In this episode of China Money Podcast, guest Michael Werner discusses Chinese banking stocks, their exposure to local governments and the property sector, and whether Chinese banks will see their non-performing loan ratios skyrocket.

Q: First, let’s look at Chinese banking stocks. In terms of valuation, are they attractive?

A: I still think the banks are attractive. We’ve seen a very strong increase in terms of the share prices over the past three to four months. But I still think you will get incremental news that will help the valuations of the banks.

As China’s Central Bank eases monetary policy that will help with valuations, thought it might not be the best for earnings. I still think for the next two to three months, we still have some upside for the banks.

Q: Now let’s turn to the fundamentals of the banks. Many people are concerned about the banks’ exposure to the property sector and local governments. How big a risk are these?

A: Yes, these are certainly risks to the banks. But I think the market has overstated the risks. We really saw that toward the end of last year. The market was pricing in for some of these loans to go to zero in terms of valuation, which in our view is simply not going to happen.

The listed banks that we cover, they had around 11 to 12 percent of their loan book exposed to local government loans. On the property side, you have around 15 percent going into residential mortgages and maybe another 10 to 12 percent going into commercial real estate. In our view, the residential mortgages are very safe with very low loan-to-values. There is a very good track record of people paying off these loans.

On the local government financing vehicle side, certainly there will be some problems. But I think the bulk of the loans are going to end up healthy. But there will be a good five to ten percent of the loans that will have trouble repaying. That’s a couple of years out, and the banks will have enough time to earn up enough reserves to provision against that.

On the commercial real estate side, the banks have actually reduced their exposure. They do have exposures, but they tend to have exposure to the largest, the best and the most liquid of the property developers. So I don’t think that will be a problem.

The largest concern that we have are the LGFV loans.

Q: So, where do you think the non-performing loan ratio will peak?

A: Our best guess right now is around 2.5 percent. Right now, the NPL ratio for the whole banking system is around one percent. Getting into 2 or 2.5 percent in the next couple of years is actually in line with what we have seen in other countries that experience slowdowns.

We think the Chinese economy will slow down to 7 to 8 percent at the end of this year to early 2013.

Q: So are you saying there are not as much trouble as people fear?

A: That’s absolutely correct. What we have seen in China is relatively good underwriting standards. I think that Chinese banks are going to surprise people on how well they are provisioned and what the ultimate NPL ratio will be.

Some people have been forecasting 8 to 12 percent (NPL ratio). That does not seem likely in our viewpoint. The government will definitely help put in place policies that will mitigate these risks. Just like during the past few years, the banks have been earning a lot of money, and the government has put in place very restrictive policies in terms of capital and provisioning.

Now on the other end, when economic growth is slower, the regulators will relax some of those restrictive measures. That counter-cyclicality (in policies) is actually positive for the banks.

Our Guest Today:
Michael Werner is senior research analyst covering the Chinese and Hong Kong banks at Sanford Bernstein & Co. He has been with Bernstein for 12 years, previously covering U.S. banks, brokerages and European banks. Werner graduated from Brown University in 2000 with a BA in Economics and a BA in Mathematics.

Visit ChinaMoneyPodcast.com for more great audio and video episodes covering important investment news and financial events in China. Follow us on Twitter @chinamoneypod subscribe to all episodes on iTunes.