institutional investor participation in margin trading could provide needed boost While the government would not normally consider the stock market when crafting policies, as its primary concern is keeping inflation under control and promoting the peoples welfare, the success of the Agricultural Bank of China IPO is an important milestone for China, which is a large concern for the Chinese government. The seemingly contradictory goals of increasing stock market liquidity while tightening monetary policy may be possible by extending margin trading from simply retail investors to include funds, securities houses and QFII, which may happen soon. As only retail investors have been allowed to participate, volumes have remained low, with the balance of margin trading and securities lending reaching just 423m yuan on 14 May in Shanghai compared to an average daily market turnover of over 90bn yuan. If institutional investors are allowed to participate in the market, however, volumes could increase substantially, with non-inflationary market liquidity increasing through leverage. At the same time, the State Council is encouraging banks to conduct their rights issues in Hong Kong as opposed to Shanghai, having just approved 287bn yuan of fundraising for BOC, ICBC, CCB and BOCOM. This will further alleviate liquidity pressures on the domestic market ahead of the ABC IPO, although has the perverse effect of meaning that the Chinese government is funding its remaining economic stimulus spending through HK share issues. 5

6 China Policy In-depth Policy: Negative Banks Outlook: Negative Performance: 1mth: -13.7%, 3mth: -7.3%, YTD: -17.8% Key Policy Themes While banks heeded the calls of the regulator to slow lending in Q1 10, with the loan books of H share banks expanding by around 7% from FY09, April lending came in at 774bn yuan, ahead of forecasts, which will likely lead to further tightening. In line with this, the regulator has continued to stress strict implementation of lending quotas, with PBOC saying it will increase window guidance in its Q1 10 monetary policy report, and stricter implementation of mortgage policies also likely. In addition, CBRC has emphasised the need to improve risk management, with reducing credit risk becoming its main focus for There are also currently risks from general monetary tightening. PBOC recently raised the reserve requirement ratio for the third time this year by 50bps, bringing the RRR to 17% for large banks. Another 50bp increase is likely in the short term, with any further increases likely to weigh more heavily on smaller banks that have higher loan-to-deposit ratios. Even without the regulator implementing stricter lending controls, banks may have trouble lending, given their eroded capital bases and the sector s falling excess to the reserve requirement ratio, which fell from 3.13% at FY09 to 1.95% at Q1 10. Any additional tightening will reduce this further, putting banks under additional pressure until their capital raisings are completed. The pressure on banks fundraising plans was partly alleviated after Central Huijin announced it would support the large banks fundraising plans. However, in light of falling liquidity on the domestic market, the State Council encouraged banks to conduct the majority of their fundraising in Hong Kong when it approved 287bn yuan of fundraising plans for the big four listed banks on 13 May. Even with fundraisings moved to Hong Kong, timing will still be an issue, as the priority of the government is to complete the Agricultural Bank of China IPO successfully. If fundraisings are delayed as a result, banks lending capacity will be further constrained. Major Sector Trends: Over the last month, the regulator has continued to stress the need to control the pace of lending and enhance risk controls, with particular focus paid to loans to the property sector and to local government financing platforms. In Q1, new loans to the property sector reached 845.7bn yuan, up 44.3% yoy, accounting for 32% of loans in Q1. CBRC had previously said that banks should closely monitor changes to the property market and strictly adopt related credit policies. In reality, however, commercial banks continued to lend to the property sector, contributing to the rise in house prices. Lending to property sector has accelerated, driving prices up This was then reflected in the April economic data, which showed property prices rising 12.8% yoy, up from 11.7% in March, with long-term household lending reaching 230bn yuan, up 134% yoy. Before the April data was released, the regulator began implementing stricter policies that were aimed at limiting the demand for loans, including: Deposits on first-home mortgages for houses greater than 90sqm will be raised from 20% to 30% Deposit on second-home mortgages will be increased from 40% to 50% and the mortgage rate will be increased to 110% of the benchmark rate Banks can stop issuing third-home or above mortgages 6

7 Outlook: Negative Stricter implementation of previously released mortgage policies Further monetary tightening to limit banks lending capacity Banks can refuse to issue loans to individuals who cannot prove they either paid taxes or made social security contributions for at least on year in the city where they intend to buy a house Banks must conduct quarterly stress tests on property loans As property prices continued to rise in April at an accelerated pace from March, the implementation of the new policies on mortgage lending is likely to become stricter. For example, while Beijing implemented the new policies on second and third-home mortgages strictly to the letter of the national government notice, Shenzhen and some other cities implemented them with a greater degree of flexibility. The degree of flexibility was intended, as it is clear that the regulators want to see property prices fall by around 10%, but do not want to kill the sector. The main goal of the regulator is not to restrict construction and property development explicitly, as real estate and construction accounted for 9% of GDP growth in 2008, but to reduce speculation in the sector. This is being done through encouraging mortgage loans for primary residences, while restricting mortgages for second and third home purchases. The implementation of policies to restrict speculative buying is likely to become stricter, which will likely translate to slower loan growth for banks. Risks of default from property, LGFP loans is limited The stricter implementation of property policies, while leading to slower loan growth, is unlikely to lead to large non-performing loans. Because banks will still have a degree of flexibility in implementing policies, a 30% fall in prices in unlikely, with a fall of around 10% being a more likely outcome. As a result, the overall impact on the banking sector will be limited, as many of the current worries are based on a more substantial deterioration in property prices. The other main risk to loans comes from local government financing platforms. In the two notes we have written on this topic, China Indepth: Local Financing, The Hole Story 26 March 2010 and China Insight: Banks Local Government Exposure 19 April 2010, we outlined the potential 1.5trn yuan black whole and individual banks exposure. However, the actual problem for the bank is generally overstated, as these loans are implicitly backed by the central government, therefore making it a fiscal problem. That being said, stricter measures to identify guarantees for specific loans are likely to be implemented, especially given reports that 40% of bank lending in Q1 10 went to local government financing platforms, which could potentially accelerate the recognition of NPLs. While this would likely be a good thing in terms of risk control, it could also mean that banks would have to reflect the loss on their balance sheets in the short term, which could weigh on the sector. Monetary policy tightening to continue The slowdown in mortgage loans has also had a knock-on effect in terms of increased banking sector liquidity. On 22 April, PBOC issued 90bn yuan of three-year notes, up from 15bn yuan in the previous issue, with the interest rate on these newly issued notes falling 1bp to 2.74%. On 6 May, the issuance volume was increased to 110bn yuan, yet the yield on these notes fell another 2bps to 2.72%. It is likely that the fall was due to increased liquidity in the sector, which may have also been one of the reasons why the PBOC increased the reserve requirement ratio by 50bps, effective 10 May, which removed roughly 320bn yuan from the banking sector. As bank lending in April came in at 774bn yuan, another 50bp increase to the reserve requirement ratio is also likely in the short term to continue tightening, with the effect likely to be felt more by the smaller banks with lower loan-to-deposit ratios, while the effect on the larger state-owned banks would be limited. An increase in interest rates, however, which is now looking more likely to be in Q3 or Q4, would not necessarily be negative for the banks lending While consumer loan volumes would likely fall, the majority of loans, which are taken out by SOEs for government mandated projects, will be unaffected. 7

8 China Policy In-depth Successful ABC IPO is the top priority of government Major Companies: In Q1 10, the banking sector reported higher profits from fee-based income, while capital ratios were maintained as the pace of lending slowed. This may have reduced the urgency with which banks need to conduct their capital raisings, especially for the large state-owned banks. This is particularly the case for Bank of China, China Construction Bank and ICBC, as they were supported by Central Huijin to reduce their dividend to shore up capital. In addition, Huijin said it will take part in their fundraising plans, reducing pressure on these banks. Following Central Huijin pledging its support for the capital raisings, the State Council approved 287bn yuan worth of capital raisings for ICBC (70bn yuan), BOC (100bn yuan), CCB (75bn yuan) and Bank of Communications (42bn yuan). The State Council also encouraged the banks to conduct a larger percentage of the fundraisings in Hong Kong, likely owing to the reduced liquidity on the domestic market. This partly reflects the priority given to the estimated bn yuan IPO of Agricultural Bank of China, which now looks likely to take place before the capital raisings, as the government would like to see the IPO succeed when it is being closely watched on such a global level. With bank capital raisings being postponed, sector lending will also be further tightened, in line with the government s overall monetary policy tightening. Of the three largest H share banks, CCB has so far announced the largest capital raising, with plans to issue 7 new shares for every existing 100, raising up to 75bn yuan through a right issue. It currently has the second highest capital adequacy ratio, at 9.17%, but with a total capital adequacy ratio of 11.44%, against the regulatory minimum of 11%, its lending could be restricted until it raises capital. ICBC remains the best capitalised of the Chinese banks, with a core capital adequacy ratio of 9.58% and total capital adequacy ratio of 11.98%. It is thought that both ICBC and BOC have abandoned plans to issue convertible bonds as a result of Central Huijin announcing it will support its capital raisings. It is now thought that ICBC will issue 1.5 for every 10 shares, raising up to 70bn yuan. Bank of China is also likely to adjust its capital raising plans and conduct a rights issue, although no details have been given on size. It has the third highest core capital adequacy ratio at 9.11%, but is close to the regulatory limit of 11% for total capital adequacy at 11.09%. The State Council recently approved BOC fundraising totalling 100bn yuan, although the bank has yet to announce details. In Q1 10, Bank of Communications, despite meeting all regulatory requirements for capital adequacy and NPL provisioning, reported that its total value of NPLs increased from FY09. Given the current concerns over this sector, the bank could come under pressure in the short term. At its results, the bank said it is working on its plans to raise 42bn yuan through a rights issue, but gave no indication of timing. China CITIC Bank reported an increase in NPLs to the property sector and missed regulatory targets for capital adequacy, reporting total capital adequacy ratio of 9.34% against a regulatory minimum of 10%. In an attempt to shore up its capital, the bank has announced plans to sell 16.5bn yuan of subordinated bonds. Even after raising capital, China Merchants Bank reported a total capital adequacy ratio of 11.53% at Q1 10, compared to the regulatory limit of 11%. With a loan-todeposit ratio of 76%, the bank may be constrained in lending in While China Minsheng Bank did not report capital adequacy ratios, the total value of NPLs increased by 58m yuan to 7,455m yuan. While not a substantial increase, it compares to a sector trend of NPL reduction. 8

9 Outlook: Negative Table 2: Banks Sector Monthly Policy DATE State Council Said to Approve 287bn Yuan of Bank Fundraising 13 May Loan Standards for Local Financing Platforms to Be United in Future 12-May Standard for Identifying Second-Home Mortgage Being Formulated 10-May 40% of New Loans This Year Went to Local Financing Platforms 10-May Regulation Details on Property Market Released in Shenzhen 7-May Central Huijin Supported Three Banks to Cut 2009 Dividend Ratio 4-May New Regulations to Limit Speculative House Purchases 4-May Reserve Requirement Ratio Raised for Third Time in May Rules on Housing Provident Fund for Second Homes to be Released 28-Apr Source: FCI Policy and Comments The State Council has approved a combined 287bn yuan of fundraising by BOC (100bn yuan), CCB (75bn yuan), ICBC (70bn yuan) and BOCOM (42bn yuan). Although the refinancing plans of some banks may be different from what was previous released, the scale of refinancing will not be changed. PBOC issued 20bn yuan of three-month bills and 90bn yuan of 91-day repurchases today. The interest rate on three-month bills is %, the 16th time for it to remain the same, lower than the 1.47% at the secondary market. PBOC also issued 14bn yuan of one-year bills on Tuesday, and considering that a total of 216bn yuan bills and repurchases will mature this week, up 94bn yuan that last week, PBOC will realise a net injection of 152 bn yuan into the open market this week. This follows 11 straight weeks of net withdrawals when PBOC withdrew 1.1trn yuan from the banking system. PBOC s hike to the reserve requirement ratio came into effect this week, removing roughly 320bn yuan from the banking system, which contributed to the slowdown in bill issuance. The slowdown in PBOC s withdrawal is only a temporary phenomenon. Next week, only 95 bn yuan bills and repurchases will mature, while three-year notes will also be issued, which means net withdrawals are likely again. The Ministry of Housing & Urban-Rural Development is formulating standards for identifying second-home mortgages with PBOC and CBRC, as required by the State Council, according to the ministry?s vice minister Qi Ji. Qi Ji said that household ownership will be determined by families and not individuals. Qi Ji also said that feedback from local markets show that the rapid growth trend in certain cities has begun to come under control. He also said that the social housing construction plan for will be released to the public before the end of July. In the first few months of the year, roughly 40% of new bank loans have gone through local government financing platforms, with the scale of local financing platform liabilities increasing rapidly, according to Wei Jianing, vice director of macroeconomics at the Development Research Centre of the State Council. In the past, there were 2-4 financing platforms for each level of local government, but this increased to over ten in There are c.3,800 local financing platforms nationwide, of which 70% are county level. Jia Kang, director of Research Institute for Fiscal Science in MOF, said that he does not consider the total amount of local financing to be problematic, but said that the biggest problem in local financing lies in the lack of regulation. The new property market policies for Shenzhen were released yesterday, which basically reiterated the newly released national policy. It should be noted, however, that Shenzhen government has stopped the trading of social housing. If social housing is transferred or sold, the government will repurchase these houses and then reallocate. The local government also pointed out that in 2010, it will start construction of 50,000 new social housing units, supply and distribute 10,000 pre-existing units and provide residential subsidy for 5,000 low-income families. Central Huijin said that it supported ICBC, BOC and CCB to reduce their 2009 dividend payout ratios from 50% to 45% to improve their capacity to supplement capital through profit retention. Central Huijin also said it will support and participate in those banks refinancing plans. According to the original plan, Central Huijin can receive 20.1bn yuan, 24bn yuan and 26.9bn yuan of dividends from ICBC, BOC and CCB, respectively. With the 5% decline, the three banks can reduce their overall dividend payments by nearly 7bn yuan, while the payout to Central Huijin will decline by 3.55bn yuan. With the A share market continuing to decline and financial shares also falling, Central Huijin s announcement was made as a signal to maintain the market stability and ease banks financing pressures. On April 30, the Beijing Government issued new property regulations requiring commercial banks to suspend issuing third home or above mortgages and loans to non-local residents who cannot provide evidence of local tax payments or social insurance contributions for at least one year. It also released a temporary regulation saying that one family can only purchase one new commercial house in Beijing. PBOC will raise the reserve requirement ratio by 50bps from 10 May, the third increase this year, bringing the RRR to 17% for large banks, while rural credit cooperatives and village banks are temporarily unaffected. This compares to the high of 17.5% for large banks in June Based on the value of yuan deposits at the end of March, this increase will remove almost 320bn yuan from the financial system. The Ministry of Housing & Urban-Rural Development is working on detailed rules for second home purchases using individuals employer-backed savings funds, with the goal of partly restricting the use of these funds to curb speculation without hurting real demand. In addition, the funding sources of property developers will be tightened. Relevant regulators intend to include trust loans into the scope of regulation on establishing quotas on the total lending scale. Currently, banks with tight lending quotas allow trust companies to lend on their behalf, with trust loans reaching 400bn yuan in Jan-Feb, accounting for a fifth of total loans. With this new regulation, real estate trust financing will also be tightened. SAFE is also currently investigating foreign capital inflow in different regions, focusing on channels, scale and direction of foreign capital inflows. 9

10 China Policy In-depth Table 3: Banks Sector Monthly Policy DATE New Restrictions on Shareholdings of Smaller Banks 28-Apr BOC Implements New Property Policies 26-Apr Interest Rate Falls on Three-Year Notes 22-Apr Banks Told to Conduct Stress Tests on Property Loans 21-Apr Banks May Face Large Loss if New LGFP Regulations are Put in Place 16-Apr State Council Stresses Curbing House Price Growth 15-Apr New Regulation on Capital Expected, Lending Risks Examined 12-Apr Policy and Comments Regulators plan to increase the entry barrier for shareholders taking a stake in small and medium sized banks, with a single shareholder prohibited from taking a stake in more than two banks of a similar size and business structure. If a shareholder has a controlling stake, it can only maintain a stake in one bank. Bank of China will adopt strict control over any kind of property speculations and will, in principle, suspend issuing third-home mortgage or above. Families which buy their first home below 90 sq m, will receive a lending rate of 85% of the benchmark rate, but first homes above 90 sq m, the deposit must be no less than 30%. Families which have a mortgage on their first home must have a 50% or greater deposit on their second, with an interest rate of 1.1x the benchmark. The bank will also raise the interest rate on all preexisting mortgages. This follows China Construction Bank s announcement on 21 April that it will begin implementing the new property regulations, while Bank of Nanjing has required a deposit of no less than 60% on third-home mortgages. BOC did not mention when its policies will be implemented, however. At the same time, CSRC will work with the Ministry of Land and Resources to tighten the regulation on property companies financing. The applications from 41 companies have been sent to MLR in order to make sure the companies purchase and use of land are in line with existing land regulations. PBOC issued 23bn yuan of three-month central bank bills and 90bn yuan of three-year central bank notes today, down 45bn yuan and up 75bn yuan from last week, respectively. PBOC also issued 35bn yuan 91- day repurchases today. Overall, the PBOC realised a net withdrawal of 65bn yuan this week, up from 14bn yuan last week. The interest rate on three-month central bank bills was maintained at %, while that for three-year central bank notes was 2.74%, down from 2.75% a the last issuance on 8 April, when the issuance was resumed after being suspended since 26 June CBRC has told banks to conduct quarterly stress tests on property loans, increase risk controls on loans to the property sector and use mortgage policies to restrict housing speculation. In line with this, CIRC has reiterated that insurance companies should not invest directly in property. This follows recent announcements from CBRC telling banks to adopt new policies on second and third home mortgages, the implementation of which still depends on the final detailed regulations which are expected to come out soon. To help recognise the risks of loans to local government financing platforms and to prevent local governments from using fiscal revenues as guarantees in the future, CBRC may require banks to change the type of guarantee for loans to local government financing platforms that are backed by local fiscal funds by the end of Q3. For those loans that don t see their guarantees change, banks will have to set aside provisions of 20% of the value of the loans. Surveys show that over 50% of the estimated 6trn yuan of loans to local government financing platform were guaranteed by local fiscal funds, which means that banks may have to set aside up to 600bn yuan of provisions if this is implemented. The State Council said yesterday that factors driving prices up are emerging now, leading to increased inflation expectations. In particular, house price increases are particularly pronounced in certain cities, including Beijing and Shanghai. The State Council again stressed the need to curb the quickly rising house prices. It said that local governments must become responsible for maintaining the healthy development of the property market. It also emphasised that China must increase the land supply for residential housing construction. To curb speculative house purchases, further differential credit policies should also be implemented. In addition, the State Council mentioned that the drafting of effective tax policies to guide personal house purchases should be accelerated. CBRC is considering implementing more detailed regulatory measures on capital adequacy and may create three to four different classifications for banks that have capital adequacy ratios above 8%. Currently, the CBRC requires that large commercial banks have a total capital adequacy ratio about 11%, while small and medium sized banks should be above 10%. During the classification process, several factors will be taken into account, including minimum and total capital requirements and the percentage of leverage. No details have been given on how restrictions would differ between classifications. At the same time, Liu Mingkang, chairman of CBRC said that banks must submit reports to the regulator outlining their loan exposure, including loans to property developers and local government financing platforms, by the end of June. After the reports are examined, the regulator may downgrade assets and increase provisions. Given the large risk exposure to the property sector, Liu said that banks should raise the minimum deposit and interest rate on loans if it is suspected to be used for property speculation. Source: FCI 10

11 First China Invest Policy Sector Review Banks Market cap Perf Sales m Price 1 mth 3 mth 12 mth YTD Price/ Book Price/ Sales Div Yield Curr Yr PE Next Yr PE Op. Margin Growth RoE 1398 HK IND & COMM BK OF CHINA - H 1,509, CH IND & COMM BK OF CHINA - A 1,509, HK CHINA CONSTRUCTION BANK-H 1,266, CH CHINA CONSTRUCTION BANK-A 1,266, HK BANK OF CHINA LTD-H 965, CH BANK OF CHINA LTD-A 965, HK BANK OF COMMUNICATIONS CO-H 333, CH BANK OF COMMUNICATIONS CO-A 333, CH CHINA MERCHANTS BANK-A 295, HK CHINA MERCHANTS BANK-H 295, CH CHINA CITIC BANK CORP LTD-A 186, HK CHINA CITIC BANK CORP LTD-H 186, CH SHANGHAI PUDONG DEVEL BANK-A 164, CH INDUSTRIAL BANK CO LTD -A 133, HK CHINA MINSHENG BANKING-H 147, #N/A N/A CH CHINA MINSHENG BANKING-A 147, CH BANK OF BEIJING CO LTD -A 82, CH SHENZHEN DEVELOPMENT BANK-A 54, #N/A N/A CH HUAXIA BANK CO LTD-A 52, CH BANK OF NINGBO CO LTD -A 28, CH BANK OF NANJING CO LTD -A 24, Average 473, New Bank Lending 2.5 2, Mid-long term Short term Bill financing 2 1, RMBbn 1, IND & COMM BK -H CHINA CONST BA-H BANK OF CHINA-H HANG SENG FINANCIAL INDX Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 0 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Source: Bloomberg, CEIC

12 Policy: Neutral Policy: Neutral Insurance Outlook: Neutral Performance: 1mth: -10.2%, 3mth: -0.5%, YTD: -5.4% Key Policy Themes While insurance companies have been increasing their equity holdings in property companies, CIRC reiterated last month that insurance companies should not invest directly in property. As the regulators are currently trying to slow credit to the property sector, it is unlikely that insurance companies will receive approval to invest directly in property in the short term. This is despite the announcement made in December on permitted investments of insurance companies which encouraged banks to invest in property, mostly infrastructure, without giving specific details of the permitted range of property investments. Bancassurance in rural areas may be improved, following a joint announcement by CBRC and CIRC that enables farmers to use agricultural insurance as collateral for loans. This is another step in the trend of increased cooperation between banks and insurance companies, following a round of banks taking stakes in insurance companies in late 2009 and early Insurance companies are likely to continue to come under pressure as long as tightening in the property sector continues, given their large equity holdings of property stocks. However, insurance companies have said they will increase the proportion of bonds in their total investment portfolios this year, which could offset some of the losses on the property portfolio should interest rates be increased. Major Sector Trends: This month, the CIRC reiterated that insurance companies are prohibited from investing directly in property. This announcement should not be surprising, given the current regulatory clampdown on credit and funding going into the property sector. Detailed regulations were expected to be released outlining the permitted investments of insurance companies in the property sector, but these have not yet been published. This comes after the CIRC issued The Interim Measure for Insurance Funds Management (Draft), outlining general restrictions on permitted investment channels for insurance companies. The legislation set restrictions on stock investments, prohibiting insurance investment in stocks on the start-up GEM board, and said that insurance companies will be encouraged to invest in property, mainly infrastructure projects, but are forbidden from investing in fixed assets without stable returns. They will be allowed to buy controlling stakes in other insurers, companies related to the insurance sector and non-insurance financial institutions, but cannot buy stakes in non-financial institutions. With property prices rising more than 10%, insurance sector investment is unlikely to be approved Property would be a good investment channel for insurance companies, as the long-term stable returns can be matched with some of the longer dated liabilities which the industry is beginning to establish. However, as long as property prices remain high and a focus of media attention, it is unlikely insurance companies will be allowed to invest in the sector. The promotion of bancassurance has continued, with CBRC and CIRC jointly releasing a document which will enable farmers to take out agricultural insurance policies, with the banks required to accept these policies as collateral for loans. Banks should then determine the terms of the loan based on the type and proportion of the insurance taken out. It is unclear exactly how big this business will be for insurance companies, as the details of the size of the subsidies and level of support have not been given, but it should be well supported by the government, as it should help relieve the financing difficulty for 11

13 China Policy In-depth NSSF pledges to support index futures Insurance companies increase fixed income portfolios 12 farmers. As insurance companies will assume much of the risk of the loans from the banks, the insurance premiums may be high. National Social Security Fund The National Social Security Fund was announced as the only pre-ipo strategic investor in the IPO of Agricultural Bank of China. It is not surprising that NSSF would be involved in the IPO, as it currently holds stakes in almost all of China s listed stateowned enterprises. Da Xianglong, chairman of the NSSF, said that the fund will invest at least 15bn yuan in ABC. In addition, Dai Xianglong said that NSSF is willing to invest in stock index futures, but will do so through qualified NSSF managers rather than direct participation. In November 2008, NSSF announced it was buying equity shares in the open market, which provided a floor for the market. This announcement has similarly provided support for the nascent index futures market (see Securities section). Also, the NSSF is likely to increase overseas investment from the current 7% to 20%. Given that the NSSF has no major liabilities in the next 10 years, it plans to reduce investment in fixed-income products, maintain the proportion of domestic stock investment and increase industrial investment. As part of its plan to increase overseas investment, it will invest both in listed and non-listed overseas companies. It is interesting to note that as part of its plans to reduce investment in fixed income and increase equity investment, the NSSF did not mention plans to increase investment in the domestic stock market. Major Companies: With insurance companies still banned from investing directly in property, companies in the sector have resorted to buying property stocks. Given the current policy tightening in the sector, this is likely to continue to weigh on insurance shares. China Life Insurance has become the largest shareholder in Sino-Ocean Land, holding 24% of the company. In addition, China Life Insurance holds Hong Kong listed stocks including BBMG, South City, Hengsheng Real Estate and Longhu Real Estate, as well as Beijing Tianhong Baoye Real Estate, Shenzhen Heungkong Holding, Beijing Urban Construction Investment & Development, Gemdale and China Vanke listed on the A share market. According to the Hong Kong Economic Journal, Ping An Insurance is planning a 10bn yuan trust with Longfor Properties to develop property projects. This is in line with the company s previous strategy, as Ping An Trust said in September that it would invest 15bn yuan in properties developed by Greentown China Holdings over the next three years, while it paid 1.6bn yuan in December for a 49% stake in a Shanghai property project with Gemdale. China Pacific insurance at its Q1 results said it will increase infrastructure investment this year. It currently has several investments in the sector which provide long-term stable returns to match against long-term life insurance liabilities. China Life in April said it would increase the proportion of bonds in its investment portfolio this year in anticipation of interest rate increases. By the end of 2009, it had about half of its 1.2bn yuan of investment assets in bonds. Ping An also said it increased its bond holdings in Q1, and will look for opportunities in high-quality corporate bonds in the medium and long term. Ping An has also finally received approval to take over TPG Capital s 16.76% stake in Shenzhen Development Bank, where it will issue 299m new shares to TPG, and will also purchase 585m new shares issued by SDB, with the approval for the new share issuance still needing CSRC approval. The combined deal will see Ping An increasing its stake in SDB to 30%. In addition, Ping An was also reported to be negotiating to purchase a stake in Shanghai Securities, but the company denied this in future reports. On an international level, there has been much discussion about Prudential s possible US$35.5bn acquisition of AIA. Possibly the most prized of AIA s assets is its Chinese insurance business, as it is the only foreign insurance company to hold a license to

14 Outlook: Neutral operate in China without a joint venture. If Prudential succeeds in acquiring AIA, it will likely have to dispose of either AIA or its joint-venture with China CITIC Group. If it were to dispose of the stake in the joint-venture, the most likely buyer is CITIC (for further details, see our report China Insight: Pru and AIA 9 March 2010). However, it was rumoured last month that Prudential may sell the Chinese business. Table 4: Insurance Sector Monthly Policy DATE Policy and Comments CBRC and CIRC to Introduce Agricultural Loan Insurance 28-Apr Regulations on Investment in Property to Come Out Soon 14-Apr Source: FCI CBRC and CIRC jointly released a document which will enable farmers to take out insurance and commercial banks will accept the agriculture related insurance as an appropriate qualification to receive credit. Banks should then determine the terms of the loan based on the type and proportion of the insurance taken out. CIRC chairman Wu Dingfu said that detailed regulations on insurance funds investing in property and private equity will come out soon. In order to prevent investment risk, insurance funds will be prohibited from investing in residential housing, participating in property development or directly investing in commercial property. As insurance premiums have been increasing rapidly, insurance companies must find new channels through which to allocate their funds. However, given the current risks of investing in the property market, CIRC has delayed releasing the relevant regulations. Several insurance companies have already made preparations for investing in property: China Life has become the biggest shareholder in Sino-Ocean Land, while Ping An signed a trust investment agreement with Gemdale and Greentown. 13

15 First China Invest Policy Sector Review Insurance Market cap Perf Sales m Price 1 mth 3 mth 12 mth YTD Price/ Book Price/ Sales Div Yield Curr Yr PE Next Yr PE Op. Margin Growth RoE 2628 HK CHINA LIFE INSURANCE CO-H 717, CH CHINA LIFE INSURANCE CO-A 717, HK PING AN INSURANCE GROUP CO-H 367, CH PING AN INSURANCE GROUP CO-A 367, HK CHINA PACIFIC INSURANCE GR-H 212, CH CHINA PACIFIC INSURANCE GR-A 212, HK PICC PROPERTY & CASUALTY -H 68, #N/A N/A HK CHINA TAIPING INSURANCE HOLD 37, #N/A N/A Average 337, Insurance Premiums P&C Life RMBbn CHINA LIFE INS-H PING AN INSURA-H PICC PROPERTY & HANG SENG FINANCIAL INDX 0 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Source: Bloomberg, CEIC

16 China Policy In-depth Policy: Positive Securities Companies Outlook: Positive Performance: 1mth: -23.0%, 3mth: -21.6%, YTD: -28.0% Key Policy Themes Policy support for financial market innovation has continued over the past month, with trading in index futures and margin trading both beginning, as well as further support being pledged for the international board, derivatives, forwards and swaps. This was overshadowed, however, by monetary policy tightening, which removed liquidity from the stock market and led to lower trading volumes and fewer new accounts being opened. Margin trading is likely to be expanded to include funds, securities houses and QFII in the short term to add much needed liquidity to the domestic stock market to support the high profile IPO of Agricultural Bank of China. Initial margin trading volumes are low, with the balance of margin trading and securities lending reaching just 423m yuan as of 14 May, but could rise substantially once institutional investors are allowed into the market. The hedging quota for index futures has been approved, which means that funds and securities houses may also be allowed to invest in index futures soon, with securities houses likely to get the nod before funds. Daily transaction volumes in futures have increased rapidly but the value of open positions remain low due to the lack of institutional investors. As institutional investors are likely to use the market more for hedging purposes, the number of positions held should increase substantially, which should play a significant role in stabilising the spot market and allowing the futures market to realise its price discovery function. Preparations for the international board are underway, although the actual timing is likely to be adjusted in line with market conditions. The successful launch of the international board is part and parcel of turning Shanghai into an international financial centre, so it is likely the regulators will push ahead with the introduction, despite governance problems. The first companies likely to list will be large international financials, such as HSBC and Bank of East Asia, as well as Red Chips such as China Mobile. Major Sector Trends: May marked the introduction of both margin trading and stock index futures, an important step in increasing the sophistication of the domestic market and providing new, diversified investment channels for Chinese investors. Institutional investors to be approved for margin trading soon The scale of margin trading remains small, with the balance of margin trading and securities lending reaching just 423m yuan as of 14 May, but this is largely due to the fact that only retail investors have been allowed to participate. It is expected that institutional investors, including funds, securities houses and QFII will get access to the market soon, which could increase volumes substantially. Crucially, the increased volumes in the market should provide liquidity to help support the market ahead of the IPO of Agricultural Bank of China. Index futures have had a much more promising start, with the daily turnover of the CSI300 Index Futures reaching 197bn yuan on 14 May, almost four times as much as the daily turnover of the underlying index of 55bn yuan. Amongst other reasons, this is because transactions costs can be more than four times higher when buying shares, while futures are also currently exempt from the stamp tax. 14