Targeted RRR cut. Targeted RRR cut not signifying a reversal in neutral monetary policy. Equity Research Investment Strategy.

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Scarlett Sparks
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1 Equity Research Investment Strategy Targeted RRR cut Targeted RRR cut not signifying a reversal in neutral monetary policy Ou Yafei SFC CE No. BFN410 oyf@gf.com.cn GF Securities (Hong Kong) Brokerage Limited 29-30/F, Li Po Chun Chambers 189 Des Voeux Road Central Hong Kong Contribution from the GF A-share research team: Dai Kang * daikang@gf.com.cn Guo Lei * guolei@gf.com.cn Ni Jun * nijun@gf.com.cn Chen Fu * chenfu@gf.com.cn * Please note that Dai Kang, Guo Lei, Ni Jun and Chen Fu are not a registered licensee with the Securities and Futures Commission of Hong Kong and is not allowed to conduct regulated activities in Hong Kong. The latest targeted RRR cut will help scale down outstanding MLFs, offset the increase in costs of funds for commercial banks during interest rate liberalization and improve the duration structure of commercial banks liabilities. Unlike what some investors might think, we do not see the rate cut as a reversal in the central bank s prudent and neutral monetary policy stance. Coupled with the PBoC s 5bps reverse repo rate hike on April 16, this combination of reverse repo rate hike + RRR cut is aimed at preventing the market from reading the RRR cut as a policy shift towards monetary easing. Additional liquidity injection created by the rate cut on top of the replacement of outstanding MLFs reflect that the PBoC does not wish to make mid-term credit supply overly tight and that it will stick to its current course of deleveraging amid mild inflation, which is in line with our previous judgment. The Rmb400bn of extra liquidity generated from this latest rate cut (after offsetting MLFs) is equivalent to an actual RRR cut of 24bps. The market has previously been concerned about the transfer of OBS financing back onto the balance sheet causing a contraction in mid-term credit supply and dampening economic growth. This latest rate cut clearly indicates that this is not what the central bank wants. We reiterate our outlook on 2Q18 that three market (mis)expectations will be adjusted. First, economic growth is better than currently perceived by the market. The market fears a significant credit contraction, but we think the latest rate cut is the first signal of targeted credit easing amid stable economic data. Second, the combination of the reverse repo rate hike and RRR cut suggests that interbank liquidity is unlikely to be loosened. Third, the structural difference in the risk appetite for different sectors might be adjusted, with risk aversion to be mitigated and market interests in new economies to slightly cool off. With the PBoC s latest moves, market consensus is likely to shift from monetary easing + credit tightening to money supply might not be as loose and credit supply might not be as tight as previously imagined. We continue to believe the A-share market is experiencing a period of fluctuations amid a slow-bull run. Absolute-return investors should moderately control their positions while waiting for clearer signs of credit easing (e.g. improvements in total financing) and further developments in Sino-US trade tensions. We suggest relative-return investors should focus on cyclical sectors (banking, property, coal, securities) whose share prices have sufficiently corrected; we also advise selective allocations in midstream manufacturing sectors such as pharma chemical, materials, packaging and machinery given capacity expansion potential, as well as mass market consumer such as retail, food processing and healthcare; for growth sectors, we prefer those whose valuations fairly reflect their business conditions such as traditional Chinese medicine and media. Risks to our key assumptions: Stronger-than-expected credit contraction, and moresevere-than-expected trade frictions between China and the US. Please see text for comments from our macro, banking and non-bank financial teams. This is a summary of a report originally written in Chinese. Please contact us for more information of the original report. The Chinese version shall prevail in the event of any discrepancy between the two versions.

2 Macro: Targeted RRR cut as guidance to improve real economy liquidity Targeted RRR cut as guidance to improve real economy liquidity, rather than response to increased downward economic pressure Relatively stable 1Q18 nominal GDP growth of 10.2% and real growth of 6.8% will help anchor the range of full-year economic growth. Organic economic growth drivers such as exports, industrial production and consumption are still stable, with property sector growth even much better than market consensus. While March data for industrial activities came in relatively low due to a smaller number of working days, data have pointed to improvements in April. As such, the latest targeted RRR cut is not a forced response to increased downward pressure on the economy, but rather a reaction to decreased liquidity in the real economy. 1Q18 total financing data came in relatively weak partly due to weaker nominal GDP and demand growth, and partly due to the fact that some financing demand in the real economy was not reflected in the form of on-balance-sheet financing amid contracting non-standard credit businesses, the movement of OBS financing businesses back onto the balance sheet, and debt swaps. The latest rate cut should be interpreted as guidance for a structural improvement in real economy liquidity amid stable economic data and depressed financing supply. "Credit easing + neutral monetary policy" aimed at helping real economy financing A targeted RRR cut announced shortly after a 5bps hike in the 14-day reverse repo rate on April 16 appear to gesture a combination of credit easing and neutral monetary policy, i.e. support for on-balancesheet Rmb loans and deposits which are more closely related with financing needs in the real economy vs. a continuation of neutral policy for the money market which is more closely related with the finance system. The structural difference in liquidity between large and smaller banks, and between banks and non-bank institutions will also be rebalanced by the rate cut. Rate cut to boost credit supply capabilities The PBoC was quite restrained in increasing the monetary base in 2017, with M2 growth mainly driven by a reduced excess reserve ratio and a higher money multiplier. However, banks' excess reserve ratio fell to a relatively low level in 2017, and the upside to the money multiplier would be limited without a RRR cut. Rate cut to recalibrate interest rate curve and lower banks' costs of funds The latest targeted RRR cut will replace ~Rmb900bn worth of MLFs and inject an additional Rmb400bn of liquidity into the system. This will not only help lower short-term interest rates and thus adjust the interest rate curve which has been distorted by regulations and bubble curbing measures since 2017, but will also effectively lower the costs of funds for banks by replacing higher-cost MLF funds (one-year rate 3.3%) with cheaper reserve funds (interest at 1.62%). Market oriented interest rates Recent PBoC guidance to relax the cap on commercial banks' deposit rates has caused market concerns about higher costs of funds pushing up financing costs for the real economy. The latest targeted RRR cut will effectively offset part of this increase in the costs of funds. By steering deposit rates higher while lowering money market rates, the central bank's latest moves will help bring the two interest rates closer together. Paving the way for new asset management rules While policy details are yet to be finalized, requirements in the to-be-implemented new asset management rules regarding OBS product defaults and restrictions on product embedding are not expected to be changed. These new rules are likely to affect asset prices and market liquidity in the short term. The latest targeted RRR cut will act as an outlet of liquidity pressure in advance to the official implementation of these rules. Risks Higher-than-expected downward economic and liquidity pressure. 2

3 Banking: Targeted RRR cut more than just a substitute for MLF Reasons for targeted RRR cut As M2 growth has remained below the PBoC's 9% target due to slower credit supply growth brought by tougher financial regulations, the central bank needs to offset the effect of tightening credit with liquidity measures. Given uncertainties with money supply through net forex purchases this year and the contraction in money supply caused by the expected decrease in fiscal deposits in 2Q18, any growth in the monetary base would have to come from the PBoC. However, relying on open market operations alone would only add to the cost and uncertainties of money supply. Furthermore, with decelerating ordinary deposit growth so far this year, intensified competition for deposits has led to continued rises in the cost of banks' liabilities; replacing MLFs with a targeted RRR cut should lower banks' fund acquisition costs and thus the overall cost of their liabilities. Why now? Starting from April 18, the banking system will enter a two-month-long period of fiscal deposit withdrawals. Continued reliance on one-year MLFs would push costs of funds further upwards, while tightening liquidity in the real economy and competition for deposits will lead to higher volatility in banks' excess reserve levels, which would subsequently affect interbank interest rates. Impact Based on a static analysis, the latest targeted RRR cut will in effect free up Rmb1.3trn of reserve funds, a figure which would continue to grow as ordinary deposits grow. Considering the difference between the one-year MLF interest rate and the RRR, this rate cut is equivalent to reducing the interests on banks' liabilities by Rmb20bn. Seen from a more dynamic prospective, i.e. considering the drag on the overall costs of banks' liabilities and the long-term effects of the targeted RRR cut, its impact would be greater. Targeted RRR cut more than just a substitute for MLF The withdrawal of fiscal deposits mentioned above is seasonal, and the annual levels of fiscal deposits are relatively stable. The longer-term impact of the rate cut will gradually be seen from 2H18, by which time interbank liquidity should become less strained. Undoubtedly, the impact of the upcoming implementation of the new rules for the asset management business has also likely been considered, and the targeted RRR cut likely implies that these new rules will be put in place soon. Liquidity still expected to tighten in 2Q18 The withdrawal of fiscal deposits will likely more than fully offset banks' excess reserves. An estimated total of Rmb2trn in fiscal deposits will likely be withdrawn during 2Q18, and any improvement in banking liquidity might not be seen until end-june (when ~Rmb2trn worth of fiscal expenditures will be made). In addition, ordinary deposits placed by entities in the real economy tend to decrease due to tax payments; the impact of this needs to be offset by an increase in bank credit which is still subject to credit expansion regulations. As such, real economy entities will continue to face pressure of tight liquidity which might only start to be mitigated by fiscal spending after the end of June. Policy outlook For full-year 2018, assumed M2 growth of 9% entails an increase of 9% or Rmb2.9trn in the monetary base. Given that the targeted RRR cut will bring additional money supply of Rmb1.4trn (Rmb1.3trn x 1.09) and that fiscal deposit movements will have a net effect of an Rmb800bn injection to banking liquidity, another Rmb700bn increase in the monetary base is still needed to meet the M2 growth target. This means at least one more RRR cut of 0.5% will be needed this year, with the fiscal deposit withdrawal period in early Oct a potential time window for this further rate cut. 3

4 Positive on banking sector The targeted RRR cut will reduce pressure related to the sources and costs of funds for banks. It will benefit banking stocks, especially large banks with higher reserve rates, and more visible relative returns can be expected from banking stocks in 2Q18. Risks Stronger-than-expected impact on liquidity, higher-than-expected interest rate volatility, faster-than-expected drop-off in the economy, significant deterioration in banking asset quality, and tougher-than-expected policies. Non-Bank Financials: Targeted RRR cut to drive sector re-rating Based on the eight RRR cuts since 2014, both the securities and insurance sectors recorded positive returns of 3%-5% within five trading days of the rate cuts with particularly high returns of 11%/14% in Feb Securities sector share prices are mainly driven by liquidity easing and policy stimulus. The latest targeted RRR cut will help increase the overall market risk appetite and drive a rebound in securities stocks. Based on sector performance over the past 2-3 years, leading securities firms' P/B valuations could go as high as 1.8-2x. We reiterate our optimism on the sector given bottom-level valuations and positive catalysts (e.g. MSCI inclusion of A shares, CDRs, London stock connect, targeted RRR cut). Insurance sector In terms of insurers' assets, the rate cut will boost the bond market, and help improve investment returns from bond trading, and enhance net asset value by driving the fair value of available-for-sale bonds. That said, higher bond prices will push up the cost of additional bond allocations. Meanwhile, increased liquidity brought by the rate cut will help invigorate stock market sentiment and to some extent strengthen equity investment returns. In terms of insurers liabilities, reduced costs of funds might make life insurance products more attractive and free up funds that can be spent on purchasing insurance products. This would help improve lackluster life insurance sales since the start of this year. Overall, the targeted RRR cut will have a positive impact on the insurance sector. Risks An economic slowdown, interest rate volatility, intensified industry competition, weaker-thanexpected operating results, and major risk and default events. 4

5 Rating definitions Benchmark: Hong Kong Hang Seng Index Time horizon: 12 months Company ratings Buy Stock expected to outperform benchmark by more than 15% Accumulate Stock expected to outperform benchmark by more than 5% but not more than 15% Hold Expected stock relative performance ranges between -5% and 5% Underperform Stock expected to underperform benchmark by more than 5% Sector ratings Positive Sector expected to outperform benchmark by more than 10% Neutral Expected sector relative performance ranges between -10% and 10% Cautious Sector expected to underperform benchmark by more than 10% Analyst Certification The research analyst(s) primarily responsible for the content of this research report, in whole or in part, certifies that with respect to the company or relevant securities that the analyst(s) covered in this report: (1) all of the views expressed accurately reflect his or her personal views on the company or relevant securities mentioned herein; and (2) no part of his or her remuneration was, is, or will be, directly or indirectly, in connection with his or her specific recommendations or views expressed in this research report. Disclosure of Interests (1) The proprietary trading division of GF Securities (Hong Kong) Brokerage Limited ( GF Securities (Hong Kong) ) and/or its affiliated or associated companies do not hold any shares of the securities mentioned in this research report. (2) GF Securities (Hong Kong) and/or its affiliated or associated companies do not have any investment banking relationship with the companies mentioned in this research report in the past 12 months. (3) Neither the analyst(s) preparing this report nor his/her associate(s) serves as an officer of the company mentioned in this report and has any financial interests or hold any shares of the securities mentioned in this report. Disclaimer This report is prepared by GF Securities (Hong Kong). It is published solely for information purpose and does not constitute an offer to buy or sell any securities or a solicitation of an offer to buy, or recommendation for investment in, any securities. 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Any recommendation contained in the research report does not have regard to the specific investment objectives, financial situation and the particular needs of any individuals. The report is not to be taken in substitution for the exercise of judgment by respective recipients of the report, where necessary, recipients should obtain professional advice before making investment decisions. GF Securities (Hong Kong) may have issued, and may in the future issue, other communications that are inconsistent with, and reach different conclusions from, the information presented in the research report. The points of view, opinions and analytical methods adopted in the research report are solely expressed by the analysts but not that of GF Securities (Hong Kong) or its affiliates. The information, opinions and forecasts presented in the research report are the current opinions of the analysts as of the date appearing on this material only which may subject to change at any time without notice. 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Chinese Banking Sector

Equity Research Financials Jan 17, 218 Chinese Banking Sector Positive (maintained) Strong loan demand expected; intensified competition in deposits Wang Wen SFC CE No. BGL298 wangwen@gfgroup.com.hk +86