China Banks:Re-rating may start as defaults accelerate

Notable monetary tightening was seen after Jan-10, when the M1-M2 growth gap reached 13ppt, and we are back to this level in June 2016.

    (a) Less attractive time deposit rates after rate cuts; (b) weakening investment demand of corporates; (c) property boom and transfer of money from retail deposits (M2) to developers’ demand deposits (M1); and (d) the time lag between local government bond issuance and loan swap are the four reasons mentioned by a PBOC official when interpreting the rapid increase of M1 in China (Xinhua, 15 July).

    We see a shift of monetary focus from liquidity easing to efficiency becoming notable from 2H16F.

    We believe the record-high M1/M2 gap suggests that the bottleneck in the monetary policy is liquidity efficiency, not supply, and a switch of monetary focus from liquidity easing to efficiency is likely needed to address this bottleneck. In 2Q16, we have seen the PBOC turning prudent on M2 growth guidance (14 May 2016), refraining from RRR/interest rate cuts, and China’s M2 velocity saw a mild improvement in 2Q16 vs. the trough in 1Q16. Looking ahead, we believe the monetary focus may shift to efficiency from 2H16F onwards - a pre-requisite for our structural re-rating call on China banks (see 2016 outlook: Changing the playbook, from easing to efficiency, 3 Nov 2015).

    Defaults may accelerate when the monetary focus shifts to efficiency, but it is exactly the hard evidence that could support a structural re-rating of China banks, in our view.