Casting a light on Shadow Banking: Near-term growth; long-term …pg.jrj.com.cn/acc/Res/CN_RES/INDUS/2013/2/27/b6209c85-a04f-4f4… · China’s shadow banking system – Rmb24 tn

February 26, 2013

China: Banks

Equity Research

Casting a light on Shadow Banking: Near-term growth; long-term cap on bank valuations

Shadow banking out of the shadows

In this report we look to address concerns over

systemic risks stemming from shadow banking,

particularly banks’ credit exposure to shadow

banking products. We estimate shadow banking

credit was Rmb23.5tn at the end of 2012 and its

net increase contributed 39% to new system wide

credit and 27% new M2 last year. We expect

continued strong growth in 2013 to Rmb31 tn,

combined with total social financing growth of

18% yoy to support c. 8% 2013E GDP growth.

Risks: 1) Weaker credit underwriting standards; 2)

rising corporate/systemic leverage; 3) liquidity

risk; 4) pro-cyclicality, 5) defaults could harm

banks’ balance sheets with possible reluctance to

expose retail investors to losses on underlying

instruments, which could distort capital allocation.

Comparison with the US

In the US, shadow banking is largely made up of

bonds and securitization. In China, however,

products are simpler and there is greater focus on

corporate loans. There is also much greater

interconnectedness with China banks.

Pressure points – Inflation and overheating

Given China’s strong internal and external liquidity,

we see limited risk of systemic crisis in the mid-

term. However, rapidly rising corporate leverage

makes corporate EBITDA interest cover/NPLs more

sensitive to CPI inflation. Therefore, overheating,

followed by tightening, could cause more collateral

damage than in previous cycles. As such, we think

it is vital for China to achieve balance in growth and

inflation via policies aimed more at consumption

and competitiveness.

Valuation implications

In addition to long-term NPL risks and rising NPL

sensitivity to inflation, we believe the opaque

interconnections between shadow banking and

China banks via wealth management products,

informal loan securitization, etc. make it difficult to

analyze banks’ true credit exposure. We think this is

likely to increase the discount rates and lower long-

term ROE for China banks, capping re-rating. We

factor in long-term concerns over shadow banking

activities into our target prices, including potential

credit exposure via WMP or informal securitization.

RELATED RESEARCH

Raise estimates but be valuation disciplined;

CQRCB/Minsheng A to Neutral; BONB to Buy”, 26 Feb. 2013

Shadow banking trip takeaways: Cyclical risk low; LT risks

remain, Jan 22, 2013

Credit watch 5: We estimate 4%-6% total potential NPLs;

Buy quality banks, CEB down to Sell, October 11, 2012

CHINA’S SHADOW BANKING ACTIVITIES ACCOUNTED

FOR 24% OF TOTAL CREDIT AT THE END OF 2012

Source: PBOC, Wind, Gao Hua Securities Research estimates.

Ning Ma +86(10)6627-3063 [email protected] Beijing Gao Hua Securities Company Limited Goldman Sachs does and seeks to do business with companies

covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S.

Bowei Cheng +86(10)6627-3095 [email protected] Beijing Gao Hua Securities Company Limited Jessica Wu +86(10)6627-3487 [email protected] Beijing Gao Hua Securities Company Limited

The Goldman Sachs Group, Inc. Global Investment Research

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February 26, 2013 China: Banks

Goldman Sachs Global Investment Research 2

Table of contents

China shadow banking: likely to grow in 2013E; overheating a risk; bank re-rating capped 4

China’s shadow banking system – Rmb24 tn in credit extension 8

How did it grow so fast? Demand, regulatory arbitrage, deregulation, competition 10

Shadow banking activities have been key drivers of M2 and credit growth year to date 12

China vs. US: Simpler, but more bank interconnections, higher corporate leverage 16

Key long-term risks: underwriting standards, pro-cyclicality, liquidity, implicit guarantees 22

Inflation/overheating is the key pressure point for systemic risk, as leverage rises 29

WMPs: Likely to remain strong in 2013, despite fundamental risks 35

Appendix 46

Disclosure Appendix 47

Prices in this report are as of the market close of February 19, 2013 unless otherwise indicated.



Exhibit 1: China H/A share banks trade at average 1.1x 13E reported P/B and 6X 13E P/E

Source: Wind, Gao Hua Securities Research estimates

19-Feb Mkt Cap 12M Potential

H-shares (HKD)Rating Price (US$ bn) Target

PriceUpside/

downside 2012E 2013E 2014E 2013E 12 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014EICBC (H) 1398.HK Buy 5.60 251 6.6 18% 1.41 1.22 1.07 1.31 6.8 6.3 5.7 4.7 4.3 3.9 5.1 5.5 6.2 11.2 8.3 11.7 22.3 20.7 20.1 BOC (H) 3988.HK Neutral 3.72 133 3.8 2% 1.04 0.93 0.84 1.03 6.4 5.9 5.4 4.1 3.8 3.4 5.5 5.9 6.5 6.4 7.5 9.3 17.2 16.6 16.3 CCB (H) 0939.HK Buy 6.39 205 7.6 19% 1.37 1.24 1.08 1.26 6.9 6.3 5.6 4.5 4.1 3.6 5.2 5.5 6.2 11.3 8.4 12.5 21.3 19.4 19.1 ABC (H) 1288.HK Buy 4.11 137 4.6 12% 1.43 1.28 1.11 1.28 7.4 6.4 5.7 4.9 4.4 4.2 4.8 5.5 5.8 20.3 15.0 12.5 20.8 21.0 20.9BoCom (H) 3328.HK Sell 6.14 44 6.0 -2% 0.99 0.88 0.79 0.97 6.7 6.2 5.6 4.2 3.8 3.4 1.4 3.1 3.4 (9.3) 8.3 10.5 17.0 15.0 14.8 CMB (H) 3968.HK Buy* 17.66 49 21.6 22% 1.54 1.30 1.11 1.34 7.4 6.6 5.7 4.7 4.3 3.8 3.1 4.1 4.1 16.1 12.0 14.4 23.0 21.5 20.8 CNCB (H) 0998.HK Neutral 5.05 30 5.4 7% 0.96 0.85 0.75 0.97 5.5 5.2 4.9 3.5 3.1 2.8 4.5 4.8 5.1 12.2 7.2 6.0 18.2 17.4 15.4 Minsheng (H) 1988.HK Buy 10.62 36 12.1 14% 1.53 1.27 1.07 1.40 6.3 5.7 5.1 4.2 3.8 3.3 3.4 4.3 4.6 28.7 10.0 12.9 25.3 23.4 22.4 CQRCB 3618.HK Neutral 4.52 5 4.7 4% 1.12 1.04 0.88 1.03 6.5 6.3 5.7 4.8 4.6 4.1 4.5 4.6 5.1 23.7 3.4 10.5 18.0 16.9 15.0 H-share average 1.26 1.11 0.97 1.18 6.7 6.1 5.5 4.3 4.0 3.5 4.2 4.8 5.2 12.1 9.6 11.2 20.6 19.4 18.7

Excluding CMB H-shares 1.23 1.09 0.95 1.16 6.6 6.0 5.4 4.3 3.9 3.5 4.3 5.0 5.4 11.5 9.2 10.8 20.3 19.1 18.4 A-shares (Rmb)ICBC (A) 601398.SS Buy 4.26 225 5.3 24% 1.32 1.15 1.00 1.23 6.4 5.9 5.3 4.4 4.0 3.6 5.5 5.9 6.6 11.2 8.3 11.7 22.3 20.7 20.1 BOC (A) 601988.SS Neutral 3.05 129 3.1 2% 1.05 0.94 0.85 1.04 6.4 6.0 5.5 4.2 3.8 3.5 5.4 5.8 6.4 6.4 7.5 9.3 17.2 16.6 16.3 CCB (A) 601939.SS Buy 4.84 183 6.1 26% 1.28 1.16 1.01 1.18 6.4 5.9 5.3 4.2 3.8 3.4 5.6 5.9 6.6 11.3 8.4 12.5 21.3 19.4 19.1 ABC (A) 601288.SS Buy 3.07 121 3.7 21% 1.32 1.18 1.02 1.18 6.8 5.9 5.3 4.5 4.1 3.9 5.2 5.9 6.3 20.3 15.0 12.5 20.8 21.0 20.9 BoCom (A) 601328.SS Neutral 5.22 44 4.8 -8% 1.03 0.92 0.83 1.01 7.0 6.5 5.9 4.4 4.0 3.6 1.7 3.9 4.3 (9.3) 8.3 10.5 17.0 15.0 14.8 CMB (A) 600036.SS Buy 13.83 45 17.5 27% 1.49 1.26 1.07 1.30 7.1 6.4 5.6 4.6 4.2 3.7 3.2 4.2 4.2 16.1 12.0 14.4 23.0 21.5 20.8 CNCB (A) 601998.SS Neutral 4.81 34 4.4 -9% 1.13 0.99 0.88 1.15 6.5 6.1 5.7 4.1 3.6 3.2 3.8 4.1 4.4 12.2 7.2 6.0 18.2 17.4 15.4 Minsheng (A) 600016.SS Neutral 10.54 43 9.7 -8% 1.87 1.56 1.31 1.71 7.7 7.0 6.2 5.1 4.6 4.0 2.8 3.5 3.8 28.7 10.0 12.9 25.3 23.4 22.4 SPDB 600000.SS Neutral 11.10 31 11.6 5% 1.17 0.99 0.84 1.09 6.1 5.5 4.8 3.9 3.6 3.1 2.0 2.1 2.6 23.5 11.1 15.9 20.7 19.5 19.0 Industrial 601166.SS Buy* 19.56 32 24.9 27% 1.51 1.28 1.08 1.39 7.4 6.5 5.4 4.4 4.0 3.5 2.6 3.2 3.8 32.5 15.1 18.5 24.0 21.4 21.4 PAB 000001.SZ Neutral 20.81 11.0 19.3 -7% 1.25 1.09 0.95 1.33 8.8 8.1 7.3 6.9 5.4 4.9 0.5 0.0 0.0 17.0 8.1 10.6 15.1 14.3 13.8 Hua Xia 600015.SS Sell 11.35 9 7.2 -37% 1.10 0.97 0.87 1.20 6.9 6.3 6.1 4.5 4.1 4.0 3.5 3.6 3.9 22.6 8.4 3.6 16.8 16.2 14.9 BONB 002142.SZ Buy 11.80 5 13.9 18% 1.58 1.33 1.12 1.37 8.4 7.3 6.4 5.5 4.6 4.1 1.9 1.9 1.9 24.6 15.6 14.0 20.1 19.8 19.1 BOBJ 601169.SS Neutral 9.79 9 10.5 7% 1.03 0.91 0.81 1.05 6.0 5.4 4.8 3.8 3.5 3.0 4.7 5.9 6.3 23.8 10.2 12.3 19.9 17.8 17.7 BONJ 601009.SS Sell 10.25 5 8.5 -17% 1.25 1.10 0.97 1.16 7.8 7.4 6.8 5.4 5.0 4.4 2.1 2.1 2.3 21.1 4.3 10.1 17.0 15.8 15.3 CEB 601818.SS Sell 3.47 21 2.7 -22% 1.23 1.03 0.88 1.19 5.9 5.4 5.0 5.0 3.8 3.3 2.5 2.8 3.0 30.6 10.1 8.1 22.5 20.9 19.0 A-share average 1.29 1.12 0.97 1.22 7.0 6.4 5.7 4.7 4.1 3.7 3.3 3.8 4.1 18.3 10.0 11.4 20.1 18.8 18.1

Big banks average 1.24 1.11 0.97 1.16 6.5 5.9 5.3 4.3 4.0 3.6 5.4 5.9 6.5 12.3 9.8 11.5 20.4 19.4 19.1Shareholding banks average 1.31 1.12 0.97 1.26 7.1 6.4 5.8 4.8 4.1 3.7 2.5 3.0 3.3 19.3 10.0 11.2 20.3 18.9 18.0City Bank Average 1.29 1.11 0.97 1.19 7.4 6.7 6.0 4.9 4.3 3.8 2.9 3.3 3.5 23.1 10.1 12.1 19.0 17.8 17.3

Adj. P/B (X) EPS growth (%) ROE (%)P/B (X) P/E (X) P/PPOP (X) Div yld (%)



China shadow banking: likely to grow in 2013E; overheating a risk; bank re-rating capped

Over the past two years there has been a rapid increase in corporate bond issuance, trust product sales, and wealth management

products (WMP), otherwise known as shadow banking activities.

These products are often not well understood by the market and have led to concerns on the systemic risks involved, particularly on

banks’ credit exposure to these products, as they are not required to disclose their exposure or make capital and provision charges.

In this report, we address the following:

Size and impact

We estimate c. Rmb24tn in credit was extended in China’s through shadow banking activities in FY12 (Exhibit 3), accounting for 24%

of total credit to corporates and consumers, and 45% of 2012E GDP.

Shadow banking activities made up 39% of the increase in total incremental new credit and 27% in incremental new M2 in FY12.

Drivers of growth

The rapid growth in shadow banking activities has been driven by strong demand for credit from corporates and rising returns from

depositors due to regulated low deposit rates. China regulators also encourage non-bank credit growth to diversify credit

concentration away from banks. In addition, regulatory requirements in the regulated banking sector (e.g., loan/deposit ratio, capital

adequacy ratio, and credit quota) are driving increasing innovation in financial products given the structural decline in forex capital

inflows.

China vs. US shadow banking

We find that China’s shadow banking products are simpler direct credit or informal securitization products, have greater

interconnections with banks, are smaller in size but grow more rapidly, contribute to fast-rising corporate leverage, and may have

higher implicit bank guarantees given their retail investor focus.

Key risks: Rising corporate and financial system leverage; implicit guarantees distort efficient capital allocation

Risks to China’s shadow banking activities include: (1) relatively weak credit underwriting standards vs. bank loans; (2) fast-rising

leverage in the non-bank corporate and financial system; (3) higher liquidity risks vs. bank loans, pro-cyclical growth that could

dampen the counter-cyclical macro policies; and (4) investors’ perception of the implicit guarantees provided by banks and

government on trust/bond/WMP, and related moral hazard issues.

If these risks are not addressed properly, we believe the systemic risks to China’s banks will gradually increase.

Investors’ perception of implicit guarantees (i.e., the bail-out of corporate bonds/trust/WMP by the Chinese government and banks)

will likely impact their investing behavior, thus distorting capital allocation.

Lastly, regarding the short-term risk, a sharp slowdown in shadow banking activities due to either severe regulatory tightening or a

number of credit events triggered by macro tightening could negatively impact M2, new credit growth, and GDP growth.



Near-term systemic risk is low, but high inflation/overheating could be a key pressure point for system distress

Given China’s strong internal and external liquidity and still relatively strong mid-term GDP growth outlook, we believe the risk of a

systemic crisis in the mid-term is low.

However, the rapid rise of corporate leverage could cause corporate EBITDA interest cover/NPL formation to be more sensitive to

high CPI inflation (e.g. 3%+), due to rising leverage and borrowing costs. Potential overheating, followed by tightening, could cause

more collateral damage than in previous cycles. We believe it is vital for China to achieve the fine balance between growth and

inflation — achieved less by investment stimulus policies and more via policies to boost consumption and/or the competitiveness of

corporate China.

WMP/trust products to continue their growth in 2013E, despite potential volatility and tighter regulations

We expect that growth in WMP/trust products and other shadow banking activities will maintain its strong growth in 2013E — albeit

slower off a high base and with potential volatility — given the government’s policies to modestly grow total social financing (TSF)

and develop corporate bond markets, favorable banking sector liquidity, and recovery in GDP/corporate earnings.

We forecast 2013E new TSF volume to reach Rmb16.9tn, up 7% yoy, with the total TSF balance of growing at 18% yoy vs. 20% in

2012. This should be sufficient to support c. 8% GDP growth as the TSF balance growth rate is higher than our EC teams’ nominal

GDP growth estimate of 12.6%.

We do not expect regulators to stop or limit the current WMP growth trend, but we believe they will likely improve current

disclosure requirements, asset matching, risk management centralization, and investor selection/protection. This could potentially

increase short-term volatility, but WMP growth should continue as part of the long-term interest rate deregulation process.

The statement by the Central Economic Working Conference of the Communist Party held on December 15-16 suggests China will

maintain modest growth in TSF in 2013, which includes many shadow banking activities.

In a worst-case scenario, if regulators require banks to move off-balance sheet WMP credit exposure back to their balance sheet

and take the same capital charges, we estimate this would reduce their CAR by a manageable 34bp in 2013E.

Raised banks’ earnings estimates on cyclical macro recovery, but remain valuation disciplined; prefer quality banks

We have published our new estimate and rating changes in a separate report published today (February 26th) “Estimates up but

keep valuation discipline; CQRCB/Minsheng A to Neutral; BONB to Buy”.

Post the recent sharp valuation rebound of China bank shares driven by cyclical macro recovery, we believe the next leg of

performance will come from consensus earning upgrade around the FY12/1Q13 result announcement. China banks’ H/A shares still

look reasonably valued in our opinion — with current prices implying 6.2%/5.7% 2013 NPLs vs. our 4%-6% estimates. (Please see the

end of the report for more detailed discussion of valuation for China banks.)

However, we believe the long-term structural issues related to shadow banking are likely to cap valuation re-rating potential of

China banks:

Rising corporate leverage increases long-term NPL risks, and raises the sensitivity of NPLs to inflation

Shadow banking’s opaque interconnections with China banks make investors difficult to analyze the true credit exposure of

WMP, informal loan securitization in interbank assets, etc. Thus, it is likely to lead to high discount rates for China banks versus

global peers.



Moreover, there are increasing signs of inflation pressure and rising property prices, and therefore a more complicated macro

backdrop in FY13 in finding balance between growth and inflation than the straightforward monetary easing situation in 3Q12/4Q12.

Although at this point, we do not expect China regulators to adopt harsh tightening measures, as inflation is still low at below

regulators’ comfort zone (CPI was 2% in January, and our ECS team forecasts CPI to gradually trend up to 3.4% in 4Q13),, we believe

the broad based cyclical recovery driven share price rebound appear to be over.

As such, we prefer banks with ability to achieve higher than peers earning growth, and with high ROE and PPOP earning power to absorb NPL risks if macro/NPL starts to deteriorate in an overheating environment.

We believe our top picks — including ICBC, CCB, ABC, CMB, Minsheng (H), Industrial Bank and BONB — have strong

franchise, CAR, ROE and earning power, and strong ability to execute growth through their strong deposit franchise, ability to grow

SME loans to offset NIM pressure, and strong execution capability. We developed a score table to rank banks in the following

criteria (Exhibit 2):

Exhibit 2: Buy rated ICBC, CCB, ABC, CMB H/A shares; Industrial, Minsheng (H), Bank of Ningbo A-shares rank highly in the fundamental stock picking scores

Note: Score 1 means better than sector average, while score -1 or -2 means worse than sector average. Higher score means better fundamentals while lower score refers to weaker

fundamentals.

Source: Gao Hua Securities Research estimates.

2013 ICBC CCB ABC BOC BoCom CMB CNCB Minsheng CQRCB Industrial SPDB PAB Hua xia CEB BOBJ BONB BONJ

Low loan/deposit ratio 1 1 1 1 1 1

High SME exposure 1 1 1 1 1

Off-balance sheet guarantee/loans (2011) 1 1 -2 -1 -1 -1 -1 -1 1 -1

2. Ability to execute growth 1 1 1 1 2 2 1

3. High CAR and return on capital

Core tier I CAR 1 -1 -1 1 1 1 1 -1 1 1 1

PPOP/RWA 1 1 1 1 1

Internal capital generation- RWA growth 1 1 1 1 -1 1 1 1 -1 -1

Implied NPL formation rates that do not match banks' risk profile 1 1 1 -1

Dividend yield 1 1 1 1 1 1

Total score 6 6 6 0 1 5 0 4 1 6 0 0 -2 -1 1 4 0

1. Ability to absorb impact from lower NIM, rising NPL

4. Reasonable valuation and dividend yield



We have factored into our 12-month target prices the long-term concerns over shadow banking activities, such as potential under-

reported credits within WMP or informal securitization:

Our 12-month target prices use conservative long-term ROE assumptions on banks’ leverage/CAR, NIM, and credit cost

assumptions to reflect concerns of under-reported leverage. Our long-term ROE assumptions factor in 10%/9.5% core tier I CAR

for big/smaller banks under Basel III capital requirement (vs. minimum 8.5%/7.5% requirement by 2019), and average 112bp

credit costs (vs. average 53bp in 2013E).

We also use adjusted BVPS to arrive at our target prices, based on average 6.3% total potential NPL ratios for China banks (vs.

1% NPL ratio that we expect the banks to report in 2013), which reduces 2013E BVPS by an average 5.5%/8.9% for H-share banks

and A-share banks. We also incorporate the credits within banks’ WMP into adjusted BVPS calculation.

See our sector report, “Estimates up but keep valuation discipline; CQRCB/Minsheng A to Neutral; BONB to Buy” (Feb 26, 2013).

Exhibit 3: China banks’ current valuation is pricing in an average 2013E NPL ratios for H/A-share banks of 6.2%/5.7%; our Buy rated

banks generally have high implied NPL ratios suggested by current share price vs. their fundamentally above-peer asset quality

China banks share prices’ implied NPL ratios

Source: Datastream, Gao Hua Securities Research estimates.

6.3

5.4

6.0

7.9

5.85.6 5.6

6.46.8

6.5

5.3

6.2

8.1

5.7 5.7

5.25.6

6.15.6

3.9

5.4

4.3

6.4

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0

1

2

3

4

5

6

7

8

9

13E NPL ratio Formation covered by general provision

Implied new formation

H-share ave. A-share ave.

Buy-rated stocks



China’s shadow banking system – Rmb24 tn in credit extension

The definition of shadow banking varies among international organizations and communities:

In the Economic Premise No. 88 published by the World Bank, “Shadow banking comprises a set of activities, markets, contracts,

and institutions that operate partially (or fully) outside the traditional commercial banking sector, and, as such, are either lightly

regulated or not regulated at all.”

According to the Global Shadow Banking Monitoring report 2012 published by the Financial Stability Board (FSB) in November,

2012, “the ‘shadow banking system’ can broadly be described as ‘credit intermediation involving entities and activities outside

the regular banking system.’” These activities typically involve part or full of the maturity, liquidity and credit transformation.

In this report, we focus our analysis of China’s shadow banking activities on credit creation outside formal banking channels. We

define China’s formal banking system to include: banks, group financing companies owned by industrial groups, and financial

leasing companies under the supervision of the CBRC and the PBOC. These are deposit-taking institutions whose loans and deposits

have been incorporated into the PBOC’s credit quota.

We estimate Rmb24tn in total credit in the following shadow banking channels in 2012, +35% yoy over 2011

Trust loan products (excluding trusts based on capital markets): Rmb5.4tn, +51% yoy

Trust loan products are corporate credit products structured by CBRC-regulated trust companies with a fixed yield, and usually

sold to retail investors and distributed by banks or trust companies. Trust companies act as trustee for the retail investors in

terms of structuring the products, monitoring the lenders and their projects, and resolving NPLs.

Entrust loans (unadjusted for intra group loans): Rmb5.7tn, +29% yoy

Entrust loans are loans that corporates lend to each other, using banks as a book entry entity. The PBOC collects such data from

banks.

Corporate bonds: Rmb6.9tn, +46% yoy

Informal loans: Rmb4.6tn, -3% yoy

Informal loans are typically loans that individuals lend to corporate/individuals without financial institutions as intermediaries or

as book entry entities.

Loans securitized through brokers’ asset management channels: up to around Rmb1tn in 2012

Loans securitized through banks’ WMPs: Banks’ WMPs had total assets of around Rmb7.1tn in 2012, +42% vs. 2011 (Exhibit 4).

We estimate around 25% of WMPs or Rmb1.8tn are credit and trust products, as well as around 10% WMP or Rmb710bn in

corporate bonds have been packaged in these products. However, most of the banks’ WMP credit exposure have been

incorporated into trust loans, entrust loans, and corporate bond data, as banks need to use a trust product to securitize these

loans into WMPs.

Please also see Exhibit 44 in the Appendix (page 46) for a detailed breakdown of banking credits and shadow banking credits.



Exhibit 4: China shadow banking credits reached Rmb24 tn in FY12, representing 24% of total corporate and consumer financing Credits from banks and shadow banking activities in China

Note: We believe the loans, corporate bonds and trust loans in banks’ WMPs have been largely captured in each category of the shadow banking activities, as these credits need to use trust products or entrust products to be packaged.

Source: PBOC, CBRC, Wind, China Trust Association, Gao Hua Securities Research estimates.

Base Low High

RMB bn 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2013E 2013E

Banks' loans and off-balance acceptance 12,913 15,533 16,974 18,597 21,676 26,148 30,055 39,601 48,614 56,045 64,148 73,308 71,326 74,931

As % of total corporate and consumer financing 86% 84% 81% 81% 80% 79% 76% 75% 70% 68% 65% 62% 73% 70% As % of total corporate financing 92% 92% 89% 89% 88% 87% 83% 83% 79% 76% 73% 71% 73% 70% As % of total GDP 107% 114% 106% 101% 100% 98% 96% 116% 121% 118% 124% 125% 122% 128% Yoy growth rate 15% 20% 9% 10% 17% 21% 15% 32% 23% 15% 14% 14% 11% 17%

Shadow banking credits 1,055 1,362 2,001 2,208 2,969 3,878 5,992 7,885 12,973 17,405 23,560 30,571 26,609 32,406

As % of total corporate and consumer financing 7% 7% 10% 10% 11% 12% 15% 15% 19% 21% 24% 26% 27% 30% As % of total corporate financing 8% 8% 11% 11% 12% 13% 17% 17% 21% 24% 27% 29% 27% 30% As % of total GDP 9% 10% 13% 12% 14% 15% 19% 23% 32% 37% 45% 52% 45% 55% Yoy growth rate 23% 29% 47% 10% 34% 31% 55% 32% 65% 34% 35% 30% 13% 38%

Informal loans + small corporate loans/pawn 964 1,163 1,485 1,431 1,673 1,951 2,885 2,576 3,961 4,679 4,561 5,198 4,789 5,473

As % of total corporate financing 7% 7% 8% 7% 7% 6% 8.0% 5.4% 6.4% 6.4% 5.2% 5.0% 4.9% 5.1% As % of total GDP 8% 9% 9% 8% 8% 7% 9.2% 7.6% 9.9% 9.9% 8.8% 8.9% 8.2% 9.3% Yoy growth rate 17% 21% 28% -4% 17% 17% 48% -11% 54% 18% -3% 14% 5% 20% Trust loans 81 253 521 960 2,444 3,592 5,424 6,812 5,858 7,051

As % of total corporate financing 0% 1% 1% 2% 4% 5% 6% 7% 6% 7% Yoy growth rate 106% 84% 155% 47% 51% 26% 8% 30% Entrust loans (un-adjusted for intragroup loans) 19 80 351 419 601 939 1,300 1,979 3,109 4,409 5,689 7,089 6,542 7,395

As % of total corporate financing 0% 0% 2% 2% 2% 3% 4% 4% 5% 6% 6% 7% 7% 7% Yoy growth rate 19% 43% 56% 39% 52% 57% 42% 29% 25% 15% 30% Corporate bonds 73 118 165 358 613 735 1,286 2,371 3,459 4,725 6,887 9,472 7,920 9,986

As % of total corporate financing 1% 1% 1% 2% 2% 2% 4% 5% 6% 6% 8% 9% 8% 9% Yoy growth rate 117% 62% 40% 116% 72% 20% 75% 84% 46% 37% 46% 38% 15% 45% Credits securitized in brokers' AM business 1,000 2,000 1,500 2,500

As % of total corporate financing 1.1% 2% 2% 2% Yoy growth rate 100% 50% 150%Memo

Bank WMPs' total AUM 467 1,327 960 1,015 2,500 5,000 7,100 8,000 7,700 8,500

Credit assets plus trust products 117 332 240 254 625 1,250 1,775 2,000 1,925 2,125 Corp bonds 47 133 96 102 250 500 710 800 770 850 As % of total GDP 2% 5% 3% 3% 6% 11% 14% 15% 15% 16% Yoy growth rate 184% -28% 6% 146% 100% 42% 60% 54% 70%



How did it grow so fast? Demand, regulatory arbitrage, deregulation, competition

We believe the rapid growth of shadow banking activities in China can attribute to:

1) Strong loan demand from corporates due to relatively low real borrowing rates vs. nominal GDP growth rates — especially

from private companies and SMEs — that could not be satisfied by the formal banking system due to loan quotas or sector

loan regulations. For instance:

Property developers, private mining or manufacturers, and local government-owned financing vehicles, as banks are either

limited by regulators on the total amount of loans to give to these sectors, or have insufficient credit quota to serve their

credit demand.

Big corporate or government-backed enterprises that issue bonds for less expensive financing than bank loans with similar

maturities.

2) Regulators continuing to promote direct financing instead of indirect financing through banks, or total social financing (TSF).

We expect regulators especially PBOC to continue to promote direct financing through non-banking financing channels instead

of indirect financing through banks, as they feel this may help diversify the credit risks away from commercial banks. However,

we believe this argument is debatable as increasing corporate debt through non-bank channels would affect banks if there were

to be NPLs from such corporates;

3) Strong household demand to diversify financial assets away from Rmb deposits, for which interest rates are still regulated.

Banks’ short-term WMPs typically offer 3.5%+ yield (c. 4%+ for non-principal guaranteed products), vs. c. 2.8% for 3-month

deposits.

4) Incentives to securitize or transfer loans outside the formal banking system to avoid the following limits and increase leverage:

Credit quota: We forecast Rmb8.8tn in FY13E.

75% loan/deposit (L/D) ratio cap: For example, in order to issue a Rmb100 loan, banks would have to prepare Rmb130 in

deposits to meet the L/D ratio cap. In contrast, moving loans to a trust or WMP would mean 100% L/D ratio rather than 75%.

Capital adequacy ratio (CAR): For instance, loans offered in trust products and WMPs do not need to book capital charges.

5) The competition among brokers, trust companies and insurance asset management business to help banks securitize or

transfer loans outside the formal banking system :

Moreover, we expect continued informal loan securitization through emerging channels such as brokers’ asset management

business. These emerging channels directly compete with traditional channels such as trust products, banks’ WMP products

and interbank entrusted payment products. Now brokers charge 5bp-10bp to cooperate with banks to securitize loans, while

trust companies still charge 20bp-30bp; and as such, brokers’ asset under management increased sharply to Rmb1.5 tn in 4Q12

from about Rmb300 bn in 3Q12.

And if trust products were to slow down due to regulatory tightening, the brokers’ asset management companies may replace

trust companies in helping banks securitize loans.



6) Forex capital inflows have declined since 2011 and have slowed M2 and deposits creation, which makes it difficult for banks to

comply with 75% L/D rule without informal loan securitization.

Given the structural slowdown in M2 and sector deposit growth, in light of the potentially lower volumes of forex capital inflows,

we believe the 75% L/D ratio cap and 20% required reserve ratio (RRR) will make it increasingly difficult for China banks to

manage liquidity.

We estimate the new capital inflow per year in 2006-2011 contributed to new M2 creation of 18%-56%. However, capital inflows

have declined since 2011, given low market expectations for Rmb appreciation amid a slowdown in China exports due to low

global demand and a rise in domestic inflation and labor costs.

In our view, China banks will likely continue to be incentivized to securitize, sell loans, and/or classify loans as an off-balance

sheet item if capital inflows remain low and China keeps the 75% L/D ratio cap. These new loans have already created

M2/deposits but are not subject to the L/D ratio cap and loan quota.

Exhibit 5: We expect capital inflows to decline in 2012E/2013E; shadow banking activities (interbank, bond, WMP) will likely contribute to new M2 growth

Source: PBOC, Gao Hua Securities Research estimates.

Rmb bn 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 1Q13E 2Q13E 3Q13E 4Q13ENew M2 in total 3,288 4,140 5,010 5,784 7,172 13,506 11,563 12,575 12,260 12,700 4,466 3,240 1,910 3,084Rmb new loans 1,920 1,649 3,066 3,634 4,170 9,629 7,951 6,875 8,200 8,800 2,816 2,640 1,760 1,584

as % of total 58% 40% 61% 63% 58% 71% 69% 55% 67% 69% 63% 81% 92% 51%

FX inflows 1,774 1,862 2,777 2,940 4,005 2,468 3,268 2,779 360 900 300 150 150 300

as % of total 54% 45% 55% 51% 56% 18% 28% 22% 3% 7% 7% 5% 8% 10%

Fiscal deposits decline -111 -176 -293 -671 -41 -437 -304 -77 197 500 -150 -350 -100 1,100

as % of total -3% -4% -6% -12% -1% -3% -3% -1% 2% 4% -3% -11% -5% 36%

Interbank, bond, WMP -295 805 -540 -120 -963 1,846 648 2,997 3,503 2,500 1,500 800 100 100

as % of total -9% 19% -11% -2% -13% 14% 6% 24% 29% 20% 34% 25% 5% 3%

M2 balance 25,411 29,551 34,560 40,344 47,517 61,022 72,585 85,160 97,420 110,120 101,886 105,126 107,036 110,120

M2 yoy growth 14.6% 17.6% 16.9% 16.7% 17.8% 27.7% 19.7% 13.6% 13.8% 13.0% 13.8% 13.6% 13.4% 13.0%



Shadow banking activities have been key drivers of M2 and credit growth year to date

New credit contribution: c.39% contribution to total debt financing, especially FAI financing

Based on the PBOC’s disclosed TSF data, we estimate new credit extended through trust loans, entrust loans, corporate bond

issuance, and bank acceptance account for 33%, 39% and 39% of total debt financing in FY11/FY12/FY13E, respectively (Exhibit 6).

We include bank acceptance data instead of bill discount loans. We find it is difficult to track bill discount loan securitization because

bill discount loans are viewed as interbank assets given banks’ guarantees of these trade bills, and thus they could easily be

packaged as part of banks’ and brokers’ WMP, as well as interbank assets.

In addition, the rapid growth in corporate long-term loans, bond and trust products in FY12 and January 2013 at 46% and 134% yoy

(at Rmb5.3tn and Rmb764bn respectively), has been a key source of fixed asset investment financing, which accelerated fixed asset

investments and helped stabilize the economy.

That said, we believe the TSF data issued by the PBOC underestimate some credits made through the shadow banking system, e.g.: 1) trust products in the TSF do not include equity trust products, and TSF data do not include loans

securitized through brokers’ asset management products, etc; and 2) It also does not account for the fluctuation in informal loans.

We believe informal loans could shrink in 2012 vs. 2011, given the small- and medium-sized enterprise (SME) bankruptcies in

Wenzhou City, Yangtze River delta, Zhengzhou City, and others.

Exhibit 6: New credits extended from trusts, entrust loans, bank acceptance, and corporate bond issuance account for 33%, 39% and 39% of TSF’s debt financing

in 2011, 2012E, and 2013E, respectively


gRmb bn 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E Jan-13

Rmb loans 2,770 1,920 1,649 3,066 3,634 4,170 9,629 7,951 7,470 8,200 8,800 1,070

Forex loans 229 117 74 97 291 52 933 415 571 916 1,000 179

Entrusted loans 62 270 68 182 338 362 679 1,130 1,300 1,280 1,400 206

Trust loans - - - 81 172 268 438 386 201 1,290 1,000 205

Bank acceptances 202 (24) 2 147 670 93 467 2,331 1,030 1,050 1,200 581

Corporate bonds issue 55 44 141 81 231 472 1,301 1,201 1,370 2,250 2,588 220

Non financial institution equities 55 56 24 131 480 286 452 586 438 251 450 24

Others - - - - - - 71 100 450 523 450 54

Total financing(new addition) 3,423 2,434 2,009 3,866 5,929 5,839 14,154 14,300 12,830 15,760 16,888 2,540 Total debt financing 3,317 2,327 1,935 3,653 5,336 5,419 13,447 13,414 11,943 14,986 15,988 2,462

L-t loan+trust loans+corp bond 1,992 2,726 6,731 6,011 3,652 5,322 764 yoy (%) 37% 147% -11% -39% 46% 134%

Medium term to long term loans 1,589 1,985 4,992 4,424 2,081 1,782 339

Total financing(balance) 17,486 19,762 21,875 25,723 31,673 37,519 51,665 65,963 78,324 94,084 110,971 88,384 yoy (%) 24% 13% 11% 18% 23% 18% 38% 28% 19% 20% 18%

Total debt financing(balance) 17,275 19,444 21,482 25,117 30,475 35,901 49,340 62,751 73,866 88,852 104,840 91,303

Shadow banking as % of total debt financing 9.6% 12.5% 10.9% 13.4% 26.4% 22.1% 21.5% 37.6% 32.7% 39.2% 38.7% 49.3%



Rapid shadow banking growth in 2013E support macro recovery, if not acceleration

Despite the potential modest slowdown of new trust volume in 2013E due to strengthened due diligence, distribution and regulatory

requirements, we forecast the total social financing (TSF) balance to grow 18%, after our meetings with several regulators, trust

companies and banks’ WMP product managers in January 2013.

As such, we expect the continued and firm macro cyclical recovery in FY13E with limited downside risks to our 8.2% GDP growth

outlook per our ECS team forecasts, as the TSF balance growth rates are higher than our 13% nominal GDP growth rate estimate.

Exhibit 7 shows that TSF balance growth rates have a 1-year lead over nominal GDP growth since 2009. Moreover, we estimate

2013E new TSF volume will account for 29% of GDP, stable vs. 30% in 2012 (Exhibit 8).

For details, please see our banking sector report, titled “Shadow banking trip takeaways: Cyclical risk low; LT risks remain”, Jan 22,

2013.

Exhibit 7: TSF balance growth rates have a 1-year lead

over nominal GDP growth since 2009

Exhibit 8: We estimate 2013E new TSF volume will

account for 29% of GDP, stable vs. 30% in 2012

Source: Wind, PBOC, Gao Hua Securities Research estimates

Source: Wind, PBOC, Gao Hua Securities Research estimates

New M2 contribution in FY12: around Rmb3.5tn, or 27% total incremental new M2

We estimate c. Rmb3.5tn in new M2 and Rmb deposits were generated by shadow banking activities in 2012, representing 27% of

total M2. Contribution to M2 growth ytd likely came from new Rmb loans, capital inflows/outflows, an increase/decrease in fiscal

deposits, and non-bank or shadow banking activities (Exhibits 9-10). We see three ways that shadow banking activities could impact

M2 creation:

Banks purchase corporate bonds in the primary corporate bond issuance market: This is similar to banks issuing loans to

corporates. However, it differs in that the loan is booked as a securities investment rather than as a loan in the banks’ balance

sheets. We estimate investments in corporate bonds by banks’ own balance sheet or WMPs accounted for around 52% of

corporate bonds issuance in 1H12, partly due to the small size of money market funds in China (Exhibit 11).

0%

5%

10%

15%

20%

25%

30%

35%

40%

TSF balance growth Nominal GDP growth

25%

15%

11%

18%

22%19%

42%

36%

27%30% 29%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

(2,000)

-

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

Rmb loans Total financing(new addition)

(Rmb bn) As % of GDP



Exhibit 9: 2012 new M2 generation from interbank /bond

/WMP totaled Rmb3.5tn in FY12s

Exhibit 10: Dec. monthly M2 movement: interbank and WMP

together contributed around Rmb1.3tn to M2

Source: PBOC, Gao Hua Securities Research.

Source: PBOC, Gao Hua Securities Research.

Exhibit 11: Commercial banks account for the 51.5% investment in corporate bonds, short-term and mid-term corporate paper

Investor distribution of corporate bonds, 1H12

Source: Chinabond.com, Gao Hua Securities Research estimates.

85,160

97,420

-

8,200

495 197

3,368

78,000

80,000

82,000

84,000

86,000

88,000

90,000

92,000

94,000

96,000

98,000

100,000

Dec11 M2 Loan

growth

FX inflows Fiscal

deposits

inflows

Interbank,

bond,

WMP

Dec12 M2

Rmb bn Breakdown of FY12 M2 growth

94,480

97,420

-454

135

1191

1160

93,000

93,500

94,000

94,500

95,000

95,500

96,000

96,500

97,000

97,500

98,000

Nov12 M2 Loan

growth

FX inflows Fiscal

deposits

inflows

Interbank,

bond, WMP

Dec12 M2

Rmb bn Breakdown of Dec12 M2 growth

Nationwide banks

33.5%

Foreign banks

0.3%

City banks 7.6%

Rural banks 10.1%

51.5%

3.2%

13.2%

24.4%

0.0%

7.7%

Banks Brokers Insurers Asset mgmt. firms

Individuals Others



Loan securitization through trusts, WMPs, and interbank channels: Banks lend to corporates that generate new M2. At the same

time, banks may use trust products to securitize these loans or discounted bills into their WMPs. They may also book these

loans through interbank assets (i.e., “interbank entrust payment products,” whereby bank A asks bank B to issue a loan to a

corporate, while bank B books the loan as an interbank asset to bank A).

Month-end and quarter-end WMP fluctuation: Banks typically allow a large amount of WMPs to mature before month-end or

quarter-end, so that these funds flow back to the banks’ balance sheets as deposits to meet the L/D ratio requirement. Thus, M2

increases, although there is no new M2 creation from these activities.

After the month-/quarter-end, banks typically start issuing WMPs to attract or retain their deposit customers, and as such,

deposits flow to WMPs and M2 decreases.

c.13% M2 growth in 2013E, largely dependent on continued growth in shadow banking activities

We forecast around 13% yoy M2 growth in 2013E, vs. 14% in 2012, based on our projection of the new Rmb loans, capital inflows,

and shadow banking securitized new loans (Exhibit 5). We view this as largely a neutral monetary stance, rather than a tightening

stance, given our GS Global ECS Research team’s forecast for real GDP growth of 8.2%.

Our detailed M2 contribution forecasts (Exhibit 5) include:

New Rmb loans of Rmb8.8tn, up from Rmb8.2tn in 2012E

Foreign exchange inflows of Rmb900bn in 2013E, a yoy increase of Rmb540bn

Fiscal deposit release of Rmb500bn, or a slightly higher fiscal deficit in 2013E vs. 2012E

Shadow banking activities including bond, WMP, and interbank activities will continue to contribute Rmb2.5tn in 2013E

Key risk to our forecasts: Whether China regulators could significantly tighten or slow shadow banking growth in 2013.

We expect some potential tightening in risk management of shadow banking activities. This may lead to some volatility in growth;

however, growth should persist given the pro-growth economic policies, stabilization of corporate profitability and corporate loan

asset quality to limit corporate defaults, and the PBOC’s M2 growth target of c.13% yoy.

Moreover, the statement by the Central Economic Working Conference of the Communist Party held on December 15-16 suggests

China will maintain a modest growth in TSF in 2013, which includes many shadow banking activities.



China vs. US: Simpler, but more bank interconnections, higher corporate leverage

We compare and contrast the shadow banking activities in China and the US:

1) Simpler products in China: Most are either debt instruments or the first layer of loan securitization

China’s shadow banking activities may be viewed as the first-layer “securitization” of loans. For instance, trust loan products could

be viewed as “privately placed bonds,” while banks may sell, transfer, or securitize loans through WMPs.

In contrast, the US has well developed non-bank financing and capital markets, including corporate bonds, mortgage-backed

securities (MBS), and other products such as structured investment vehicles (SIV), collateral debt obligations (CDO), which are more

complex products based on securitized asset-backed securities (ABS)/MBS or corporate loan portfolio.

2) Greater interconnection with China commercial banks: bridge loans, liquidity support, regulatory arbitrage

There is a stronger interconnection between China’s shadow banking activities and the commercial banking system, including:

Shadow banking usually provides bridging loans to corporates so they can make bank loan payments, as China banks have a

strict regulatory requirement of not allowing corporates to revolve any of their working capital loans, i.e., all corporate loans

have to be repaid before borrowing them again even for trade finance purposes.

As such, China corporates have to manage their liquidity more strictly than their overseas counterparts. Many corporates seek

short-term bridge loans from informal loan lenders or entrust loan lenders to meet their short-term liquidity needs.

Many of these activities may be used by banks to arbitrage loan quota, L/D ratio, and capital requirement. For instance, banks

can sell or transfer loans to their WMPs by using a trust loan structure. In this way, banks can serve customers’ loan needs

without having to meet the credit quota, L/D, or capital requirement.

Moreover, banks may act as liquidity providers to WMPs and trust products in the event of a default. Given China’s social

stabilization policy, there may be implicit guarantee to banks’ WMPs, corporate bonds or trust products borrowed by the state-

owned enterprises (SOE) or big private companies. This means that some banks may be asked by the government to provide

liquidity or to “bail out” a defaulted corporate borrower.

Exhibit 13 summarizes the connections between China’s shadow banking activities and official banking activities.

In contrast, the underlying assets for US ABS, MBS, SIVs, and CDOs originate from banks or specialized finance corporations. These

products may be bought by institutional investors and mutual funds. There are fewer social concerns in the event of an underlying

asset default in the US, and there is no need for banks to satisfy a loan quota and L/D ratio limit.



3) Size: China’s shadow banking activities are much smaller than the US, but have grown rapidly

Exhibit 12 shows that China’s shadow banking activities are smaller than the US if we measure the underlying credits behind these

two systems.

China: The size of shadow banking credit exposure has grown rapidly since 2008. Shadow banking credits in 2012 accounted for

24% of the total credit balance to corporate and consumers, vs. 15% in 2009 (Exhibits 4 and 14).

US: Despite the decline in activity since the 2008-2009 global financial crisis, US shadow banking is now similar in size to US

commercial banks, as measured by liabilities vs. US commercial banks (Exhibit 15).

4) Credit exposure more skewed to corporate leverage vs. consumer leverage in the US

China’s shadow banking is mainly exposed to corporate credit and has little exposure to household credit, while a significant

amount of US securitization and related structure products are based on mortgages or MBS, or other consumer credits such as

credit card receivables.

Most of the credit exposure of shadow banking activities such as trust, entrust loans, WMPs and corporate bonds, and the majority

of informal loans in China are extended to corporates. Thus, the rapid growth of these products will likely increase already-high

corporate leverage.

5) Investor base: The majority of trust/WMP investors are retail investors in China, vs. institutional investors in US

The high proportion of retail investors in China also highlights the risk that banks may be required to provide liquidity support to

troubled corporate borrowers in the event of a credit default to achieve social stability goals. Other risks include reputational risk, or

bank staff mis-selling WMPs to retail customers who are not suitable for buying such products.

China is similar to the US during the 1980s: Interest deregulation accelerated MMF/bond growth,

as the backdrop for disintermediation, shadow banking activity growth

In the US, interest rate deregulation in the 1980s triggered MMF growth and individual investors moved their deposits out of the

banking system into money market funds (MMF), thus raising banks’ L/D ratios.

In 2011, assets under management at MMFs in China totaled less than Rmb1tn (or US$170bn), vs. US$2.5tn in the US and US$8.8tn

for the entire mutual fund market in the US.

We believe China banks’ WMPs are similar to China MMFs in terms of the underlying investment assets, and China banks

manufacture, manage, and distribute these products themselves. To some extent, the majority of profits generated by WMPs are

retained within the China banks. In contrast, profits generated by MMFs in the US move out of the banks.

As such, we view China’s WMP growth as a way for its banks to mitigate the impact of increasing disintermediation trend of bank

deposits moving to high yield WMP or MMFs, and as a result of deposit interest rate deregulation in China which started in June

2012.



Exhibit 12: China shadow banking activities are relatively simple loans or loan securitization, vs. the US Diagram of shadow banking activities in China vs. US, and the regulators

Source: Federal Reserve Bank of Dallas, Gao Hua Securities Research.

Source of Funds

(deposits)

Use of funds

(borrowing)Regulators NPL loss absorption

Traditional commercial banks (intermediated)

Households/Corporations

Households/Corporations

CBRC/PBOC on CAR, L/D, RRR, NPLs, lending standards, etc

Banks recover/restruture NPLs, and use profits to absorb losses

Shadow Banking activities

1. Non-intermediated

Lenders bear the losses.

2. Intermediated

Qualified individual investors/Corporates

Corporates

CBRC has some capital requirements (50X+ leverage on AUM/equity) and product marketing

Individuals/Corporates

CorporatesCBRC has some product marketing regulations


Corporates

CSRC has some capital requirements (50X+ leverage on AUM/equity) and product marketing regulations

For banks' loan securitization through brokers' WMP, brokers expect banks to provide implicit liquidity support


CorporatesPrior approvals from NDRC, CSRC, PBOC; disclosure requriement

Investors should bear the loss though some local government tends to bail-out local SOE debts

US shadow banking (multiple intermediaries)Households/

Corporations/Institutions/SecuritiesLenders/

Pension funds

MMF

purchases

CP,

ABCP,

repo, etc.

ABS

intermediatio

n

ABS

issuance

Loan

warehousing

Loan

origination

Household/BusinessBorrowing

SEC regulates securitization

Investors bear the loss

NOTE: MMF is money market mutual fund; CP is commercial paper; agreement, and ABS is asset-backed securities.ABCP is asset-backed CP, repo is repurchase

Lenders bear the losses. But banks may be hurt given the cross-lending of corporate

Legally trust companies and banks are not liable for NPL loss for trust and WMPs, but in practice, they may be asked to pay customers' loss after recovering the assets given social stability concerns

IndividualsIndividuals/Corporates

Corporates Corporates

Banks WMP

Banks package and securitize loans

Brokers' WMP

Brokers package and securitize loans, usually under banks' request

Corporate bonds

Brokers/banks as underwriters to help corporate issue bonds

1. No regulators on specifc activities2. Interest rate cap at 4x of PBOC's benchmark rates

Credit Intermediation

Informal loans

Entrusted loans

Corporates lend to each other

Banks work as book entry entities

Trust products

Trust companies structure/package loans,

euqity investment, mezzanine debts

Deposit taking banks, group finance companies and financial

leasing companies, take deposits,

originate and hold loans



Exhibit 13: China shadow banking activities: most activities have an interconnection with banks As of end-2012


OFFICIAL BANKING SYSTEM

Commercial banks‐ Banks, group financing

companies, financial leasing firms‐ Assets: RMB 131tn‐ loans: RMB 67tn

Bank WMPs‐ Total assets: RMB 7.1tn‐ Total credits: RMB 1.8tn‐ Supervised by CBRC

Entrusted loans‐ Total credits: RMB 5.7tn‐ No regulation limit on

capital‐ Firms lend to each other

Brokers’ asset mgmt.‐ Total credits: RMB 1tn‐ Capital regulation similar

to trusts’

Trust companies‐ Total AUM: RMB 7tn‐ Total credits: RMB 5.3tn‐ Supervised by CBRC

Corp bonds(incl. LGP bonds)‐ Total size: RMB 7tn

Informal loans‐ Total size: About RMB

4.5tn

1.shift deposit back and forth2.securitize loans as a channel to banks3.generate fee income for banks

1.not account for credit quota2.work as bridge loans of corporates to repay/rollover bank loans

1. about 52% bonds bought by banks and their WMPs2.A significant part underwritten by banks

1. securitize loans as a new channel to banks1. banks distribute trust

and make fee income 2. Securitize loans as a channel to banks

1.work as bridge loans of SMEs/property firms to repay/rollover bank loans



Exhibit 14: China’s shadow banking credits accounted for 24% of total credit in

2012 Shadow banking as % of total corporate and consumer debts

Exhibit 15: US shadow banking’ liabilities exceeded commercial banking

activities since 1995 and are similar in size to commercial banks in 2012 The size of commercial banks and shadow banking liabilities

Note: US shadow banking liabilities equal the sum of the following liability items from the flow of funds accounts: CP, repos, borrowed securities, agency- and GSE-backed securities, mortgage pools, ABS, and MMFs, minus commercial banks’ federal funds (excess reserves), repos, and CP. Abstract from the Staff paper by the Federal Reserve Bank of Dallas, published in November 2012, titled “understanding the risks inherent in Shadow banking”.


Source: Flow of Funds Accounts of the United States, the Federal Reserve Bank of Dallas.

Exhibit 16: Compared with other developing countries, China’s shadow

banking system is relatively small vs. Thailand, Philippines Share in total financial sector assets in 2010

Exhibit 17: Shadow banking’s share in total financial sector has grown in the

past few years Share in total financial sector assets in 2010

Note: For China, informal lending is not captured in this chart. Abstract from the paper of World Bank Economic premise published in November 2012, titled “Chasing the Shadows: How Significant Is Shadow Banking in Emerging Markets?”

Note: For China, informal lending is not captured in this chart, which cause under estimation of shadow banking’s share, especially in 08/09/10. Abstract from the paper of World Bank Economic premise published in November 2012, titled “ Chasing the Shadows: How Significant Is Shadow Banking in Emerging Markets?”

Source: FSAPs, Central bank, other regulatory agency reports, World Bank.

Source: FSAPs, Central bank, other regulatory agency reports, World Bank.

24%

26%

0%

5%

10%

15%

20%

25%

30%1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013E



Exhibit 18: Money market funds’ assets under management (AUM) grew as deposits moved from the banking system to money

markets funds Total assets of US money market mutual funds (USD billion)

Source: Federal Reserve.

Exhibit 19: In the 1970s and 1980s, interest liberalization policies in US were implemented while banks’ L/D ratio trended up as

deposits flow to mutual funds or shadow banking products Loan/deposit ratio of US banks

Source: FDIC.

0

500

1000

1500

2000

2500

3000

3500

4000

1974 1979 1984 1989 1994 1999 2004 2009

1978: NOW accounts

1982: MMDA & time deposit rates (>3.5 years ) relaxed

1983: SuperNow account rates and all time deposit rates relaxed

1986: Liberalized NOW check account rates

1980: Suspended Regulation Q in law

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010



Key long-term risks: underwriting standards, pro-cyclicality, liquidity, implicit guarantees

We see many benefits from China’s shadow banking activities, including:

Provides private companies with access to credit through shadow banking activities, albeit at higher costs than bank loans.

They are unable to access credit through commercial banks due to either their small size or regulatory limits such as property

tightening.

Lowers borrowing costs of corporates as credit supply increases.

That said, we believe shadow banking’s rapid growth increases the long-term risks and fragility of China’s financial system, as we

explore below.

Long-term risks: Underwriting standards, pro-cyclicality, liquidity, implicit guarantees

1) Relatively weak underwriting standards and liquidity vs. bank loans (Exhibit 20)

Shadow banking activities typically do not have as strong credit underwriting standards as banks, either due to a lack of corporates’

financial information and historical cash flow records, or lack of incentives to properly analyze credit risks (e.g., corporate bond

underwriting).

We believe the underwriting standards of China’s shadow banking activities vary depending on the product. Our ranking from

stronger to weaker is:

Loans securitized by WMPs: Most banks require their branches to undertake a formal loan approval process for securitization of

WMPs, partly as banks may have reputational risks or implicit guarantees for these products. Therefore, the underwriting

standards are similar to on-balance sheet loans. In most cases, banks put loans with above-average internal rating in WMPs to

avoid potential reputational risks in case of these underlying loan defaults.

Trust products: Trust companies, like banks, acknowledge the reputational risks or the perceived implicit guarantees involved in

issuing trust products. Although trust companies may not have the same level of access to or knowledge of clients’ financial

background as banks have, and although some projects and borrowers may have higher business risks than the typical bank

loan borrowers, many trust products are carefully evaluated and structured and usually have a high level of collateral.

In the case of trust products becoming NPLs, trust companies typically first attempt to recover/sell the assets or the projects

(e.g., for property projects) to other investors, or restructure these debts. There are active distress debts markets in China, and

buyers may include private equity investors, the big four asset management companies including Huarong AMC, Cinda AMC,

Oriental AMC and Great Wall AMC that specialized in NPL resolution, and private investors.

Corporate bonds and WMPs issued by brokers: Transparency and disclosure of corporate bonds are the highest among shadow

banking activities. However, the due diligence process and skill of brokers’ staff are not as effective as bank account managers

that have the ability to constantly monitor corporate cash flows.

Informal loans: Lending decisions are typically based on personal relationships between lender and the bank representative and

the personal reputation of the borrowers. Thus, informal loans have limited due diligence. The cross-guarantees of informal

loan borrowers also reduce the incentives of informal loan lenders to perform due diligence.



Exhibit 20 shows a comparison of corporate bonds, trust loans/WMPs, and bank loans in term of disclosure, funding costs,

liquidity.

Exhibit 20: Comparison of the underwriting standards, transparency, leverage and capital charges, NPL solutions of shadow banking activities


2) Increases leverage of the overall financial system

Trust products, bonds, and WMPs issued by brokers are charged a very small amount of capital, while WMPs issued by banks and

informal loans have no capital requirement.

For trust firms and brokers, their net capital (shareholder equity minus capital deductions) must be higher than the minimum risk

reserves, namely c.1.5% of trust companies’ AUM or that of brokers’ asset management business (WMPs). We estimate trust

companies and broker WMPs could in theory have over 50X effective leverage in terms of total asset management product

balance/equity (Exhibit 22).

3) Increases leverage of China’s corporate sector; risk of over-investment and corporate NPLs

The majority of shadow banking credits and around 85% of bank loans are extended to corporate borrowers. We believe the rapid

growth in shadow banking credit could further increase China corporates’ leverage, which already have a high debt/GDP ratio vs.

most countries.

Earlier, we pointed out that a high and rising corporate leverage could increase the imbalance of China’s economy, reduce long-

term corporate investment, and borrowing demand, and increase long-term asset quality and NIM risks for China banks through

loan pricing power decline (see Financial Services: China credit watch 4: 1Q weak but rebound possible; D/E a long-term issue, May

8, 2012, and Banks: Prefer quality banks; cut estimates/TPs on NIM: CMB (H) to CL Buy, July 5, 2012).

Underwriting

standards

Leverage/

capital

charges Transparency

NPL resolution/

legal protection

for creditors

Liquidity to

support

credits

Implicit

guarantee/

moral hazard

Total

score Supervisors

Bank loans 1 1 1 2 1 1 7 CBRC, PBOC

Corporate bonds 4 5 1 1 4 3 18Prior approval of CBRC,

CSRC, NDRC

Trust products 3 4 3 3 4 3 20 CBRC

Loan securitization in the WMPs 2 4 4 4 2 4 20 CBRC

WMP issued by brokers 5 4 4 4 4 3 24 CSRC

Informal loans 6 5 5 6 6 0 28

Some activities of micro

lending firms supervised by

PBOC/CBRC

Note: 6/0 represents highest/lowest risk



Our international comparison study suggests that China corporate debts as a percentage of GDP in 2011 is one of the highest in the

world. However, total system leverage, including consumer and government debts, remains relatively low vs. developed economies

and in a global context (Exhibit 23).

As such, we believe developing consumer credit and domestic consumption in China is key to raising domestic demand, GDP, sustainable corporate profitability/ROE, and in turn, banks’ sustainable ROE and valuations. We believe

this could be achieved by:

Supporting consumers’ property upgrade needs (not just first homes), and enforcing more market-oriented property tightening

measures, such as using property taxes and greater downpayment requirements to curb demand for property investment, in

addition to the current administrative purchasing restriction measures.

Encouraging growth in other consumer loans such as credit cards, auto loans, and other consumption loans. We view the

CBRC’s new risk-weighting for other consumer loans of 75% (previously 100%) as positive.

Improving social safety nets. China has come a long way in terms of setting up a national basic pension system and medical

care system, but we think China still needs to improve its coverage and scope of coverage to include the rural population.



Exhibit 21: Detailed comparison of corporate bonds, trust products, and bank loans

Source: Gao Hua Securities Research.

Corporate and inter-bank bondsTrust loan products, WMP and other

private debtsBank loans

Disclosure • Relatively strong disclosure • Relatively weak disclosure

• Though there is no disclosure,

banks have more information about

the borrowers than bond investors

Funding

costs

• Different interest rates relativley

reflect fundamentals

• Good firms have relatively low

finding costs

• Higher interest rates reflect

relatively higher risk of the

borrowers

• Issuers are often firms that have

difficulties in accessing to normal

credit or loan channels

• With no open market on loan

transfer, interest rates are priced

solely based on banks' internal risk

rating system, and supply and

demand.

• Similar firms may have similar

funding costs

Investors • Institutional investors• Mostly individual investors

-

Credit and

liquidity

• After a major credit event, the

liquidity of certain bonds could

drop significantly

• A business's ability to refinance

may be greatly affected by the

market

• SOE and large-scale corporate

bonds could have an implicit

guarantee due to government

support or being "too big to fail"

• Many products are thought to be

implicity guaranteed by banks

• Slow response to information

• Bank loan liquidity is supported by

deposits

• Banks' non-performing loan

classification may have some lag

• Accounting audits and rating

quality need further improvement

• Government-led corporate

restructuring could be inconsistent

among different geography or

corporate which could harm some

creditors' interests

Credit system infrastructure

• The bankruptcy law and bankruptcy courts are

inadequate



Exhibit 22: Effective leverage of trust firms and brokers’ asset management business could potentially be as high as 50X Table of required risk reserve ratio (Required risk reserve = risk reserve ratio * asset mgmt. products’ AUM)

Source: CBRC, CSRC.

Exhibit 23: China’s corporate debt as a % of GDP is one of the highest despite having low overall macro leverage

International comparison of leverage of consumers, corporate and government, 2011

Source: Gao Hua Securities Research

Single

client trust

Collective trust(incl.

products with bank

cooperation) Broker Asset mgmt. A B C D 3-year A

Fixed income 0.1% 0.2% Single investment WMPs 0.6% 0.8% 2.0% 4.0% 0.4%

Securities like stocks 0.3% 0.5% Collective WMPs 0.6% 0.8% 2.0% 4.0% 0.4%

Equity related investment(incl. PE) 0.8% 1.5% Specified investment WMPs 0.3% 0.4% 1.0% 2.0% 0.2%

Public low-rent housing loans 0.5% 1.0%

Other real estate loans 1.0% 3.0%

General loans 0.8% 1.5%

Others 1.0% 3.0%

0.2%WMPs with limited quota

and investments0.3% 0.4% 1.0% 2.0%

171%

86%100%

44%

12%

59%

2.6%21%

35%54%

32%49% 45%

9%

113%

115%75%

133%

113%

116%

141%

151%109%

83%

56%

49%36%

22%

35%

93%

86%55%

94%

31%

60%19%

48%

22%

68%

9%

6%

9%

0%

50%

100%

150%

200%

250%

300%

350% Consumer debts as % of GDP

Corporate debts as % of GDP

Government bonds as % of GDP



Exhibit 24: China corporate leverage continues to rise while consumer and central government leverage remains relatively stable Credit/GDP, 2000 to 2013E


0.2 0.6 1.8 4.3 6.4 8.9 11.6 12.4 11.9 11.1 12.3 11.9 15.6 18.7 18.8 21.9 23.0

1.5 6.1 7.59.2 10.0

13.615.5 15.1 18.7 17.2

20.6 18.119.6

19.4 17.918.1 17.8

13.1 11.910.8

9.6 10.612.9

11.09.0

10.09.2 7.8 6.6

6.0 5.3

07

910 11

1314

14.4 15.1

22.5 22.719.0 17.7 16.9

93

100105

101

95

98

103 9487

85 7875

87 85

8590 91

0.00.0

0.0

0.0

0.0 0.0 0.0 0.00.0

0.0

0.0

8.5

7.1

7.0

95

107

114

128 131

142

153147 147 147

146 144

174

186

194

210217

0

30

60

90

120

150

180

210

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013E

Informal lending

Loans made by HK banks

Micro lendings

Credits in brokers' AM

business

Trust loans not captured by

PBoC data

Pawnshop loans

Bank acceptance

Entrust loans

Trust loans captured by

PBoC data

ABS

Medium-term notes

Corporate bonds

Corporate loans (excl. LGP

loans)

Convertibles

LGP loans

NPLs carved out for bank

restructuring

Government bonds

Consumer loans

Total loans and debt as % of

GDP

(as % of GDP)

Consumer

Govt.

Quasi-

govn't

Corporate



4) Greater liquidity risk vs. loans, and pro-cyclical growth rates, which may reduce the effectiveness of counter-cyclical macro policies in China

Shadow banking credits, unlike commercial banks, typically do not have liquidity support from the PBOC, and thus could be

subject to “run” risk if credit quality deteriorates significantly and investors lose confidence in these products.

Growth rates tend to be pro-cyclical, i.e., rapid growth when the economy is strong, or credit contraction/crunch if there are

credit default events when the economy is on a downward trend.

The pro-cyclicality of shadow banking will likely reduce the effectiveness of China’s countercyclical macro policies, in our view.

For instance, informal loans and entrusted loan activities grew rapidly in 2010/1H11 as China’s economy grew, triggering tightening

policy (Exhibit 25). Many corporates, especially SMEs and privately owned entities, applied for credit through informal loans and

entrusted loans, which further fueled the economic expansion and reduced the effectiveness of tightening policies.

However, GDP growth slowed in 2H11/2012, triggering credit default of informal loans. Growth in informal loans and entrusted

loans also slowed yoy, leading to further liquidity tightening at a time when China needed to gradually loosen its monetary policies.

During the 2008-2009 financial crisis in US, the sharp decline in sub-prime MBS in the US impacted investor confidence in MBS and

SIVs, which led to fewer shadow banking assets (Exhibit 15). This led to a weaker economy at a time when the US needed more

credit to help support the economy.

Exhibit 25: There is an inverse relationship between informal loan growth and bank loans


-20%

-10%

0%

10%

20%

30%

40%

50%

60%Informal loans Bank loans



5) Investors’ perception of implicit guarantee on trusts, corporate bonds, and WMPs, and moral hazard.

Given China’s long-term objective to maintain social stability, the government or other lenders may provide implicit guarantees to

investors of trusts, corporate bonds, and WMPs. For instance, the recent bailout of Hailong’s corporate bonds by the local

government in Shangdong Province suggests the existence of such implicit guarantees.

In the event of a credit default, some banks and trust companies will likely have to provide liquidity to borrowers that default in

order to achieve “social stabilization” goals and/or to protect their reputations. From China banks’ perspective, for trust products

that are sold directly to investors, we believe the disclosure and investor selection is better than for WMPs, and thus banks would

have less implicit guarantee concerns than trust companies that restructure these products.

We believe this increases the financial system’s moral hazard as this encourages investors to buy these products without carefully

considering the viability of the borrowers.

Further, if this perception of implicit guarantees persists, we believe it could significantly impact the pricing of financial

instruments and distort capital allocation. For instance, local government-funded platforms and SOEs are typically viewed as

having low operational and financial efficiency, but having local government support, and therefore could provide access to credit

and bonds at a less expensive rate than private companies in China.

Inflation/overheating is the key pressure point for systemic risk, as leverage rises

Near-term systemic and regulatory risks likely manageable, unless China overheats

Given the size and rapid growth of China’s shadow banking system, we see a number of NPL risks from these shadow banking

activities in 2013E/14E. However, we do not expect these risks to lead to systemic concerns in the near term, for the following

reasons:

1) No internal cash call: China’s banking system still has ample liquidity, as evidenced by 69% average L/D ratios and 20% reserve

requirement as of 3Q12.

2) No external cash call: China has accumulated over US$3tn forex reserve, and its balance of payments will reach US$223

bn/US$242 bn in 2013E/2014E, or 2.4%/2.3% GDP;

3) China’s economy and corporate earnings are stabilizing following three years of tightening since 2H09, owing to increasing

credit to the economy provided by bank loans and shadow banking credits.

As the shadow banking credit risks are mainly corporate NPL risks, the stabilization of GDP growth, corporate earnings, and

property prices should support the overall credit quality of shadow banking activities in 2013 and 2014.

Improving liquidity may be demonstrated by the recent decline in interbank rates and WMP yields vs. the peak in 2011.

There may potentially be regulatory risk if China regulators stop or slow down one of the shadow banking activities due to risk

concerns, which may cause temporary credit tightening, such as when CBRC required banks to stop selling bill discount loans to

rural credit cooperatives in 3Q11.



However, we believe the regulatory risks may be mitigated by:

The current macro policy to keep GDP growth stable at around 7.5% to 8% in 2013. China is already shifting to maintain stable

growth from the government’s overall tightening tone in 2011.

Moreover, if the PBOC wants to achieve c.13% M2 growth and reasonable TSF growth in 2013, shadow banking activities such

as trust, entrust loans and corporate bonds would still need to grow.

There will likely be a few other loan securitization channels available such as broker/insurance WMPs even if the CBRC tightens

shadow banking activities. The CSRC and CIRC are also encouraging brokers and insurance companies to conduct financial

product innovations.

Exhibit 26: 1-week interbank rates declined ytd and have recently stabilized

Exhibit 27: 3-month interbank rates declined ytd and have recently stabilized

Source: Datastream. Source: Datastream.

0

2

4

6

8

10

12

Sep

-05

Dec-0

5

Mar-

06

Ju

n-0

6

Sep

-06

Dec-0

6

Mar-

07

Ju

n-0

7

Sep

-07

Dec-0

7

Mar-

08

Ju

n-0

8

Sep

-08

Dec-0

8

Mar-

09

Ju

n-0

9

Sep

-09

Dec-0

9

Mar-

10

Ju

n-1

0

Sep

-10

Dec-1

0

Mar-

11

Ju

n-1

1

Sep

-11

Dec-1

1

Mar-

12

Ju

n-1

2

Sep

-12

Dec-1

2

1w interbank rate Average since 04

0

1

2

3

4

5

6

7

8

9

10

Sep

-05

De

c-0

5

Mar-

06

Ju

n-0

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Sep

-06

De

c-0

6

Mar-

07

Ju

n-0

7

Sep

-07

De

c-0

7

Mar-

08

Ju

n-0

8

Sep

-08

De

c-0

8

Mar-

09

Ju

n-0

9

Sep

-09

De

c-0

9

Mar-

10

Ju

n-1

0

Sep

-10

De

c-1

0

Mar-

11

Ju

n-1

1

Sep

-11

De

c-1

1

Mar-

12

Ju

n-1

2

Sep

-12

De

c-1

2

3m interbank rate Average since 04



Exhibit 28: EBIT interest cover of industrial companies continues to recover

as total credit grows and borrowing costs decline

Exhibit 29: Industrial companies’ average borrowing costs declined in 2H12

vs. the peak in 2011 partly due to falling interest rates

Source: CEIC, Gao Hua Securities Research.

Source: CEIC, Gao Hua Securities Research.

High inflation or overheating could be the pressure point for systemic risks, cap bank valuation

However, the rapid rise of corporate leverage could cause corporate EBITDA interest cover/NPL formation to be more sensitive to

high CPI inflation (e.g. 3%+ CPI), due to rising leverage and borrowing costs. As such, overheating, followed by tightening, could

cause more collateral damage than in previous cycles.

1) The rapid rise of corporate leverage and D/E ratios increase the sensitivity of NPL creation

For instance, using A-share listed non-financial corporates as an example, we compared the sensitivity of the implied NPL ratio of

these corporates based on corporate EBITDA interest cover in 1H12 with a, average D/E ratio of 85%, and those in FY05 with an

average D/E of 70%. If a listed corporate’ EBITDA cannot cover interest costs during the reporting period, we deem the debts of

these corporate as implied NPLs.

Our sensitivity analysis (Exhibit 30) suggests that a 50bp rise in borrowing costs could lead to an incremental increase in implied

NPL ratios by 2.1pp to 12.9% from our base case of 10.8% in 1H12, vs. only 0.2pp to 10.6% from 10.4% in FY2005.

-1

0

1

2

3

4

5

6

7

May

-99

Oct

-99

Mar

-00

Aug

-00

Jan-

01Ju

n-01

Nov

-01

Apr

-02

Sep

-02

Feb-

03Ju

l-03

Dec

-03

May

-04

Oct

-04

Mar

-05

Aug

-05

Jan-

06Ju

n-06

Nov

-06

Apr

-07

Sep

-07

Feb-

08Ju

l-08

Dec

-08

May

-09

Oct

-09

Mar

-10

Aug

-10

Jan-

11Ju

n-11

Nov

-11

Apr

-12

Sep

-12

UpstreamDownstreamTotal

(X)

(EBIT interest cover of 410,000+ industrial companies, X)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Feb

-05

Ju

n-0

5

Oct-

05

Feb

-06

Ju

n-0

6

Oct-

06

Feb

-07

Ju

n-0

7

Oct-

07

Feb

-08

Ju

n-0

8

Oct-

08

Feb

-09

Ju

n-0

9

Oct-

09

Feb

-10

Ju

n-1

0

Oct-

10

Feb

-11

Ju

n-1

1

Oct-

11

Feb

-12

Ju

n-1

2

Oct-

12

Finance cost/av. Liability(monthly, annualized)%



Exhibit 30: Rising sensitivity of corporate NPL creation to inflation: Given the rising D/E leverage to 85% in 1H12 from 70% in FY05,

China listed A-shares’ implied NPLs based on EBITDA interest cover are more sensitive to inflation and rising borrowing costs in

1H12 than FY05 previously

Source: Company data,, Gao Hua Securities Research estimates

Effective borrowing

costNPL ratio

Effective borrowing

costNPL ratio

1H12 base case 10.8% 2005 Base case 10.4%

-2.75% 5.4% -2.75% 8.4%-2.50% 5.5% -2.50% 9.5%-2.25% 5.5% -2.25% 9.5%-2.00% 5.6% -2.00% 9.5%-1.75% 5.6% -1.75% 9.6%-1.50% 6.1% -1.50% 9.8%-1.25% 8.2% -1.25% 10.0%-1.00% 8.6% -1.00% 10.0%-0.75% 9.0% -0.75% 10.2%-0.50% 10.4% -0.50% 10.3%-0.25% 10.6% -0.25% 10.4%0.00% 10.8% 0.00% 10.4%0.25% 12.1% 0.25% 10.5%0.50% 12.9% 0.50% 10.6%0.75% 13.5% 0.75% 10.7%1.00% 14.8% 1.00% 10.7%1.25% 17.0% 1.25% 11.1%1.50% 18.7% 1.50% 11.1%1.75% 21.0% 1.75% 11.8%2.00% 21.9% 2.00% 12.0%



2) Our study of the relationship between the corporate operating loss of loss making industrial companies, CPI inflation, and banks’ valuation, suggest that:

Asset quality trend of corporates remains a major China bank share price driver. For instance, Exhibit 31 shows that

CMB A-share prices usually peaked when the operating loss growth of loss-making industrial companies started to accelerate, a

sign that corporate distress is increasing.

The tipping points for inflation to increase the operation loss of loss making corporate became lower in May 10 at 3.1%, vs. 3.4% in June 2007 (Exhibit 32), as the results of rising corporate leverage.

Rising inflation to over 3% could start to hurt the profitability of loss making corporate which usually the source of NPL

creation, as these corporate have less ability to absorb rising labor and raw material costs.

We will continue to monitor the corporate loss growth and inflation relationship in FY13, as we believe:

On the negative side, current corporate leverage is even higher than the level in May 2010

On the positive side, the commodity price and raw material price pressure is less than in May 2010 and June 2007, as PPI in

January 201 3 was -1.6% yoy, vs. 7.1% in May 2010, and vs. 2.5% in May 2007.

Lower raw material prices could benefit corporate earnings, especially for weak loss-making corporates that are more sensitive

to rising costs than financially strong corporates.

Exhibit 31: CMB A-share share prices usually peaked when corporate loss

growth started to accelerate

Exhibit 32: When CPI rose to more than 3.1% in May 10 vs. 3.4% in June 07,

the corporate operation loss growth started to accelerate

Note: GSCA stands for GS China Activity Index

Source: Datastream, CEIC, Gao Hua Securities Research estimates

Source: Datastream, CEIC, Gao Hua Securities Research estimates

-100

-50

0

50

100

150

2000

5

10

15

20

25

30

35

Jan

-04

Ju

n-0

4

No

v-0

4

Ap

r-05

Sep

-05

Feb

-06

Ju

l-06

Dec-0

6

May-0

7

Oct-

07

Mar-

08

Au

g-0

8

Jan

-09

Ju

n-0

9

No

v-0

9

Ap

r-10

Sep

-10

Feb

-11

Ju

l-11

Dec-1

1

May-1

2

Oct-

12

%%. Rmb GSCA yoy CMB A price Industrial operating loss yoy (RHS, inverted)

Mar05 Oct05 May07 Nov08 Feb10 Aug12

-80

-40

0

40

80

120

160

200

-4

-2

0

2

4

6

8

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Feb

05

Ju

n 0

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Oct 05

Feb

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Ju

n 0

6

Oct 06

Feb

07

Ju

n 0

7

Oct 07

Feb

08

Ju

n 0

8

Oct 08

Feb

09

Ju

n 0

9

Oct 09

Feb

10

Ju

n 1

0

Oct 10

Feb

11

Ju

n 1

1

Oct 11

Feb

12

Ju

n 1

2

Oct 12

CPI(%) Total operating loss' yoy(RHS)

Bottoming CPI 3.4 Bottoming CPI 3.1



3) Too much credit growth from shadow banking or rate hikes could further raise corporate borrowing costs to a distressed level again, similar to 2011

Exhibit 33 shows our estimates of total corporate financing costs including shadow banking as percentage of GDP in each year since

1994.

The surge of corporate financing costs in 2010 and 2011 was largely driven by the rapidly growth in shadow banking credit by 65%

and 34% yoy respectively, which were typically at higher costs than banks, and which helped accelerate GDP growth and

overheating. This in turn led PBOC to raise interest rates.

After a temporary fall in total financing costs in 2012 due to two rate cuts and rapidly issuance of lower cost corporate bonds, we

forecast financing costs/GDP in 2013E should rise vs. 2012, as we forecast shadow banking credits in our base case grow at 30% yoy,

but with no rate cut factored into our outlook.

In a bullish case scenario of more rapid shadow banking credit growth at 38% yoy in 2013E(Exhibit 4), we project the total financing

costs for corporate/GDP could surge to back to the 2011 level.

We are closely watching out the inflation trajectory in China as the key downside risks for banks’ valuation. Our

global ECS team forecast a gradual, rather than, sharp rise of CPI inflation to 3.4% in 4Q13 (exhibit 34). However, there could be

upside risks if the strong TSF/credit and real economy growth trend in January 2013 continues.

Exhibit 33: Rapid growth of shadow banking credits could raise corporate

borrowing costs again to the distressed level in 2011 Corporate financing costs (including shadow banking credits) as % of GDP

Exhibit 34: Our ECS team forecasts CPI inflation in 13E to gradually trend up

to 3.4% yoy in 4Q13

Source: Gao Hua Securities Research estimates

Source: Goldman Sachs Research estimates

6%

7%

8%

9%

10%

11%

12%

13%

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013E

Total corporate financing cost incl. shadow bankingCorporate loans' costLow caseHigh case

As % of GDP

-6

-4

-2

0

2

4

6

8

10

12

-6

-3

0

3

6

9

12

2005 2006 2007 2008 2009 2010 2011 2012 2013

China Quarterly CPI Path

yoy(RHS) qoq sa ann(LHS)

% chg

GS Forecasts

% chg



WMPs: Likely to remain strong in 2013, despite fundamental risks

There are three types of WMPs.

1) Principal-guaranteed products with underlying assets of interbank assets and high quality securities such as financial

institutions bond, and typical yields of around 3%-4% depending on maturity. These products are manufactured, distributed,

and managed by banks. Banks put these products on their balance sheet to qualify as deposits in the regulatory L/D ratio

requirement.

2) Non-principal guaranteed products with underlying assets of a pool of interbank assets, financial bonds, corporate bonds and

loans, and typical yields of over 4%. These products are also manufactured, distributed, and managed by banks. These contracts

explicitly state that banks do not guarantee the repayment of principal to investors in the event of investment losses.

3) 3rd-party trust products or private equities products that are distributed through banks: These products are only distributed by

banks, but are not manufactured or managed by banks.

Exhibit 35 shows the total size of bank-managed WMPs (i.e. type 1 and 2 WMPs) grew to Rmb7.1tn in FY12 from Rmb5tn in 2011.

WMPs currently account for over 8% of M2 and total system deposits, +2pp yoy. Exhibit 36 shows the number of WMPs that have

been issued increased sharply and peaked in 3Q12, but has been still active in 4Q12, especially for non-listed smaller banks such as

city commercial banks (Exhibit 37).

Exhibit 35: Bank WMPs grew significantly as a % of M2/deposits

Exhibit 36: The number of new WMPs (including 3rd-party products)

issued has been trending up since 2009

Source: CBRC, PBOC, Gao Hua Securities Research estimates.

Source: Wind, Gao Hua Securities Research.

467

1,327 960 1,015

2,500

5,000

7,100

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

2006 2007 2008 2009 2010 2011 2012

Rmb bnbank WMP vs. deposits (RHS) vs. M2 (RHS)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

Jan

-09

Mar-

09

May-0

9

Ju

l-09

Sep

-09

No

v-0

9

Jan

-10

Mar-

10

May-1

0

Ju

l-10

Sep

-10

No

v-1

0

Jan

-11

Mar-

11

May-1

1

Ju

l-11

Sep

-11

No

v-1

1

Jan

-12

Mar-

12

May-1

2

Ju

l-12

Sep

-12

No

v-1

2

Jan

-13

# of newly issued WMPs



In our view, the rapid growth in banks’ WMPs reflects the increasing competition for deposits among China banks, and increasing

pressure from interest rate deregulation:

Most banks suggest they are obligated to offer WMP products at competitive yields to keep their customers, though WMPs may

not help them to comply with the L/D ratio requirements. The CBRC has a 30% credit limit within a WMP portfolio, effectively

setting a low 30% L/D ratio cap for WMPs vs. 75% L/D cap for on-balance sheet loans.

Depositors demand deposit rates that are higher than the official benchmark.

Given our expectations for low capital inflows in 2013E and our assumption that they will likely not contribute meaningfully to

M2/deposits generation, we believe banks’ WMP will continue to grow in 2013E/2014E.

Exhibit 37: Non-listed smaller banks have been aggressively expanding

WMP issuance Market share of number of monthly WMP issuance

Exhibit 38: The average expected yield of WMPs are market-negotiated



Some credit risks and risk to implicit bank guarantees; less concern on liquidity risks

Credit risks

We estimate around 35% of total WMPs funds is credit, according to an interview by Caixin Media with CBRC officials— comprising

25% total WMP AUM are loan securitization and trust-bank cooperation products, and corporate bonds 10% of total AUM. Thus, we

estimate around Rmb2tn to Rmb2.5tn of credit in WMPs, as of FY12.

Typically, loans and trust products must go through a bank’s loan appraisal or product due diligence process to avoid reputational

risks or prevent from lending to corporates that are likely to default. Risky assets like equity-related/structural assets are usually sold

to private banking WMPs for high net worth individuals that have a high risk tolerance.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

20

08

-1

20

08

-4

20

08

-7

20

08

-10

20

09

-1

20

09

-4

20

09

-7

20

09

-10

20

10

-1

20

10

-4

20

10

-7

20

10

-10

20

11

-1

20

11

-4

20

11

-7

20

11

-10

20

12

-1

20

12

-4

20

12

-7

20

12

-10

20

13

-1

Non-listed

banks

Other listed

banks

Big 5

0%

1%

2%

3%

4%

5%

6%

Jan

-11

Feb

-11

Mar-

11

Ap

r-11

May-1

1

Ju

n-1

1

Ju

l-11

Au

g-1

1

Sep

-11

Oct-

11

No

v-1

1

Dec-1

1

Jan

-12

Feb

-12

Mar-

12

Ap

r-12

May-1

2

Ju

n-1

2

Ju

l-12

Au

g-1

2

Sep

-12

Oct-

12

No

v-1

2

Dec-1

2

Jan

-13

Average yields of 3M WMP issued by listed banks



As such, we believe the quality of credit assets in those pools are generally similar to that of traditional loans, as WMP credit assets

generally follow the application process and underwriting standards of official loans.

Exhibit 39: We estimate around 35% credit assets in WMPs


Credit assets

Interbank deposits

Bond

Equity related(incl. equity

trust)

Others(structured

derivative etc)

WMP asset pool

High net worth

individuals

Retail investors

As % of banks’ total wealth mgmt assets

Financial 25%

Corp 10%

25‐30%

c.24%

c.36%

<10%

<.5%



Implicit guarantees and implicit liquidity support from banks

The contract of banks’ non-principal guaranteed WMPs state that investors assume principal losses on their portfolios, and banks

have a fiduciary obligation to ensure the credit assets they are invested in are in good condition at the time of investment.

However, due to a lack of risk disclosure and transparency to individual investors on the underlying assets, in practice banks may

have to reimburse the losses of investors if investors pursue legal channels to seek bank compensation, for the following reasons:

One credit asset may not match one WMP product. Many China banks issue multiple WMPs on the back of an asset pool with a

combination of interbank and credit assets (Exhibit 39). Therefore, banks may find it difficult to prove that the credit default is

for a particular WMP.

There is no specific disclosure to investors about which corporate loans are in the WMPs. Thus, banks are subject to insufficient

disclosure claims.

In practice, in the event of a loan default, some banks may offer an on-balance sheet loan to the corporate to mature the loans in the

WMP to protect WMP investors from incurring a loss.

We are less concerned about WMP liquidity risks

There are also some market concerns on WMP’s liquidity, as:

There are maturity mismatches between the underlying assets (usually 3-month interbank assets to 1-year loans) and WMPs

with maturities ranging from 1 day or 7 days to 3 months or 6 months.

The cash streams generated by the pools are shared by a number of WMPs with various expected returns and maturities.

However, we are less concerned about these liquidity risks because:

When WMPs mature, the liability will first become the demand deposits of customers of the same bank (Exhibit 40). If the

customer wishes to transfer his/her deposit to another bank, this transfer is supported by the liquidity of the entire bank.

The maturity mismatch of WMPs is similar to the on-balance sheet assets and liabilities of the same bank.

We estimate the average maturity of WMPs as of end-1H12 is 0.42 years vs. 0.53 years for time deposits of listed banks. As the

duration of most credit assets are less than 3 years, concerns on WMPs’ duration mismatch are not as severe as their on-

balance sheet business. Exhibit 40 shows the fund flow of three types of WMPs when these products are issued and when they

mature.



Exhibit 40: Principal or non-principal guaranteed WMP: liquidity is linked to banks’ deposits upon maturity, while trust products are not An illustration of banks’ wealth management product (WMP) cash flow


We do not think regulators will stop WMP growth or put credit onto banks’ balance sheet in 2013

Many investors are concerned that regulators may stop WMP growth, or to account for these credits onto banks’ balance sheet,

given the recent news reported by Bloomberg on December 4 about Huaxia Bank’s WMPs and other trust-related WMP defaults.

We do not think regulators will take such measures because:

Our discussion with various regulators suggest that they believe WMPs are the result of banks’ preparation for interest rate

deregulation, and the growth trend would be hard to reverse;

If bank regulators stop WMP growth, the other informal loan securitization could potentially continue to grow in the financial

system, given the asset management product innovation of brokers and insurance companies as alternative loan securitization

channels. Banks may need WMPs to compete with brokers and insurance companies for customers.

The head of the Disciplinary Committee of CBRC Mr Du Jin Fu spoke on December 11, 2012, regarding WMP development. He

mentioned that WMP’s growth strategy is key for banks’ future competitiveness, and banks should provide more information

and risk disclosure, improve risk management and staff training, and promote product innovation to satisfy customers’ needs.

The contracts of non-principal guaranteed products state that investors should bear the investment losses. If regulators require

banks to reflect the credits on their balance sheet, it would suggest such products are actually principal guaranteed, which could

potentially lead to even more confusion and moral hazard.

Cash

Return to banks

- High quality bonds - Interbank assets- Interbank assets - Credit assets Cash- financial bonds - financial bonds

- Corporate bonds Maturity

WMP A, WMP B... WMP 1, WMP 2...Return to banks

Trust products Corporates

Trust WMP to high net wealth

individuals

Return money

3rd party products such as trust WMP that banks manufacture, manage and sell

Banks' assets

Banks' deposits

Upon maturity

Principal guaranteed

WMP

Non-principal

guaranteed WMP

A pool of assets A pool of assets

Before maturity Before maturity



We believe the recently reported WMP incident (Bloomberg, December 4, 2012) involving Hua Xia Bank was company-specific .

The product was allegedly sold by a sub-branch in Shanghai and involved the sale of an unauthorized private equity product to

investors. A large amount of funds was later reported missing by the borrowing company that was alleged to be conducting

inappropriate activity. We believe this shows the weak internal controls at Hua Xia Bank. However, we think this product is not a

typical WMP that has assets as collateral, and thus should not be a reason for the regulators to stop or limit WMP growth.

As such, we believe regulators may require China banks to improve their disclosure, risk management/due diligence, investor education, and selection of WMPs, rather than stop WMP growth or require banks to reflect the credits in WMPs back to their balance sheet.

China regulators could take a while to fundamentally correct WMP distortions and risks

We believe China banks have several options to fundamentally improve WMP disclosure and reduce moral hazards and investor

perception of implicit bank guarantees:

1) Consider eliminating the 75% L/D ratio cap: We believe 75% L/D cap is likely one of the key reasons that China banks increasingly

securitizing loans to generate deposits/M2 in light of the limited forex capital inflow. In our view, removing the 75% L/D cap would

fundamentally help reduce banks’ incentives and practices to use WMP as a way to securitize loans, as banks may be self-funded

without L/D ratio caps, like banks in developed countries.

2) Require banks to move their WMP operations to a separately run mutual fund company owned by the banks. This would help

reduce the interconnection between WMPs and the banks’ balance sheet, and perceived implicit guarantees and liquidity support.

3) Develop institutional investors such as money market fund industry and develop bond markets, to gradually replace banks’

WMP and trust products. We note banks’ WMPs are essentially money market funds managed by banks, but the consumer bases

are retail depositors. However, WMPs do not provide frequent asset market valuation as mutual funds do. Trust loan products are

essentially “private placed bonds” but have fewer disclosure requirements than bonds.

4) Require banks to match assets to each WMP rather than asset pool-matching several WMPs, and to fully disclose the underlying

credits to investors. This will likely require IT enhancement; we believe only a few banks such as ICBC can currently meet such

requirements.

5) Require banks to centralize product approvals to head office and/or authorized a few provincial branches. We are concerned that

some banks allow provincial branches to develop, approve, and sell their own products, which may lead to weak reporting and

control of such activities.

6) Require banks to only sell WMPs with underlying credit assets to qualified investors that have Rmb1mn+ in financial assets. For

principal guaranteed products without credit assets, banks can sell them to non-qualified investors.

That said, we believe China regulators will likely focus on the latter three measures to improve WMP disclosure and risk

management as the first three measures would require the revision of Commercial Banking Laws and strong coordination between

banking and securities regulators.

We would be more positive if regulators act on the first three measures as well, as we believe they are fundamentally more effective

than the latter three measures.



Sensitivity analysis suggest manageable negative impact on banks in a downside scenario

We believe WMPs’ perceived implicit guarantees given the social stabilization concerns in practice negatively impact banks’ profits

and increase effective leverage, as few provisions or reserves for WMPs have been recorded to deal with potential investment loss.

In our downside risk sensitivity analysis, if we assume regulators require banks to take 1.5% provision of total credits with the

WMP in 3Q12, or put 8.5%/7.5% core tier I CAR on these credits for big/smaller banks, this would suggest only a manageable

negative impact on banks’ profits and CAR (Exhibit 41):

If we assume 8.5%/7.5% core Tier I CAR on these credits for big/smaller banks, this may impact banks’ 2013E Tier I CAR by

modestly 34bp on average, which we believe is manageable given the high core Tier I CAR of listed banks and CBRC’s recent

permission to allow banks innovate other Tier I capital instruments to strengthen capital.

Requiring banks to take a 1.5% provision ratio or 1.5% risk reserve for off-balance sheet WMPs would reduce pretax profit in

2013E by an average 2.8%. However, as our 2013E credit cost estimates for banks already build in their over-provision against

reported NPLs, we believe banks could easily put this magnitude of credit costs within our estimates. Thus, the real earnings

impacts could be minimal.

Minsheng, Industrial, Huaxia, and CEB would be impacted the most on Tier I CAR under these downside scenarios



Exhibit 41: We estimate WMP’s potential under-reported CAR by c. 32bp Banks’ WMP credit exposure, and the impacts on CAR and profits


Target prices now incorporate potential under-reported credits in WMP and informal credit securitization

We adjust our target prices to incorporate the potential under-reported credit exposure within banks’ non-principal guaranteed

wealth management products and/or informal loan securitization:

When making our adjusted book calculation, we assume the same NPL ratios for the underlying credits with the banks’ WMP

as those for the on-balance-sheet loans.

We believe it is likely for banks to have an implicit guarantee and liquidity support on these credits given: 1) the current way of

structuring the underlying assets for WMPs as an asset pool rather than individual product matched by individual asset; 2) the

poor disclosure to customers on the underlying assets; and 3) the potential political pressure to reimburse credit losses of retail

customers to maintain social stability.

RMB mn

As end of

3Q12

Total WMP

balance On/B WMP Off/B WMP

Credit/trust

assets as %

of off/B WMP

Credit/trust

assets in

WMP pool

Credit/trust

assets as %

of RWA

Current WMPs

provision

coverage

Estimated increase

of provision ratio

needed

Excess

coverage

needed

Case 1:

Impact on 2013E

Pretax profit

Case 2:

Impact on 2012E

Core CAR(bp)

13E tier I

CAR

ICBC 998,300 139,762 858,538 47% 403,513 4.2% 0% 1.5% 6,053 -2.0% -35 10.1%

CCB 800,000 400,000 400,000 20% 80,000 1.1% 0.1% 1.4% 1,080 -0.4% -9 11.4%

ABC 500,000 100,000 400,000 25% 100,000 1.4% 0% 1.5% 1,500 -0.7% -12 9.9%

BOC Group 730,000 440,000 290,000 20% 58,000 0.8% 0.2% 1.3% 638 -0.3% -6 10.0%

BoCom 422,300 183,900 238,400 55% 130,975 4.3% 0% 1.5% 1,965 -2.7% -37 11.1%

CMB 382,000 64,940 317,060 24% 76,400 3.7% 0% 1.5% 1,146 -2.1% -28 8.5%

CNCB 200,000 20,000 180,000 50% 90,000 4.6% 0% 1.5% 1,350 -3.0% -35 9.6%

SPDB 214,800 107,400 107,400 50% 53,700 2.9% 0% 1.5% 806 -2.0% -22 8.5%

Minsheng 280,000 - 280,000 45% 126,000 6.7% 0% 1.5% 1,890 -4.1% -50 8.6%

Industrial 424,200 41,444 382,756 50% 191,378 12.2% 0% 1.5% 2,871 -6.9% -92 9.9%

CEB 261,450 72,373 189,077 45% 85,085 6.3% 0% 1.5% 1,276 -4.2% -47 8.2%

Hua Xia 151,323 5,908 145,415 45% 65,437 7.9% 0% 1.5% 982 -7.2% -59 8.2%

PAB 141,900 73,900 68,000 50% 34,000 3.7% 0% 1.5% 510 -3.1% -28 7.8%

BOBJ 98,250 69,900 28,350 50% 14,175 2.5% 0% 1.5% 213 -1.6% -19 11.0%

BONB 30,000 1,500 28,500 25% 7,125 3.8% 0% 1.5% 107 -2.4% -28 11.1%

BONJ 18,879 750 18,129 45% 8,158 4.0% 0% 1.5% 122 -2.6% -30 9.6%

CQRCB 17,300 8,650 8,650 20% 1,730 0.7% 0% 1.5% 26 -0.4% -5 11.0%

Average 39.0% 4.1% -2.7% -32Total 5,670,702 1,730,427 3,940,275 26.9% 1,525,675

Note: Case 1 assume 1.5% general provision ratio in 13E or 1.5% capital requirement as of RWA charged for off-balance sheet WMPs

Case 2 assume 8.5%/7.5% capital requirement as of RWA charged for off-balance sheet WMPs of big banks/other listed banks

Credit/trust assets of CNCB/Industrial include interbank repos with trust beneficiaries



That said, in the mid-term if banks strictly follow CBRC’s risk management guidelines on WMP to match each WMP with each

underlying asset, and increase efforts to disclose the underlying assets to retail customers, and if China regulators allow retail

investors to take credit losses from such products, we could remove WMP credits from adjusted book estimates.

We have streamlined our long-term ROE estimates to incorporate WMP credits and informal credit securitization by:

1) Assuming 10%/9.5% core tier I CAR for big/smaller banks in the long-term, vs. CBRC Basel III CAR minimum requirement of

8.5%/7.5% by 2019.

We believe the high targeted long-term core tier I CAR and low long-term leverage should incorporate the potential under-

reported risk weighted assets from WMP, and/or informal credit securitization through interbank channels.

Note that vs. our previously assumed long-term leverage that was based on the consultant Basel III CAR rule issued by CBRC in

2010, we have-fine tuned our estimates by using the newly announced CBRC final Basel III CAR rule. This leads to the increase

of long-term leverage assumptions for some smaller banks such as Minsheng, Industrial, CMB and BoCom, as they benefit from

the final CAR rules in terms of lower risk weighting for small business loans.

2) Assuming average 112bp long-term credit costs vs. 53bp credit costs in 13E to capture high long-term NPL risks and potential

under-reported credit exposure with shadow banking activities.

Exhibit 42 shows the detailed GS CAMELOT 3-stage DDM valuation assumptions for China banks.

Exhibit 43 shows our long-term ROE/leverage/ROA estimates vs. 13E current ROE/leverage/ROA for listed banks.



Exhibit 42: Our detailed GS CAMELOT 3-stage DDM valuation model assumptions for China banks


3-Stage Dividend Discount Bond Mid-pointModel Assumptions Equivalent P/B

CAMELOT- TotalAdj. Disc. Terminal Stage 3 Growth Implied Sust. ROE

CAMELOT Risk Rate Div. No. of (a) (b) Div Growth No. of Div. Growth Fully loaded target Div. by

Quotient Prem. (d) CAGR Yrs ROE Payout =a*(1-b) Yrs ROE Payout =a*(1-b) P/B P/E Disc. RateICBC (H) 1.00x 6.5% 11.0% 10.0% 3 16.0% 58% 6.7% 10 14.8% 73% 4.0% 1.73 11.7 1.35 1.54 BOC (H) 1.06x 6.9% 11.4% 8.4% 3 13.0% 50% 6.5% 10 11.6% 66% 4.0% 1.10 9.5 1.02 1.06 CCB (H) 1.02x 6.6% 11.1% 10.4% 3 16.0% 58% 6.7% 10 14.6% 73% 4.0% 1.69 11.6 1.31 1.50 ABC (H) 1.05x 6.8% 11.3% 13.8% 3 15.0% 56% 6.6% 10 14.0% 71% 4.0% 1.61 11.5 1.24 1.43 BoCom (H) 1.10x 7.1% 11.6% 9.4% 3 13.0% 50% 6.5% 10 10.6% 62% 4.0% 0.97 9.2 0.91 0.94 CMB (H) 0.99x 6.4% 10.9% 7.9% 3 16.0% 50% 8.0% 10 15.7% 75% 4.0% 1.85 11.8 1.44 1.64 CNCB (H) 1.14x 7.4% 11.9% 7.0% 3 13.0% 40% 7.8% 10 12.3% 68% 4.0% 1.06 8.6 1.04 1.05 Minsheng (H) 1.10x 7.2% 11.7% 13.1% 3 16.0% 45% 8.8% 10 15.8% 75% 4.0% 1.82 11.5 1.35 1.59 CQRCB 1.24x 8.0% 12.5% 6.9% 3 14.3% 38% 8.9% 10 13.2% 70% 4.0% 1.08 8.2 1.05 1.07 ICBC (A) 1.00x 6.5% 11.0% 10.0% 3 16.0% 58% 6.7% 10 14.8% 73% 4.0% 1.73 11.7 1.35 1.54 BOC (A) 1.06x 6.9% 11.4% 8.4% 3 13.0% 50% 6.5% 10 11.6% 66% 4.0% 1.10 9.5 1.02 1.06 CCB(A) 1.02x 6.6% 11.1% 10.4% 3 16.0% 58% 6.7% 10 14.6% 73% 4.0% 1.69 11.6 1.31 1.50 ABC (A) 1.05x 6.8% 11.3% 13.8% 3 15.0% 56% 6.6% 10 14.0% 71% 4.0% 1.61 11.5 1.24 1.43 BoCom (A) 1.10x 7.1% 11.6% 9.4% 3 13.0% 50% 6.5% 10 10.6% 62% 4.0% 0.97 9.2 0.91 0.94 CMB (A) 0.99x 6.4% 10.9% 7.9% 3 16.0% 50% 8.0% 10 15.7% 75% 4.0% 1.85 11.8 1.44 1.64 CNCB (A) 1.14x 7.4% 11.9% 7.0% 3 13.0% 40% 7.8% 10 12.3% 68% 4.0% 1.06 8.6 1.04 1.05 Minsheng (A) 1.10x 7.2% 11.7% 13.1% 3 16.0% 48% 8.3% 10 15.8% 75% 4.0% 1.81 11.4 1.35 1.58 SPDB 1.12x 7.3% 11.8% 13.5% 3 15.9% 49% 8.1% 10 12.0% 67% 4.0% 1.27 10.6 1.02 1.15 Industrial 1.05x 6.8% 11.3% 16.8% 3 18.0% 47% 9.5% 10 15.9% 75% 4.0% 2.13 13.4 1.40 1.77 PAB 1.12x 7.3% 11.8% 9.3% 3 14.0% 46% 7.6% 10 13.7% 71% 4.0% 1.29 9.4 1.17 1.23 HuaXia 1.19x 7.8% 12.3% 6.0% 3 13.4% 40% 8.0% 10 9.7% 59% 4.0% 0.73 7.5 0.79 0.76 BONB 1.08x 7.0% 11.5% 14.8% 3 16.0% 45% 8.8% 10 15.7% 75% 4.0% 1.85 11.7 1.37 1.61 BOBJ 1.17x 7.6% 12.1% 11.2% 3 16.0% 50% 8.0% 10 12.4% 68% 4.0% 1.22 9.8 1.03 1.12 BONJ 1.20x 7.8% 12.3% 7.2% 3 16.0% 50% 8.0% 10 11.4% 65% 4.0% 1.00 8.8 0.93 0.96 CEB 1.10x 8.0% 12.5% 9.1% 3 16.5% 49% 8.4% 10 11.0% 64% 4.0% 0.97 8.8 0.88 0.93

Stage 1 Stage 2



Exhibit 43: Our long-term ROE, leverage ratios and credit costs factor in potential under-reported credits through WMP and informal loan securitization, as well

as long-term NIM/NPL risks Sustainable ROE estimates for China banks vs. 2013E ROE estimates, and vs. our previous long-term ROE estimates


ICBC CCB BOC ABC BoCom CMB CNCB Minsheng CQRCB SPDB Industrial CEB Hua Xia PAB BOBJ BONJ BONB AverageSustainable ROE 14.8% 14.6% 11.6% 14.0% 10.6% 15.7% 12.3% 15.8% 13.2% 12.0% 15.9% 11.0% 9.7% 12.4% 12.4% 11.4% 15.7% 13.1% Leverage (asset/equity long-term) 13.7 14.8 13.2 15.3 14.5 13.9 15.6 16.3 14.2 14.2 16.8 14.2 16.9 14.5 17.0 14.0 17.2 15.1

% change vs 2013E forecased leverage -12% 5% 0% -13% 0% -16% -5% -15% 2% -20% -9% -29% -21% -17% 1% -4% 8% -9% ROA 1.08% 0.99% 0.88% 0.92% 0.73% 1.13% 0.79% 0.97% 0.93% 0.85% 0.95% 0.78% 0.57% 0.85% 0.73% 0.82% 0.91% 0.88%

NII / Total assets 2.25% 2.30% 2.00% 2.40% 2.15% 2.50% 2.30% 2.45% 2.95% 2.25% 2.30% 2.20% 2.25% 2.35% 2.10% 2.25% 2.60% 2.33%

Credit costs (bps) 95 100 98 110 110 75 120 120 120 120 120 120 125 120 115 130 100 112

FY13E ROE 20.7% 19.4% 16.6% 21.0% 15.0% 21.5% 17.4% 23.4% 16.9% 19.8% 21.4% 20.9% 16.2% 14.3% 17.8% 15.8% 18.9% 18.7%Leverage(asset/equity) 15.5 14.0 13.2 17.6 14.6 16.6 16.4 19.1 13.9 17.7 18.4 19.9 21.3 17.5 16.9 14.7 16.0 16.7

ROA 1.33% 1.39% 1.04% 1.19% 1.03% 1.29% 1.06% 1.23% 1.22% 1.10% 1.17% 1.05% 0.71% 0.82% 1.05% 1.08% 1.25% 1.12%

NII / Total assets 2.38% 2.55% 2.05% 2.57% 2.23% 2.67% 2.44% 2.53% 3.02% 2.37% 2.43% 2.38% 2.35% 2.27% 2.25% 2.34% 2.95% 2.46%

Credit costs (bps) 47 52 37 57 56 46 70 60 30 60 84 64 62 60 64 75 75 59

Sustainable vs. FY13EROE -5.9% -4.9% -4.9% -7.0% -4.4% -5.8% -5.1% -7.6% -3.7% -7.8% -5.6% -9.8% -6.5% -1.9% -5.3% -4.3% -3.1% -5.5%Leverage(asset/equity) (1.9) 0.7 - (2.4) (0.1) (2.7) (0.8) (2.8) 0.3 (3.5) (1.6) (5.8) (4.4) (2.9) 0.1 (0.7) 1.3 (1.6)

ROA -0.25% -0.40% -0.16% -0.28% -0.30% -0.17% -0.27% -0.26% -0.29% -0.25% -0.22% -0.27% -0.13% 0.03% -0.32% -0.26% -0.34% -0.24%

NII / Total assets -0.13% -0.25% -0.05% -0.17% -0.08% -0.17% -0.14% -0.08% -0.07% -0.12% -0.13% -0.18% -0.10% 0.08% -0.15% -0.09% -0.35% -0.13%

Credit costs (bps) 48 48 61 53 54 29 50 60 90 60 36 56 63 60 51 55 25 53

Previous ICBC CCB BOC ABC BoCom CMB CNCB Minsheng CQRCB SPDB Industrial CEB Hua Xia PAB BOBJ BONJ BONB Average

Sustainable ROE 14.7% 14.7% 10.7% 14.0% 10.5% 15.0% 10.4% 12.8% 11.7% 10.0% 14.5% 12.0% 9.6% 11.1% 10.7% 10.7% 12.8% 12.1% Leverage (asset/equity long-term) 14.4 14.1 13.4 15.8 13.6 13.1 15.6 14.9 16.2 15.3 15.2 17.0 17.0 16.8 17.7 15.6 17.8 15.5 ROA 1.02% 1.04% 0.80% 0.89% 0.77% 1.14% 0.67% 0.96% 0.69% 0.65% 0.95% 0.68% 0.56% 0.66% 0.60% 0.69% 0.72% 0.79% NII / Total assets 2.20% 2.20% 1.90% 2.30% 2.10% 2.40% 2.30% 2.75% 2.75% 2.15% 2.15% 2.05% 2.20% 2.25% 2.00% 2.25% 2.25% 2.25%

Credit costs (bps) 95 95 98 110 120 68 120 110 170 110 100 120 125 105 110 130 100 111

ChangesICBC CCB BOC ABC BoCom CMB CNCB Minsheng CQRCB SPDB Industrial CEB Hua Xia PAB BOBJ BONJ BONB Average

Sustainable ROE 0.1% -0.1% 0.9% 0.0% 0.1% 0.7% 1.9% 3.0% 1.5% 2.0% 1.4% -1.0% 0.1% 1.3% 1.7% 0.7% 2.9% 1.0% Leverage (asset/equity long-term) (0.68) 0.66 (0.27) (0.53) 0.95 0.81 (0.00) 1.41 (1.96) (1.11) 1.58 (2.83) (0.08) (2.25) (0.70) (1.60) (0.56) (0.4) ROA 0.1% -0.1% 0.1% 0.0% 0.0% 0.0% 0.1% 0.0% 0.2% 0.2% 0.0% 0.1% 0.0% 0.2% 0.1% 0.1% 0.2% 0%



Appendix

Exhibit 44: Detailed corporate, consumer, and government borrowing in China

Source: PBOC, CBRC, Gao Hua Securities Research estimates.

Base Low High

Rmb bn 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2013E 2013E

Corporate loan balance (including LGP loans) 10,781 12,060 13,969 16,895 18,974 20,804 24,645 30,026 36,048 47,486 61,587 73,450 87,709 103,878 97,935 107,336

As % of GDP 109% 110% 116% 124% 119% 112% 114% 113% 115% 139% 153% 155% 169% 177% 167% 183%

Yoy growth rate 7% 12% 16% 21% 12% 10% 18% 22% 20% 32% 30% 19% 19% 18% 12% 22% Excluding LGP loans 10,781 11,260 12,901 15,486 17,136 18,431 21,613 26,197 31,319 39,830 52,487 64,450 78,509 93,942 88,568 97,069

As % of GDP 109% 103% 107% 114% 107% 100% 100% 99% 100% 117% 131% 136% 151% 160% 151% 165% Yoy growth rate 4% 15% 20% 11% 8% 17% 21% 20% 27% 32% 23% 22% 20% 13% 24% Interest bearing loans(excluding acceptance) 10,781 12,060 13,969 16,765 18,869 20,697 24,391 29,102 35,030 46,002 57,772 68,605 81,814 96,783 91,451 100,026

As % of GDP 109% 110% 116% 123% 118% 112% 113% 109% 112% 135% 144% 145% 158% 165% 149% 163% Yoy growth rate 12% 16% 20% 13% 10% 18% 19% 20% 31% 26% 19% 19% 18% 12% 22%

Banks' loans and off-balance acceptance 10,020 11,200 12,913 15,533 16,974 18,597 21,676 26,148 30,055 39,601 48,614 56,045 64,148 73,308 71,326 74,931

As % of total corporate and consumer financing 89% 88% 86% 84% 81% 81% 80% 79% 76% 75% 70% 68% 65% 62% 73% 70% As % of total corporate financing 93% 93% 92% 92% 89% 89% 88% 87% 83% 83% 79% 76% 73% 71% 73% 70% As % of total GDP 101% 102% 107% 114% 106% 101% 100% 98% 96% 116% 121% 118% 124% 125% 122% 128% Yoy growth rate 7% 12% 15% 20% 9% 10% 17% 21% 15% 32% 23% 15% 14% 14% 11% 17% Domestic bank loans 10,020 11,200 12,913 15,403 16,868 18,489 21,422 24,500 28,281 37,231 43,412 49,311 55,892 63,568 62,599 64,835

As % of total financing 93% 93% 92% 91% 89% 89% 87% 82% 78% 78% 70% 67% 64% 61% 64% 60% Yoy growth rate 7% 12% 15% 19% 10% 10% 16% 14% 15% 32% 17% 14% 13% 14% 12% 16% Loans from HK banks - - - - - - - 725 757 885 1,387 1,889 2,361 2,645 2,243 2,786

As % of total financing 2% 2% 2% 2% 3% 3% 3% 2% 3% Yoy growth rate 4% 17% 57% 36% 25% 12% -5% 18% Bank acceptance - - - 130 105 107 254 924 1,017 1,484 3,815 4,845 5,895 7,095 6,484 7,310

As % of total financing 1% 1% 1% 3% 3% 3% 6% 7% 7% 7% 7% 7% Yoy growth rate -19% 2% 137% 264% 10% 46% 157% 27% 22% 20% 10% 24%

Shadow banking credits 761 860 1,055 1,362 2,001 2,208 2,969 3,878 5,992 7,885 12,973 17,405 23,560 30,571 26,609 32,406

As % of total corporate and consumer financing 7% 7% 7% 7% 10% 10% 11% 12% 15% 15% 19% 21% 24% 26% 27% 30% As % of total corporate financing 7% 7% 8% 8% 11% 11% 12% 13% 17% 17% 21% 24% 27% 29% 27% 30% As % of total GDP 8% 8% 9% 10% 13% 12% 14% 15% 19% 23% 32% 37% 45% 52% 45% 55% Yoy growth rate 7% 13% 23% 29% 47% 10% 34% 31% 55% 32% 65% 34% 35% 30% 13% 38% Informal loans + small corporate loans/pawn 732 827 964 1,163 1,485 1,431 1,673 1,951 2,885 2,576 3,961 4,679 4,561 5,198 4,789 5,473

As % of total corporate financing 7% 7% 7% 7% 8% 7% 7% 6% 8.0% 5.4% 6.4% 6.4% 5.2% 5.0% 4.9% 5.1% As % of total GDP 7% 8% 8% 9% 9% 8% 8% 7% 9.2% 7.6% 9.9% 9.9% 8.8% 8.9% 8.2% 9.3% Yoy growth rate 7% 13% 17% 21% 28% -4% 17% 17% 48% -11% 54% 18% -3% 14% 5% 20% Trust loans - - - - - - 81 253 521 960 2,444 3,592 5,424 6,812 5,858 7,051

As % of total corporate financing 1% 1% 2% 4% 5% 6% 7% 6% 7% Yoy growth rate 212% 106% 84% 155% 47% 51% 26% 8% 30% Entrust loans (un-adjusted for intragroup loans) - - 19 80 351 419 601 939 1,300 1,979 3,109 4,409 5,689 7,089 6,542 7,395

As % of total corporate financing 2% 2% 2% 3% 4% 4% 5% 6% 6% 7% 7% 7% Yoy growth rate 332% 338% 19% 43% 56% 39% 52% 57% 42% 29% 25% 15% 30% Corporate bonds 29 34 73 118 165 358 613 735 1,286 2,371 3,459 4,725 6,887 9,472 7,920 9,986

As % of total corporate financing 1% 1% 1% 2% 2% 2% 4% 5% 6% 6% 8% 9% 8% 9% Yoy growth rate 25% 16% 117% 62% 40% 116% 72% 20% 75% 84% 46% 37% 46% 38% 15% 45% Credits securitized in brokers' AM business 1,000 2,000 1,500 2,500

As % of total corporate financing 1.1% 1.9% 2% 2% Yoy growth rate 100% 50% 150%

Consumer credits 424 699 1,067 1,574 1,988 2,194 2,406 3,275 3,723 5,331 7,511 8,878 11,398 13,484 12,766 15,911

As % of GDP 4% 6% 9% 12% 12% 12% 11% 12% 12% 16% 19% 19% 22% 23% 21% 29% Yoy growth rate 65% 53% 48% 26% 10% 10% 36% 14% 43% 41% 18% 28% 18% 12% 18%

Central government debts 2,216 2,397 2,933 3,403 4,107 5,841 6,113 7,878 8,830 9,806 10,908 11,616 12,549 13,585 13,302 14,432

As % of GDP 22% 22% 24% 25% 26% 32% 28% 30% 28% 29% 27% 25% 24% 23% 22% 23% Yoy growth rate 8% 22% 16% 21% 42% 5% 29% 12% 11% 11% 6% 8% 8% 6% 15% Government Bonds 916 1,097 1,633 2,103 2,418 3,452 3,724 5,489 5,693 6,669 7,771 8,479 9,412 10,448 10,165 11,295

As % of GDP 9% 10% 14% 15% 15% 19% 17% 21% 18% 20% 19% 18% 18% 18% 17% 18% Yoy growth rate 20% 49% 29% 15% 43% 8% 47% 4% 17% 17% 9% 11% 11% 8% 20% NPL carved out during banks restructure 1,300 1,300 1,300 1,300 1,689 2,389 2,389 2,389 3,137 3,137 3,137 3,137 3,137 3,137 3,137 3,137

As % of GDP 13% 12% 11% 10% 11% 13% 11% 9% 10% 9% 8% 7% 6% 5% 5% 5% Yoy growth rate 30% 41% 0% 0% 31% 0% 0% 0% 0% 0% 0% 0% Memo: LGP loans +LGP bonds 6 806 1,079 1,436 1,871 2,461 3,152 4,008 4,981 8,275 10,036 10,340 11,686 12,936 11,686 13,789

As % of GDP 0% 7% 9% 11% 12% 13% 15% 15% 16% 24% 25% 22% 23% 22% 19% 22% Yoy growth rate 24% 66% 21% 3% 13% 11% 0% 18% GB+ LGP loans+LGP bonds 2,222 3,203 4,012 4,839 5,978 8,302 9,265 11,886 13,810 18,081 20,944 21,956 24,235 26,521 24,988 28,221

As % of GDP 22% 29% 33% 36% 37% 45% 43% 45% 44% 53% 52% 46% 47% 45% 41% 46% Yoy growth rate 227% 44% 25% 21% 24% 39% 12% 28% 16% 31% 16% 5% 10% 9% 3% 16%

Total financings to corporate, consumer, govt.) 13,420 15,157 17,968 21,872 25,069 28,840 33,163 41,179 48,601 62,623 80,006 93,945 111,656 130,947 124,003 137,679

As % of GDP 135% 138% 149% 161% 157% 156% 153% 155% 155% 184% 199% 199% 215% 223% 204% 226%

Yoy growth rate 13% 19% 22% 15% 15% 15% 24% 18% 29% 28% 17% 19% 17% 11% 23% As % of GDP(entrusted loans adjusted for

intragroup loans) 135% 138% 149% 161% 156% 155% 152% 153% 153% 181% 195% 194% 210% 217%

Corporate credits (incl. LGP loans) as % of

GDP((entrusted loans adjusted ) 109% 110% 116% 124% 118% 111% 113% 111% 113% 136% 150% 151% 163% 171%



Disclosure Appendix

Reg AC

We, Ning Ma and Bowei Cheng, hereby certify that all of the views expressed in this report accurately reflect our personal views about the subject company or companies and its or their securities. We

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Ning Ma: China Brokers, China Financials. Bowei Cheng: China Brokers, China Financials.

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