<p>Asia Banks Sector<br/>SECTOR REVIEW<br/>Asset quality: banks pressure index –<br/>September update<br/>■<br/>By popular demand, we have updated the Credit Suisse pressure index<br/>for banking systems in Asia to September (refer to the detailed report<br/>Asset Quality – How bad can it get? 29 August 2008 using June data).<br/>■<br/>The index values have risen across the board from June, with India<br/>flashing red. Scorching loan growth, plunging industrial production<br/>and asset markets, declining forex reserves and a worsening trade<br/>deficit contribute to India’s stress. Korea suffers from these in addition<br/>to a high loan-deposit ratio, offset partially by the currency<br/>depreciation. China and Malaysia show the least pressure on their<br/>banking systems, helped by restrained loan growth and trade surplus.<br/>■<br/>NPLs continued to fall in the first nine months of this year in most<br/>markets in Asia; with the exception of Korea and India. The key factor<br/>alleviating the pressure this time is very low interest rates across Asia.<br/>We are convinced that the cycle is turning, NPLs and credit costs will<br/>rise materially in 2009 but (unlike 1998-99) our analysts are forecasting<br/>it will be an earnings rather than a book value event.<br/>■<br/>Asset quality sensitivity is maximum in Taiwan and Korea: just about<br/>3% of loans turning bad would wipe out their profits in 2009.<br/>■<br/>While banks may outperform in a bear rally in the near term, we remain<br/>very concerned about the earnings outlook for 2009 and 2010. Unlike<br/>investors who have a choice, we cannot avoid banks. China remains<br/>the preferred market given the government’s ability to conduct fiscal<br/>and monetary stimulus where we are MW banks and OW insurance.</p><p>Asset quality: Bank pressure index<br/>– September<br/>Updating the Credit Suisse pressure index for September, we find that index values have<br/>gone up across the board (implying rising stress on the banking systems) driven by<br/>slowing industrial production, worsening trade balance, falling stock markets and<br/>continuing robust loan growth.<br/>The market that continues to show the highest levels of stress is India. Loan growth has<br/>been running at double the GDP growth rate for past five years, industrial production<br/>growth has collapsed to low single digit while trade deficit has widened due to falling<br/>exports while import bills remained high. India (apart from Korea) is the one market that<br/>has seen some increase in NPLs this year, but it is mostly from consumer loans. We<br/>suspect future impairment will arise from SME and real estate loans plus possible future<br/>corporate customers. We have been UW Indian banks, especially state owned, due to<br/>asset quality concerns although we recognise the risk that large rate cuts and relaxations<br/>by Reserve Bank of India are a positive and may defer the manifestation of NPLs.<br/>Korea suffers from the above problems in addition to which Korean banks are dependent<br/>on wholesale funding. However, the risks are partially being mitigated by the currency<br/>depreciation due to which Korea index reading is not as high as India’s.<br/>China and Malaysia turn out to be the markets with least pressure on their banks as there<br/>has been no over-extension of credit (loan growth has lagged GDP growth over the past<br/>five years) and healthy trade surpluses.<br/>How is the index likely to behave in 4Q08? We see it worsening further given the sharp<br/>deterioration in both domestic (deceleration in industrial production) and external (exports<br/>to US and European markets) demand in October-November so far. Also, stock markets<br/>crashed in October and have yet to recover, while credit growth has continued apace due<br/>to closure of bond markets and generally tight liquidity.<br/>Going into 2009-10, we believe NPLs and credit costs will jump substantially leading to a<br/>massive erosion in profitability of banks. At this stage, our analysts are projecting it to be<br/>an earnings event (unlike Asian financial crisis which destroyed equity and book values in<br/>most banks in the severely affected countries of Thailand, Korea, Indonesia, and<br/>Malaysia). We have bumped up our credit cost assumptions in 2009 such that our<br/>forecasts are significantly behind consensus in each market.<br/>Asset quality sensitivity – Taiwan and Korea<br/>Taiwan and Korea remain the two markets with maximum sensitivity. Just about 3% of<br/>their loans turning bad (from our base case assumption of around 1%) would wipe out<br/>their profits in 2009 assuming a loss ratio of 60%. Put another way, a 1% increase in NPL<br/>or a 50-60 bp increase in credit cost would erase about four-fifth of profits in Taiwan and<br/>nearly half of profits in Korea. Singapore also shows up here as very sensitive because we<br/>have cut our profitability assumptions very aggressively for next year.<br/>Net net<br/>While we expect a relief rally in the near term, partly driven by massive rate cuts, we are<br/>worried about the variability to earnings in 2009-10E. Unlike clients, we do not have a<br/>choice but to invest in banks. Hence we stick to China as the main OW market based on<br/>government’s ability to inject fiscal and monetary stimuli but considering the risks, we are<br/>MW banks and go OW on China through insurance. Singapore proved to be a safe haven<br/>during the Asian financial crisis and we are at mild OW given decent domestic demand<br/>growth expected next year apart from (very) negative real rates and a (very) steep yield<br/>curve. Also, Singapore banks are well capitalised and liquid.</p><p>CS bank pressure index: September<br/>Unsurprisingly, the banking pressure index levels have gone up across the board in Asia<br/>since our last update in June. As loan growth has remained generally strong, plunging<br/>asset markets, declining forex reserves and decelerating production growth have added to<br/>the pressure. The only alleviating factor has been the depreciation of the real effective<br/>exchange rate in some markets.</p><p></p><p>
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