60756520 JP Morgan China Banks

www.morganmarkets.com

Asia Pacific Equity Research15 July 2011

China banksA revisit to local government debt and the sector's resilience against asset quality risks

Banks

Samuel Chen AC

(852) 2800-8557

[email protected]

J.P. Morgan Securities (Asia Pacific) Limited

Cindy Xu

(852) 2800-8502

[email protected]

J.P. Morgan Securities (Asia Pacific) Limited

See page 29 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan 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.

We disagree with Moody’s on its recent Chinese banks report: We believe that Moody’s guesstimate on the size of local government debt is based on a misinterpretation of PBOC and CBRC data. We also disagree with Moody’s assumptions on potential delinquencies. We believe the root of the sector’slegacy NPLs is misunderstood by many investors.

Outstanding debt is within current affordability: The recent NAO report provides much detail on the history and current status of the local government debt. Based on debt-to-GDP or debt-to-current fiscal strength ratios, debt affordability is still not stretched in general we think. We believe it is, by far,not even necessary to consider bailouts, especially given that pre-emptive measures have already been adopted by regulators in the past 18 months.

LG debt issue can be solved through China’s growth in coming years: Webelieve this issue is unlikely to pose a systemic risk given that: 1) politically and fiscally, the central government will prevent such a crisis. We think the problemis not poor fiscal revenues, but the current fiscal system that needs reform. 2) No trigger for uncontrollable liquidity crunch, thanks to largely closed capital accounts and huge liquidity inflow locked in China. 3) Strong fiscal revenue growth expected in coming years to boost debt affordability. Budget revenue (ex. land sales) may still increase by 20% CAGR in the next five years. 3) Over 70% of such debt is used in transportation, infrastructure and energy sectors, and forms a good asset base that can be sold if necessary. The Chinese government also owns other saleable assets (land, SOE stakes).

Valuations factor in a prolonged economic downturn: We believe structural change in the nature of the economy, and substantial improvement in the balance sheet, recurring profitability, and credit environment/infrastructure in place after ongoing reforms will prevent bad history from repeating. Stress tests also show the sector can withstand a very severe economic downturn without any capital loss. We believe the current valuation of listed banks have factored in a multi-year recession, in which huge NPLs lead to persistent profit declines.

Range-bound in the near term: Investor sentiment may remain weak in the volatile global financial markets though, where the concern is indeed more on Europe and its impact on the global economy. We also think there are also a limited number of catalysts in the very short term. However, we still expect 20-30% upside in 6-12 months, with strong downside support.

Table 1: Stress tests of asset quality's impact to earnings: NPLs and financial metrics in various 2012 earnings scenarios (sector avg.)

Source: J.P. Morgan estimates, Bloomberg. Valuations are based on market closing prices as of 13 July 2011. Data is based on listed banks avg.

Rmb bn

Earning

growth

Gross

new NPLs

new NPL as %

of 11E loans

NPL

ratio

% inc.

in NPL

Credit

costs ROE

Core tier-

1 ratio CAR PE (x) PB (x)

Implication of the new NPL formation rate (as % of 11E

balance in various sectors to be new NPLs)

Base case 22% 215 0.6% 1.0% 10% 0.54% 22.2% 9.7% 12.6% 6.1 1.2

1% manufacturing loans plus 1.5-2% property loans and LGFV

loans plus about 0.5% other corp. loans to default in 2012

Scenario 1 0% 558 2.0% 2.3% 147% 1.25% 17.2% 9.4% 12.4% 6.1 1.2

5% manufacturing loans, plus 5% property loans, plus 5% LGFV

loans plus about 3% other corp. loans to default in 2012

Scenario 2 -20% 1,037 3.3% 3.4% 274% 1.87% 14.0% 9.2% 12.2% 7.2 1.3

8% manufacturing loans, 8% property loans and LGFV loans plus

about 3.5% other corp. loans to default in 2012

Scenario 3 -30% 1,277 4.0% 4.0% 338% 2.17% 12.3% 9.1% 12.1% 8.3 1.3

10% manufacturing loans plus 10% property loans and 12% LGFV

loans plus about 3-3.5% other corp. loans to default in 2012

Scenario 4 -50% 1,757 5.3% 5.1% 465% 2.56% 8.9% 8.9% 11.8% 11.6 1.3


loans plus about 4.5% other corp. loans to default in 2012

Scenario 5 -100% 2,956 8.5% 8.0% 782% 3.40% 0.0% 8.3% 11.3% NM 1.4


loans plus about 8-10% other corp. loans to default in 2012

Figure 1: Vintage local government debt/contingent debt, Rmb bn

Source: NAO.

Debt borrowed before end of 2008, 3,199 ,

29.8%

Debt borrowed after 2008 but

used for projects already started in 2008 & before, 2,283 , 21.3%

New debt raised since 2009 for new projects , 5,236 ,

48.9%

渐飞研究报告 - http://bg.panlv.net

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Samuel Chen(852) [email protected]

We strongly disagree with Moody's view on local government debt

The sentiment toward Chinese banks is at an all-time low since the Global Financial Crisis in 4Q2008. The major reason is intensified concern on the Chinese economy and asset quality outlook, as a recent Moody’s report warns of potential negative outlook on the sector, citing its belief that the local government-related loans were under-estimated by the National Audit Office. Nervousness was further fueled as Temasek recently sold some US$3.6 billion worth of shares in CCB-H and BOC-H, while BoA also plans to reduce its stake in CCB-H upon expiry of the lockup in late August.

We agree that the sector can hardly deliver any meaningful share price performance in the short term, given little positive catalysts to boost the sentiment in the sector and lower risk appetite among global equity investor in view of the adverse developments in European government debt. A range-bound trading pattern is more likely in the short term. However, in this report:

We argue why we disagree with Moody’s on its cautious outlook on Chinese banks and why we are not as concerned about the local government debt, despitea likely modest pickup in some LGFV delinquencies due to the short-term tighter credit supply. Instead, we believe the NAO's recent thorough report on local government debt provides many useful data points to help better understand local government debt in China.

We argue that the bad asset quality history is unlikely to repeat, and that the history of legacy NPLs in 1990s is also misunderstood by many investors. In fact, the key source of legacy NPLs in China is not local government debt, but low-efficiency SOEs in manufacturing and wholesale/retail sectors in the planned economy era.

We provide detailed stress tests on LGFV loans and the overall earnings/balance sheet resilience against asset-quality stress. Through those stress tests, we illustrate that the earnings outlook is quite unlikely to be as gloomy as many investors are worried.

We conduct a valuation exercise based on the stress tests to also show that the current valuation has factored in a multi-year economic downturn, in which huge NPL formation will lead to persistent profit declines for 2-3 years, so that ROEswill shrink to high single-digit and around low-teen percentage, while NPL eventually built to mid-to-high teen percentage. In our view, this is unlikely in th eforeseeable future.

From both a fundamental and valuation perspectives, we remain confident on the sector’s outlook and we still expect 20-30% upside in the next 6-12 months. Possibly triggered by more confidence in earnings post-1H11/3Q11 earnings release, we think a rally is still likely toward late-3Q11/4Q11 as the CPI trends downwards rapidly while economic growth in 2H11 holds still fairly strong.


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Moody's guesstimate on the size of LGFV loans is its own interpretation

We believe that like any market participant, Moody’s has neither enough resources nor enough access to present valid evidence to state that the National Audit Office’s recent report underestimates the local government-related loans by Rmb3.5trn. Like us, it may just have a few individual analysts covering the whole sector and certainly no better access to government finances other than public data. Indeed, as it admitted in its own report, its suspicion arises from seemingly inconsistent figures from the PBOC, CBRC and NAO. It cited CBRC’s Rmb9.1trn and an Rmb14trn it derived from its own interpretation of PBOC’s June 1 report, and took an average of the above two figures to get the size of local government loans at Rmb12trn. In our view, this is the wrong interpretation.

We believe Moody’s misinterpreted PBOC’s statement as well as CBRC data

Like many, Moody’s did not read PBOC’s 2010 Regional Financial Conditions Report in detail, or misinterpreted the original wording. In its annual 2010 China Regional Finance Report, released on 1 June 2011, the PBOC stated that loans to local government-related entities “should not be over 30%.” As the PBOC officially clarified in a most recent press release, what it said in the same paragraph following that summary sentence is that “in various regions, the loans to local government-related entities did not exceed 30% of loans in respective regions.” In other words, 30% is the ceiling of a range between 0 and 30% for various individual local governments. Indeed, as PBOC clarified, some regions have much lower exposure.

Meanwhile, it also did not observe CBRC’s data in detail. While CBRC did mention that as of 2010 its statistics show LGFV loans were Rmb9.1trn, CBRC also said that to better reflect the nature of the loans, it had allowed Rmb2.84trn loans with sufficient cash flows to be reclassified as normal corporate loans; thus, LGFV loans were Rmb6.25bn. The reclassification illustrates the sophistication in the definition, as some entities might be local government–related, but indeed operate fully as commercial entities.

Modest data inconsistency arises from different definitions and scope

The root of data inconsistency is the definition issue, as classification by itself is a very complicated issue. This is simply due to the specific political framework in China. Investors need to realize that given that China is a socialist country, a significant number of operating assets, particularly infrastructure assets (highways, railway, ports, etc.) and other key assets, such as land and most natural resources, are all held by the Chinese government, mainly in the three local levels of local governments. Thus, broadly many entities are local government-controlled, including many commercial SOE entities. It is thus often difficult for investors to distinguish which are the debts local governments may back up and which are pure commercial entities, even though the latter may also be government-owned. For instance, listed entities, such as Anhui Expressway (995 HK), may indeed be initially regarded as LGFVs, but indeed function as pure corporate entities.

Therefore, when some ministries, such as the CBRC and PBOC, started to conduct investigation and studies in 2010, initially the definition of local government funding vehicles became overly broad and included many commercial operating entities with strong cash flows. This is also why later last year, after a thorough classification based on cash flows, CBRC indeed allowed some Rmb2.84trn of loans, which were

PBOC already clarified the

misunderstood statement it had on local government-related

loans in a recent press briefing.

The PBOC report was used by Moody’s as a major challenge to

NAO's figure on the size of LG

debt.


4



originally classified as LGFV loans, back as usual corporate loans. Such reclassification exercise may last throughout 2011.

PBOC data is based on the initial very broad definition, including seven categories of entities. Such data also include loans to education and healthcare, as well as some Rmb2trn of loans belonging to the Ministry of Railways. This is broader than just LGFV loans.

CBRC data focused on LGFV corporate entities. While it also used quite a broad definition, mainly based on ownership, CBRC also said earlier this year that, out of the Rmb9.1trn LGFV loans as of 2010, Rmb2.84trn have been regarded as normal corporate loans, namely no longer regarded as LGFV loans.

NAO data, in our view, is the most-detailed and precise figure given the resources it has dedicated and the access. It focused on all the local government liabilities, including explicit contractual obligations and contingent and implicit liabilities.

We also disagree with Moody’s delinquency assumptions

We also disagree with Moody’s rough delinquency assumptions on various loan categories. Neither are the rational of those assumptions consistent with reality nor even with history during which risk control was much weaker than that in today’s environment. As can be seen in the next section, history also proves that default rateson local government-related loans are much lower than Moody’s assumptions.

First, we believe linking its perception on the quality of loans to the degree of government obligation is contradictory to its own conclusion and not correct. As shown in Table 2, Moody’s thinks the risks are higher on debt with implicit government obligations than on debt guaranteed by the governments. Data shows those debts with implicit government obligations indeed have better quality (lower past due ratios) than those of government contingent liabilities (the opposite ofMoody’s assumptions). We believe that the governments’ contingent liabilities and implicit obligations mean there are other entities as primary borrowers who are a major source of debt repayment, rather than the governments. Presumably those borrowers have at least some cash flow so that it is not the government's contractual obligation.

Meanwhile, we also think those loans that Moody’s perceived as underestimated “government-related loans” at most are just some government-controlled commercial entities that operate like corporates. This may be evident in CBRC’s reclassification. The Rmb2.84trn that has been reclassified as normal corporate loans are all in normal categories with sufficient cash flows. While we agree that such loans are unlikely to end up with zero NPLs, we think it is a fraction of Moody’s assumption of 50-75% eventual delinquency.

Finally, we think its assumption on the rest of the system loans at 5% likely delinquency has no obvious evidence too. Note that, out of other loans, over 30% are now personal loans, most of which are collateralized loans, such as mortgage loans. We agree the current roughly -1% NPL ratio may not be sustainable in the longerterm, yet we are confident that this may be kept at low single-digit percentages.


5



Table 2: Summary of what Moody thinks on various categories

Category

Size (Rmb trn)

% of 10 system Moody' view

Moody' delinquencyassumptions Our position

Loans with explicit governmentobligations 5.0 9.8% High Not material No material NPLsGovernment contingent liabilities 1.9 3.9% Medium 10-30% Overdue ratio 2.23%Loans with Implicit governmentobligations 1.5 2.9%

Low give no explicit contractual obligation 30-50% Overdue ratio 1.28%

Moody's perceived underestimated government loans 3.5 6.9% Poor 50-75%

If any, there could be just commercial entities, mostly in normal categories as seen in CBRC's reclassification

Others loans 39.0 76.4% Fair 5% Currently low at about 1% but low single digit is possible.Overall 50.90 100% 8-12% Currently low at about 1% but low single digit is possible.

Source: Moody’s, J.P. Morgan estimates.

Misunderstood history: LG debt is not a major source of legacy NPLs

Many investors cited the historically large NPLs as a key reference. In our view, they failed to recognize the big change in the nature of the Chinese economy as well as the banking sector, and failed to take a closer look at the history in China.

Indeed, the legacy NPL problem Chinese banks suffered in 1990s was largely not an issue with the local government debts, but the result of a change in the nature of the economy from a planned state economy to more of a market-based open economy. Specifically, it’s more relevant to SOE reforms, which will no longer happen to a large extent, since nowadays SOEs mainly only remain in the key strategic sectors and many surviving SOEs are quite profitable businesses. Until the mid-1990s, there was virtually no private sector in China. In particular, in many manufacturing sectors, the domestic market is very fragmented, and low-efficiency local SOE manufacturing or wholesale/retail businesses dominate the local markets. The SOE reform in the 1990s wiped out a number of those low-efficient firms, leaving banks with huge NPLs.

This can be seen in the historical balance sheet data before the pre-IPO restructuring in many state-controlled banks. In Figure 2, we show the NPL ratios in key relevant sectors and their weights in NPL stocks as of 2002 or 2003. As can be seen, the local government-related loans (or LGFV loans), mostly in transportation, infrastructure and energy/utilities, not only have much lower NPL ratio historically, but also accounted for a small fraction of historical NPLs.


6



Figure 2: NPL ratios in key sectors in 2002/2003 in a few key banks: Even before the pre-IPO financial restructuring at some big banks, key LGFV related sectors are not key area of concerns

Source: Company reports.

Figure 3: Individual sectors' share in total NPLs balance as of 2002/2003: Most historical NPLs are in manufacturing and wholesale/retail sectors


Meanwhile, as we show in Figure 5, by the end of 1998, the total size of local government-related debt or contingent debt was only about Rmb0.5trn, according to NAO, versus the NPL balance estimated to be over Rmb2trn then. This also hints that most legacy NPLs are not local government-related debts.

Another factor to support our argument is the asset quality history of China Development Bank, which was the first bank to provide LGFV loans and is still the largest player in local government project financing, given its policy bank status and business focus. We estimate that over half of CDB’s loan book is local government-related loans, and it accounted for approximately one-third of LGFV loans. In the past 10 years, while the loan balance has increased by nearly six times to over Rmb4.5trn as of 2010 year-end, its asset quality has been maintained at a very good level, with NPL balance little changed and NPL ratio below 2% for 8 years.

Figure 4: CDB has kept asset quality very good, despite 21% CAGR loan growth in the past 10 years


6.4% 6.3%2.7% 4.8%

0.4%4.9%

8.4%4.1%

8.0%1.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

ICBC 2003 CCB 2002 BoComm 2002 BOC 2003 CMB2003

Manufacturing Wholesale/retailProperty development & related Transportation & logisticsPower and water utilities

2.4% 4.0% 0.9% 2.3% 1.6%1.2%6.4%

0.9%6.2% 3.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

ICBC 2003 CCB 2002 BoComm 2002 BOC 2003 CMB2003

Manufacturing Trading Property development Transportation Power and utilities

50

32

23 21 17 14 15 13

28

35 31

7.47%

4.25%

2.54%1.88%

1.18% 0.81% 0.72% 0.59%

0.96% 0.94% 0.68%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

-

10

20

30

40

50

60

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

NPL balance NPL ratio


7



NAO’s reports gave useful details on local government debt

In our view, the NAO’s report on local government debt represents the best effort so far and is the most objective. NAO sent over 41,000 people, who worked over threemonths auditing around 1.87mn debt accounts from 25,590 government bureaus and institutions, 6,576 LGFV corporates, 54,061 other institutions and 373,805 projects, on one-by-one basis. It covers all three major levels of local governments that shoulder most economic responsibility, namely provincial, municipal and county governments. The data covers not only the debt that governments have responsibility of repayment, but also contingent liabilities, such as loans that carry government guarantee or those loans that local governments may help bail out in case of financial difficulty. In our view, NAO’s report provides very useful clarification and background knowledge that should help clear a lot of misunderstandings generally seen among global investors.

History of local government debt

As shown in the NAO’s report, local governments started to borrow debt from 1979, and by 1996, most local governments already had some degree of debt.

Admittedly since late 1990s, local government-related debt has significantly increased to Rmb10.7trn, or close to 27% of GDP as of 2010 year-end, from about 12% as of the end of 2002. This was mainly driven by the acceleration in urbanization in China and significant boost in infrastructure in China, as well as enlarging size of the economy. Growth rates on CAGR basis also has consistently stayed at above 20% in the past decade.

Table 4: By 1996, all provincial governments, and most municipal governments already started to have some debt

Periods Provincial/individually-planned cities Municipal governments County governmentsNo. of

governments started

borrowing

Cumulative no. of

governments with debt

As % of total

No. of governments

started borrowing

Cumulative no. of


As % of total

No. of governments

started borrowing

Cumulative no. of


As % of total

1979—1980 0 0 - 4 4 0.0102 51 51 0.01841981—1985 28 28 77.78% 56 60 15.31% 300 351 12.63%1986—1990 5 33 91.67% 121 181 46.17% 833 1184 42.61%1991—1996 3 36 100% 172 353 90.05% 1221 2405 86.54%

Source: NAO. Note: There are 31 provincial-level governments in Mainland China, and 5 individually-planned cities which enjoy the fiscal independence within their respective provinces and directly

report to the central government in terms of fiscal affairs.

However, we stress that in considering the debt issues, investors should bear in mind that these are not pure government debts that do not generate any cash flows as seen in some other countries. As illustrated in later sections, most of the debts are indeed spent in basic public infrastructure, transportation and energy sectors, which form a sizable good asset base that could be sold if necessary. Such debts accounted for nearly 75% of total debt utilized so far. Indeed, a significant portion of those debts are also cash-flow producing assets at the same time, which is also well-illustrated in CBRC’s LGFV loan breakdown data.

Table 3: Scope of NAO's auditing work on local government debt

Levels Provincial,municipal, county

Debt accounts 1,873,683No. of gov. bureaus & institutions 25,590No. of LGFV corps. 6,576No. of other institutions 54,061No. of projects 373,805

Source: NAO.


8



Figure 5: local government debts have grown significantly over the past decade due to significant boost in infrastructure

Source: NAO, J.P. Morgan estimates.

Figure 6: Growth rates of local government-related debt since late 1990s.

Source: NAO.

Size and breakdown of local governments’ debt/contingent debt

According to NAO, as of 2010 year-end, local government debt (including contingent liabilities) was Rmb10.7trn, of which Rmb8.5trn was bank loans. Out of Rmb10.7 trillions, Rmb1.1trn remains cash and deposits, while Rmb9.6trn has been spent. Table 5 below shows the breakdown of such debt by degree of governments’ obligation and seniority of borrowing governments. As seen in Table 6, local governments’ explicit repayment obligation is about Rmb6.7trn, while about Rmb4trn are contingent and implicit liabilities, some of which might need their support in case of financial difficulties.

Table 5: Breakdown of local government debt & contingent debt by degree of responsibility and seniority of government levels

Degree of responsibility Total Provincial Municipal CountyRmb bn Amount % Amount % Amount % Amount %Responsible for repayment 6,711 100.00% 1,270 18.92% 3,246 48.37% 2,195 32.71%Guaranteed by local governments 2,337 100.00% 1,198 51.25% 767 32.81% 372 15.94%Other debt that might need local government support 1,670 100.00% 744 44.54% 650 38.96% 276 16.50%

Subtotal 10,717 100.00% 3,211 29.96% 4,663 43.51% 2,843 26.53%

Source: NAO.

Table 6 shows the breakdown of such debt by source of funding. In total, as of 2010 year-end, Rmb8.5trn of debt is in the form of bank loans. Within the Rmb8.5trn of local government-related loans, nearly 60%, or Rmb5.02trn, are those loans thatlocal governments have the responsibility for repayment, while loans guaranteed bylocal governments are Rmb1.9trn (22.6%) and other relevant loans that might need government support were Rmb1.5trn, or 18%.

Table 6: Source of funding for local government related debt

Source of debt funding TotalLocal governments

responsible fore repaymentDebt guaranteed by local

governmentsOther debt that might need support in case of difficulty

Rmb bn Amount % Amount % Amount % Amount %Bank loans 8,468 79.0% 5,023 74.8% 1,913 81.9% 1,532 91.8%Fiscal support by supervisory gov’mt 448 4.2% 213 3.2% 235 10.0% - 0.0%Bonds issued 757 7.1% 551 8.2% 107 4.6% 99 5.9%Other social borrowing 1,045 9.8% 924 13.8% 82 3.5% 39 2.3%Total 10,717 100.0% 6,711 100.0% 2,337 100.0% 1,670 100.0%

Source: NAO.

0.3 0.5 1.4 4.5 5.6

9.0 10.7 11.8

4.2%5.8%

11.5%

16.9% 17.7%

26.8% 26.9%25.5%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

-

2.0

4.0

6.0

8.0

10.0

12.0

14.0

1997 1998 2002 2007 2008 2009 2010 2011E

Rm

b tr

n

Local govn't debt as % of GDP

24.8%

48.2%

33.3%26.5% 23.5%

61.9%

18.9%10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

19

97

19

98

19

97-2

002

CA

GR

20

02-2

007

CA

GR

20

08

20

09

20

10

20

11

E


9



As illustrated in Figure 7, about half of the local government debts are in more developed Eastern China, while the Western and Central provinces accounted for 27.3% and 23.1%, respectively, as of 2010 year-end.

Figure 7: Geographical breakdown of local government debt, Rmb bn

Source: NAO.

Figure 8: Breakdown by local government-related loans by degree of government responsibility in repayment, Rmb bn

Source: NAO.

Most of local government-related debts are funding for saleable assets

As we had argued earlier, the majority of debt at the same time also helped buildgood assets that provide cash flow or can be sold if necessary. As Table 5 shows, other than Rmb1.1trn monetary cash assets that have not been used, public infrastructure, transportation, land reserves, and energy-related spending accounted for nearly 75% of such utilized debt. To a large extent, such debt-raising in the past decade is a critical ingredient to the economic success China has achieved over the past 10-15 years.

Table 5: Breakdown by funding usage areas of debt that have already been spent

Areas fund are usedTotal Responsible fore repayment Debt guaranteed by local


Amount % Amount % Amount % Amount %Public infrastructure 3,530 36.72% 2,471 42.03% 492 22.55% 567 36.53%Transportation 2,392 24.89% 872 14.83% 1,077 49.39% 444 28.58%Land reserves 1,021 10.62% 938 15.95% 56 2.55% 27 1.75%Education/science/culture/health & public housing 917 9.54% 437 7.43% 132 6.04% 348 22.39%Agricultural/forestry/Water 458 4.77% 327 5.57% 87 4.01% 44 2.81%Environment protection 273 2.84% 193 3.29% 40 1.85% 40 2.56%Reducing local financial risks 111 1.15% 82 1.40% 28 1.29% 1 0.03%Industrial 128 1.33% 68 1.16% 58 2.66% 2 0.14%Energy 24 0.25% 4 0.08% 19 0.87% 1 0.04%Others 758 7.89% 486 8.26% 192 8.79% 80 5.17%Total spent 9,613 100.00% 5,880 100.00% 2,181 100.00% 1,553 100.00%

Source: NAO.

Table 6: Breakdown of local government related debt by types of borrowers

Borrowers' type TotalLocal governments

responsible fore repaymentDebt guaranteed by local


Amount % Amount % Amount % Amount %LGFV corporates 4,971 46.38% 3,138 46.75% 814 34.85% 1,019 61.04%Gov’mt bureaus & institutions 2,498 23.31% 1,582 23.57% 916 39.19% - 0.00%Fiscally subsidized institutions 1,719 16.04% 1,123 16.74% 155 6.64% 440 26.38%Public sector institutions 250 2.33% 110 1.63% 30 1.30% 110 6.57%Other entities 1,280 11.94% 758 11.31% 421 18.02% 100 6.01%Total 10,717 100.00% 6,711 100.00% 2,337 100.00% 1,670 100.00%

Source: NAO.

Eastern China, 5,321 , 49.6%

Central China, 2,472 , 23.1%

Western China, 2,925 , 27.3%

Local government responsible for

repayment, 5,023 , 59.3%

Local government has guarantee on

debt, 1,913 , 22.6%

Other relevant debt, 1,532 ,

18.1%


10



Meanwhile, about half of the debt is new debt for new projects since 2009 According to NAO, in the outstanding debt, about Rmb5.4trn are debts already borrowed before the end of 2008, or are those borrowed since 2009, but used for projects already started before the end of 2008. As seen in Figure 6, this includesRmb3.2 trillion of debts that were already borrowed before the end of 2008, and Rmb2.28 trillion follow-on funding for projects already started in 2008 or before. Based on such data, we could derive the change in balance. As shown, during the past two years, local governments in total repaid Rmb2.4trn of debts already.

Figure 9: Breakdown of local government-related debt by project vintage, Rmb bn

Source: NAO.

Figure 10: Reconciliation in the change of balance of local government related debt between end of 2008 and 2010

Source: NAO, J.P. Morgan estimates.

Not a systemic risk in the foreseeablefuture

The huge growth in new loans in the past two years mainly is driven by an increase in the leverage of Chinese government. We also argued in the past 18 months that local government-related loans will not pose a significant systemic risk. Our main argument is premised on a few observations:

China’s centralized hierarchical political system means the central government naturally will intervene to prevent any systemic debt crisis, especially given that the size of China’s government debt is still manageable from debt-to-GDP perspective.

Outstanding debt is currently still within affordability. More importantly, the government’s debt affordability is still improving, in view of the expected strong fiscal revenue growth in China in the next few years and that Chinese governments possess large amount of saleable assets.

Lack of any liquidity trigger. Historically and globally most NPLs emerged as a result of liquidity issues. Given that most of such debt is domestic and that L/D ratios remains consistently at about 66%, and a largely closed capital account, there is no trigger for a systemic liquidity crisis that leads to credit crunch or emergence of large NPLs.

Debt borrowed before end of 2008, 3,199 ,

29.8%

Debt borrowed after 2008 but

used for projects already started in 2008 & before, 2,283 , 21.3%

New debt raised since 2009 for new projects , 5,236 ,

48.9%

5.62.4 2.3

5.2

10.7

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Bal

ance

200

8YE

Rep

aym

ent i

n 09

/10

New

deb

t for

exi

sting

pr

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ts s

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20

08/b

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New

deb

t for

new

pr

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ts s

ince

200

9

Bal

ance

201

0YE

Rm

b tr

n


11



Lastly, stress tests show that banks have a strong balance sheet and solid operating profitability to withstand a huge pickup in provisioning or loan loss.

This is not to say, however, that the local government debt will be free of NPL issue. Indeed, even now it does have very low NPL ratios, and in our current models, we also assume that about 1-2% of LGFV loans can become NPL per annum. We,however, don’t expect the delinquency ratios of LGFV loans to end up as high single-digit percentage.

LG debt burden can be reduced in the next few years through China’s economic growth

It’s a centralized hierarchical system, politically and fiscally

In our view, in assessing the underlying credit risks of the local government debt, investors must put them in a broader China context, particularly if this becomes a systemic issue. China is a highly centralized hierarchical system in which the supervisory governments have implicit claim and responsibility on assets and

liabilities held by their direct subordinate governments. Thus, in reality it is quite impossible for a single local government to fail on its explicit debt without any bailout from its supervisory governments or the central government. While this is not to say there will be no individual loan default cases, as some entities may be more commercial entities without explicit government backing, we believe the central government will ensure no large-scale defaults to happen.

Meanwhile, the central government is responsible, since the root of local government debts is also the problem in the current fiscal system design in China. As can be seen in Figure 11, there is an imbalance in the budget revenue share and budget expenditure share between central and local governments. Local governments in China indeed shoulder the majority of responsibility in economic development. During 2010, collectively local governments accounted for over 80% of the economic expenditure in China. Indeed, over the past 10 years, consistently around 90% of fixed-asset investment per annum is at local level rather than the central government level. Clearly, given that the local governments carry the majority of economic development projects, most of the project financing has become local government debt. However, most of such debt is used to finance infrastructure, transportation, energy development, which forms good asset base.

It’s worth noting that under current fiscal-system design, central government revenue transfer has always been an important source of local government revenues every year. Obviously, if there is no such supplementary mechanism to tackle such imbalance in revenue and expenditure share, it would mean enlarging fiscal deficit at local governments’ level and enlarging surplus at central government level. In reality, currently the central government solves such deficit primarily through revenue transfer and subsidies, to support certain projects and less-developed regions. As seen in Figure 12, after such transfer, there is largely break-even at the local governments’ fiscal balance. Thus, from this perspective, when considering the local government revenues, investors have to consider the central government’s annual transfer and subsidies as an integral part of the revenue source for local governments.

Local government debts arise

from the current fiscal system’sdesign problem, rather than poor

revenues at local governments.


12



Figure 11: Local government debts mainly arise from problems in the current fiscal system design in China: Local governments accounted for over 80% of budgetary expenditures

Source: CEIC.

Figure 12: Currently the central government mainly uses a central government transfer/subsidy to resolve the imbalance between local governments' revenue and expenditures

Source: CEIC.

The size of Chinese government debt is still manageable

Compared with many developed countries, China’s total government debt is still at a very manageable level. As seen in Figure 13, even after including the local governments’ debt and contingent liabilities, as well as some central governments’ implicit liabilities in AMC bonds/some policy bonds, the overall government debt remains at about 50% even after a pickup in 2009. This is still well below many developed countries.

Figure 13: Debt to GDP: Despite a pick up in 2009, total government debts in China remain at very manageable levels, considerably lower than many developed countries

Source: CEIC and J.P. Morgan estimates. Note: Others categories include some AMC bonds or part of policy banks' bonds. All these

are domestic. Note in reality policy banks' bonds can at least be partially self-funded.

Meanwhile, even on a static basis, the current local government debt outstanding is well within their fiscal affordability as a whole. According to NAO, in aggregate local governments’ debt outstanding was Rmb6.7trn, and this was only 52.25% of the overall local governments’ fiscal resources for debt repayment. Even including all contingent liabilities, Rmb10.7trn was also only 70.45% of the fiscal strength of local governments. Therefore, in general the current debt outstanding is still within current affordability.

Moreover, it’s quite impossible that all the contingent or implicit liabilities will need local governments to repay debt, since there are already cash flow generating primary borrowers. Indeed, according to NAO, the overdue debt ratios on those debts with government guarantee, or those likely to get implicit government support in case of financial stress as of 2010, stood at only 2.23% and 1.28%, respectively.

48.9% 47.8% 47.6% 45.0% 45.4% 45.1% 47.7% 47.2% 45.9% 46.7% 47.6% 48.9%

68.5%65.3%

69.5% 69.3% 69.9% 72.3% 74.1% 75.3% 77.0% 78.7% 80.0% 82.2%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Revenue share Expenditure share

(344) (396) (533) (677) (738) (870) (1,005) (1,213) (1,477)(2,060)

(2,844)(3,299)

65 70 67 59 88

171 143 137

337

239

12 (64) (3,500)

(3,000)

(2,500)

(2,000)

(1,500)

(1,000)

(500)

-

(100)

-

100

200

300

400

500

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Rm

b b

n

Rm

b b

n

Deficit before central govn'mt transfer Fiscal balance after central govn'mt transfer

17.7% 15.6% 17.3% 16.8% 16.7%

16.9% 17.7%26.8% 26.9% 25.5%

5.4% 5.8%

6.6% 6.5% 6.7%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

2007 2008 2009 2010 2011E

central government debt Local government debt Others (policy bonds etc.)


13



Fiscal revenue growth should remain strong to improve debt affordability

Provided that the Chinese government may keep economic growth at a certain level in the next few years, we believe the local government debt issue may also be less of an issue in three years time. In the past 10 years, local governments’ total revenues in aggregate have grown at a CAGR of approximately 25%. While land sales revenue grew from virtually none to last year’s significant Rmb2.9trn, a major driver for the revenue growth remains budget sources, including local governments’ own budget revenue and central government's fiscal revenue transfer. We estimate that even if we assume some contraction in land sales in each of the next few years, expected 20% CAGR budget revenue growth shall keep local government revenue growth at about 16% in the next 5 years to over Rmb20trn a year by 2015.

Figure 14: Local governments’ total revenues have been growing strongly

Source: CEIC, J.P. Morgan estimates.

We discuss below three major sources of local government revenues:

Local government’s own budgetary revenue: This represents their share in taxes and some non-tax revenues. Over the past 10 years, the local governments' budget revenue grew at a CAGR of 20.3%. This indeed was only slightly less than 40% of local government’s annual revenue indeed. It’s worth noting that the local governments’ revenue growth is largely consistent with the nation’s aggregate government revenue growth. While the central government obtains the majority of some key tax incomes, such as VAT, income tax and tariffs et cetera, the local governments share the majority of business operation taxes and some non-budgetary revenue, such as land sales proceeds and surcharges on education, city reconstruction and water/drainage. Overall, the sources of revenue pool are still similar.

Central government transfer: While the percentage of central government revenue transfers back to the local governments varied slightly every year, the growth rate in such revenue sources are largely consistent with the local governments’ own budget revenues, given that the growth rates in central government revenue and local government revenue are quite consistent. Over the past 10 years, the central government revenue transfer grew at a CAGR of 21.4%, and accounted for over 30% of the local government’s total revenues on national aggregate basis.

Non-budget revenues, including some surcharges and levies, but mainly land sales revenue: Such non-budget revenues predominantly belong to the local governments. There are some levies and surcharges, such as levies for city

0.6 0.6 0.8 0.9 1.0 1.2 1.5 1.8 2.4 2.9 3.3 4.1 5.1 6.2 7.4 8.8 10.2

0.4 0.5 0.6 0.7 0.8 1.0 1.1 1.4 1.8 2.3 2.9

3.2 4.1

4.9 5.8

6.8 7.8

0.0 0.0 0.1 0.2 0.3 0.4 0.6 0.9

1.3 1.0 1.4

2.9 2.5

2.5 2.6

2.9

2.9

-

3

6

9

12

15

18

21

99 00 01 02 03 04 05 06 07 08 09 10 11E 12E 13E 14E 15E

Rm

b tr

n

Budget local revenue central govnmt subsidy & transfer Ex-budget land sales revenue

Land sales revenue is important

and gives local governments extra financial resources for

local economic development,

but is not as big a source of revenue as some media or

investors thought


14



reconstruction funds, water/drainage funds, education funds. Land sales proceeds,however, accounted for the vast majority of such revenue in recent years. Given the lack of historical data on those levies, we use land sales as a proxy to such revenue stream. In 2010, despite tough austerity measures on the property sector, land sales revenue surged to new high and doubled from 2009 level to Rmb2.9trn, or over 25% of total local governments revenue sources.

Figure 15: Central government's fiscal subsidy and revenue transfer to local governments has been rising

Source: J.P. Morgan estimates, CEIC.

Figure 16: Growth in China's total budgetary revenue and China's local governments budget revenue are largely consistent

Source: CEIC.

Lastly, in our view, land sales revenue will not collapse: While we assumed some contraction or no further growth in land sales revenue in the next 4-5 years, in our view, it might be too naive to think that land sales revenue may collapse. Our view isthat China is very different to some Western developed countries, which have largely seen completion of the urbanization and whose population density is much lower than some Asian countries.

In China, urbanization is half way through, with urbanization rate still at about 47% vs. 60-80% or above in developed countries, and land prices in suburban areas or less-developed areas can improve with more infrastructure development.

Population density is much higher. This means scarcity value in lands, supported by much higher underlying housing demand than that in developed countries.

Income growth in China is much faster than that in many developed countries. This is unlikely to change in the next decade or so.

We believe that in foreseeable future while land sales proceeds could drop due to less land sales, land price indeed can hardly fall from the current level in the medium/longer term. This will be particularly the case in most tier-2/3 cities or even smaller cities, where urban development is accelerating and economic growth isgaining more momentum. Indeed, despite lingering fear of a slowdown in land sales, YTD in many places, land sales remain very strong.

No liquidity trigger for rapid asset quality deterioration

In general, history shows that foreign debt is much more vulnerable than domestically funded debt, given the higher uncertainty in refinancing. The Chinese government debt is predominantly domestic debt. In the case of local government debt, due to the absence of municipal bonds largely, the majority of such debts are domestic bank loans. In our view, in foreseeable future, given a largely closed capital account, there is no liquidity trigger for systemic risks on such debt.

3,6924,358

5,427

63% 61% 65%67% 66% 69%

67% 64% 63%68%

77% 74%

62% 65% 67%67% 67%

0%

10%

20%

30%

40% 50%

60%

70%

80%

90%

0

2,000

4,000

6,000

8,000

10,000

12,000

99 00 01 02 03 04 05 06 07 08 09 10 11E 12E 13E 14E 15E

Rm

b b

n

Central government revenue central government subsidy as % of central govnmt revenue

17.0%

22.3%

15.4% 14.9%

21.6%19.9%

22.5%

32.4%

19.5%

11.7%20.0%

14.5%

21.8%

9.1%

15.7%

20.7%

27.0%

21.2%28.8%

21.5%

13.7%

24.6%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

00 01 02 03 04 05 06 07 08 09 10

National Budget Rev. Local Budget Rev.


15



Although there is obvious monetary tightening and tight control on credit supply, the overall liquidity condition is fully under the central government control. Although market liquidity becomes tighter as PBOC continues to sterilize foreign-currency fund inflows arising from trade surplus/current-account surplus, these remain the central bank's foreign assets, at over Rmb23trn as of May 2011, or approximately 50% of 2011E GDP.

In the banking sector, it’s also worth noting that despite a significant pickup in the loan growth in 2009, deposit growth has largely matched loan growth and Rmb-denominated L/D ratio has been largely remained at approximately 66%-67%.

Figure 17: Liquidity keeps flowing into China due to ballooning trade/current account surplus in recent years: PBOC’s ballooning FX-assets on its balance sheet

Source: CEIC.

Figure 18: System Rmb-denominated L/D ratios remains largely unchanged at a very low 66-67%

Source: PBOC, CEIC.

In our view, unless the government made an obvious policy mistake through severe over-tightening, asset quality risks from liquidity crunch is not imminent, since it's entirely within the government’s control. One of the necessary conditions for China to potentially have liquidity risks must be full convertibility of the Rmb currency, which may not happen in the next few years.

Short-term liquidity pressure, however, could affect some LGFV loan quality

While we do not see a significant pickup in the local government debt default, on isolated cases there certainly can be some NPLs too as always. After all, the degree of government involvement in various debts is different and some entities set up by the local governments are commercial entities anyway. Given the regulator’s effort to improve the lending practice and quality of LGFV loans, inevitably some weaker local government-related loans might be under refinancing pressure and could be NPLs.

It’s worth noting that given the significant pickup in debt since 2009, the amount to be repaid by local governments in 2011 significantly may pick up significantly to Rmb1.87trn vs an estimated Rmb1.1trn in 2009 and Rmb1.3trn in 2010. In isolated cases, there could be delinquency or temporary overdue. This is also somewhat reflected in our current base-case assumptions for various listed banks. However, we believe most such cases may be successful restructured with limited eventual loss rates.

On the other hand, in the past two years, local government revenues have also picked up by about 55%. Thus, in terms of debt repayment as a percentage to annual revenues, the ratio only picked up modestly. Meanwhile, also note that are still

0

5,000

10,000

15,000

20,000

25,000

Dec

-199

9

Jun-

2000

Dec

-200

0

Jun-

2001

Dec

-200

1

Jun-

2002

Dec

-200

2

Jun-

2003

Dec

-200

3

Jun-

2004

Dec

-200

4

Jun-

2005

Dec

-200

5

Jun-

2006

Dec

-200

6

Jun-

2007

Dec

-200

7

Jun-

2008

Dec

-200

8

Jun-

2009

Dec

-200

9

Jun-

2010

Dec

-201

0

Rm

b bn

60%

65%

70%

75%

80%

Dec

-03

Ma

r-0

4

Ju

n-0

4

Sep

-04

Dec

-04

Ma

r-0

5

Ju

n-0

5

Sep

-05

Dec

-05

Ma

r-0

6

Ju

n-0

6

Sep

-06

Dec

-06

Ma

r-0

7

Ju

n-0

7

Sep

-07

Dec

-07

Ma

r-0

8J

un-

08

Sep

-08

Dec

-08

Ma

r-0

9J

un-

09

Sep

-09

Dec

-09

Ma

r-1

0J

un-

10

Sep

-10

Dec

-10

Ma

r-1

1

RMB L/D ratio L/D ratio

The government credit tightening and stringent control

on local government debt

financing poses a key near-termchallenge to the sector.


16



Rmb1.1trn of monetary assets that remain in the form of cash/bank deposits, which may help alleviate near-term cash flow.

We believe such issues will be significantly relieved post-2012 as the repayment burden drops over time, while expected strong fiscal revenue growth will also help boost the local government's ability to repay loans.

Table 7: Repayment schedule of local government-related debt

Repayment year Total Local governments responsible fore repayment

Debt guaranteed by local governments

Other debt that might need support in case of difficulty

Amount % Amount % Amount % Amount %

2011 2,625 24.5% 1,868 27.8% 365 15.6% 392 23.5%2012 1,840 17.2% 1,298 19.4% 297 12.7% 245 14.7%2013 1,219 11.4% 799 11.9% 227 9.7% 194 11.6%2014 994 9.3% 618 9.2% 227 9.7% 149 8.9%2015 801 7.5% 493 7.4% 178 7.6% 130 7.8%

2016 or after 3,238 30.2% 1,634 24.4% 1,043 44.6% 561 33.6%Total 10,717 100.0% 6,711 100.0% 2,337 100.0% 1,670 100.0%

Source: NAO.

There is no need for a master bailout plan yet

We do not agree with Moody’s cautious asset quality outlook on the basis that the Chinese central government still has no master plan. In our view, the Chinese government has already implemented various measures to tackle this issue, which in our view is enough. We simply see no need for any “bailout” plan at this stage or in the foreseeable future.

Meanwhile, we believe the Chinese government genuinely hopes to boost the competitiveness and soundness of its banking sector, whose healthiness plays a critical role in supporting the economy. We thus believe the central government will give strong backing to the banking sector to avoid any major credit quality issues.

There are already enough measures and attention on local government debt

Over the past 18months, various relevant ministries, such as CBRC, PBOC, MOF and NDRC, have worked to improve the quality of existing LGFV loans and mitigated the future credit risks.

Curbing the growth on local government debt. Since early 2010, the regulators have used a combination of various tools or explicit guidelines to urge banks to slow down LGFV loans growth. As seen in Figure 3, the growth in local government debt has already significantly slowed down to 18% in 2010 and has been further slowing down this year. New project launches also slowed down. Moreover, the central government no longer allows using existing LGFV entities to finance public sector projects without any cash flows.

A State Council document in June last year emphasized that local governments should be responsible for the existing debt as of end of June 30, 2010, effectively validating the guarantees or implicit government responsibility on such debt. Earlier this year, CBRC repeated the same message forbidding more lending to existing LGFV entities to finance new public sector projects.

Ongoing examination, monitoring and classification of LGFV loans based on cash flow generating capability. Banks have largely cleaned up “package LGFV


17



loans" and matched lending to underlying project cash flows. Many excess borrowing that have not been spent are taken back.

Cleanup and improvement in underlying loan terms to get more protection. Backed by the central government, since late last year CBRC has worked with banks to negotiate with local governments to get more collateral or asset/equity injection into LGFV entities, and additional valid third-party guarantee.

Admittedly during the governments’ cleanup, some weaker LGFV loans may experience liquidity pressure and thus emerge as NPLs, though often can be restructured with eventually low loss rates. However, we also believe this makes outstanding loans more robust in terms of quality and collateral. Moreover, as we mentioned earlier, we are not concerned also because we see expected strong fiscal revenue growth and still-abundant alternative financial resources (assets available for sale if necessary) to boost affordability in the coming years. Therefore, we believe at this stage, it is way too early for the government to announce a “bailout" plan, since this issue may eventually be digested by China’s strong economic growth in the next 2-3 years.

Other approaches that can help solve the issue

We also see other approaches the central government can adopt to solve the LG debt issue without a need for bailout plan.

Tackling the fiscal root: Even without fiscal reform, simply increasing revenue transfer to local governments could also help increase their ability to repay debts. However, this might lead to “moral hazard” issues. In our view, in the longer term, the government needs to reform the current fiscal system and match local government's revenue share to their responsibility in the economic development (i.e. expenditure share).

More flexibility in local governments’ bond issuance. The MOF will continue to issue on behalf of some provincial governments in the domestic market. The central government has already considered allowing more provincial governments and qualified municipal governments to issue muni-bonds in the domestic bond market.

The government is also carefully developing the asset securitization market in China. China Development Bank also has the task to be a pioneer in such areas in securitizing some LGFVs loans.

A bailout may be the last option, but indeed not a bad option to banks at all

While bailout and transfer of any potential bad loans arising from the local governments can be a viable solution, it would require consensus and agreement among major parties involved, including ministries such as CBRC, NDRC, MOF, and PBOC, local governments, and banks. We, however, see moral-hazard issues as key obstacles in such options. Given that in reality many of these loans are made by banks voluntarily from various considerations, it’s impossible to force all banks to transfer their loans at given prices, if banks viewed the potential default rate or loss rate differently.

Even if we assume that there would be a bailout, banks will not suffer much from such a plan. Even if we assume banks to transfer all loans at potential risks, the majority of which may not turn out to be NPLs, the earnings impact from potential loss would still be modest. As seen in the Table 8, even if we assume banks to share loss equivalent to 20% or 30% of their total outstanding “LGFV loans without


18



sufficient cash flow”, the actual earnings impact is mostly single-digit percentage of 2011 earnings. Clearly as a percentage of 2012 or 2013 earnings, the impact may be even smaller, given that PPOP in the next two years may continue to expand at a solid pace. Note that this assumed loss rates are already very extreme, which implies 60-90% loss rates on such loans transfer, in the case of 3-3-3 split (central government, relevant local governments and banks each taking one-third of loss).

Table 8: Estimated impact in bailout scenarios, in which governments take out all last 2 categories of LGFV loans and banks to share losses.

Source: J.P. Morgan estimates.

Banking sector has strong ability to withstand losses

This time history will not repeat

We believe that most Chinese banks are quite unlikely to experience huge NPL formation as seen in 1990s, simply given that structural change in the nature of the Chinese economy as well as the banking sector. Both the probability of default and loss rates on NPLs has significantly improved. Meanwhile, the banking sector also had much higher capability to absorb very high credit loss.

Nature of economy substantially changed. As we mentioned, the SOE reform during China’s transition from planned economy into a market economy has been completed and such event will no longer repeat.

Loan mix has changed: Loan mix and borrowers mix have improved significantly. In late-1990s, there was virtually no mortgage or other personal loans and many unviable SOE dominated banks’ loan book. As of end of 2010, retail loans accounted for 22% of total system loans, most of which are mortgage and other fully collateralized or guaranteed lending. In addition, a SME loan, mostly to private sector has increased to approximately 20% too. While SMEs in general carries more operating risks, given very underpenetrated SME banking in general, there has been in general stringent cherry-picking among SME

Rmb bn ICBC CCB BOC ABC BoComm CMB Citic Minsheng Industrial SPDB Huaxia SZDB

1Q11 LGFV loan balance 510 284 380 390 152 130 118 77 95 100 46 30

2011 total loans 7,726 6,432 6,421 5,631 2,582 1,665 1,464 1,224 996 1,329 615 637

1Q11 LGFV loans as % of 11E total loans 6.6% 4.4% 5.9% 6.9% 5.9% 7.8% 8.1% 6.3% 9.5% 7.5% 7.5% 4.7%

Cash flow coverage breakdown

Fully covered (>=100% 67% 67% 64% 62% 67% 85% 78% 70% 72% 55% 71% 75%

Largely covered (>=70% ) 18% 15% 16% 16% 20% 8% 13% 16% 10% 20% 15% 10%

Partially covered (>=30% , <70% ) 9% 8% 8% 9% 7% 5% 2% 8% 7% 16% 7% 15%

Barely covered (<30% ) 6% 10% 12% 13% 6% 2% 7% 6% 11% 9% 7% 5%

Assuming transferred amount (last 2 catogaries) 76.5 51.1 76.0 85.8 19.7 9.1 10.7 10.8 17.1 25.0 6.4 6.0

Bank loss: of banks take 20% loss on risky loans 15.3 10.2 15.2 17.2 3.9 1.8 2.1 2.2 3.4 5.0 1.3 1.2

Estimated provisioning already taken on such loans 7.7 5.1 7.6 8.6 2.0 0.9 1.1 1.1 1.7 2.5 0.6 0.6

Additional provisioning needed 7.7 5.1 7.6 8.6 2.0 0.9 1.1 1.1 1.7 2.5 0.6 0.6

As % of 2011E Loans 0.1% 0.1% 0.1% 0.2% 0.1% 0.1% 0.1% 0.1% 0.2% 0.2% 0.1% 0.1%

as % of 2011E earnings 2.7% 2.2% 4.4% 4.7% 2.9% 1.9% 2.6% 3.3% 5.7% 7.2% 5.9% 4.6%

Bank loss: of banks take 30% loss on risky loans 26.8 17.9 26.6 30.0 6.9 3.2 3.7 3.8 6.0 8.8 2.3 2.1

Additional provisioning needed 19.1 12.8 19.0 21.5 4.9 2.3 2.7 2.7 4.3 6.3 1.6 1.5

Credit cost impact 0.0% 0.3% 0.4% 0.5% 0.3% 0.2% 0.3% 0.3% 0.6% 0.7% 0.4% 0.3%

Impact to 2011 earnings 6.7% 5.5% 11.1% 11.8% 7.3% 4.8% 6.6% 8.4% 14.3% 18.1% 14.8% 11.5%


19



borrowers which has helped banks' credit risk control. This is also proven during 2008's Global Financial Crisis. Those SOEs still alive today which still accounted for over one third of loan book are typically quite profitable business in key strategic sectors with heavy government control. In the foreseeable future we don’t see any change given an expected stable political environment.

Asset mix also has changed: Loan to asset ratio in the sector has dropped from over 80% in mid 1990s to currently about 53% in system. Most non-loan assets are very simple and liquid domestic assets, mostly in the form of sovereign bonds or central bank reserves. In other words, sector’s balance sheet is still under-leveraged.

Lending norms and overall credit infrastructure significantly improved. To be fair, the government has spent much effort to build a financially sound banking system over the past 10 years. It has also devoted much effort to improve credit culture and infrastructure in plan to urge banks to be more commercial. Nationwide extensive credit bureau system has been installed and been extensively used in the past 5 years. The regulator CBRC arguably has consistently guarded against any potential risks and installed stringent regulatory norms, urging banks to avoid potential risks. Meanwhile, many banks have also gone through thorough internal reform and reorganization, which typically involves IT system upgrade, much more centralized risk control and depriving lower-tier branches of their credit approval authority, installation of stringent collateral/guarantee requirement which limits loss.

Structural improvement in underlying operating profitability. Increased credit pricing flexibility, lower statutory tax rate and rapid development in fee business are among the major drivers for a significant boost in sustainable revenue generation capability and pre-provisioning operating profitability. As seen in Figure 19 below, the sector profitability has consistently improved over the past 10 years, and pre-provisioning operating ROA tripled to about 2% expected for 2011E/2012E. Therefore, the ability to absorb NPL-driven credit provisioning per annum significantly boosted. With sector L/A ratio at about 53%, and Operating ROA at about 2%, the listed Chinese banks can remain profitable with roughly 3.5% or in some cases even 4% annual credit charges. In other words, many banks will stay profitable even if NPL ratio jumps from current 1% to around 6%-8% within one year. As we already illustrated in Table 1 on the cover page, this will imply incredibly high NPL formation at nearly 20% a year in a few sectors that investors had most concerns on.


20



Figure 19: Chinese banks have substantially improved their pre-prov. operating ROA in the past 10 years

Source: Company reports and J.P. Morgan estimates.

Figure 20: Sector loan to asset ratios have declined significantly over the past 10-15 years

Source: PBOC, CBRC.

Stress tests on the LGFV loans

Stress tests show that earnings risks from potential pickup in LGFV loans default are still very manageable, let alone risk of weaker balance sheet. While it’s not our base case, in stress tests we assume three scenarios, namely 10%, 15% and 20% of LGFV loans default abruptly within 2011, and banks make additional provisioning equivalent to 50% of such default, without considering the general provisioning they have made so far. As illustrated in Table 9, even assuming 20% of LGFV loans default suddenly within 2011, many banks can still keep ROE at mid-teen percentage and some banks including ICBC, CCB, ABC and CMB can even maintain ROE at around 20%, thanks to superior pre-provisioning operating profitability. Given thatthe sector is trading at 7-8x 11E PE, this would mean even in extreme cases, valuation would remain very cheap at 10x earnings should 20% of LGFV defaults immediately in current year, which in our view is very unlikely.

Table 9: Stress test results of 11E ROE in various LGFV NPL ratio Scenarios: even if 20% LGFVs loans default immediately in 2011, ROE will stay at mid-high teen percentage.

11E ROE ICBC CCB ABC BOC BoComm CMB Citic Minsheng SPDB Industrial Huaxia SZDBBase case 23.8% 23.0% 23.3% 18.4% 20.6% 23.8% 20.3% 20.1% 19.0% 22.0% 16.6% 20.9% 10% LGFV loan 21.9% 21.8% 21.2% 16.6% 18.6% 20.9% 17.7% 18.0% 16.6% 18.9% 13.5% 18.8% 15% LGFV loan 21.0% 21.2% 20.1% 15.7% 17.6% 19.5% 16.3% 16.9% 15.3% 17.4% 11.9% 17.7% 20% LGFV loan 20.1% 20.6% 19.0% 14.8% 16.5% 18.0% 15.0% 15.8% 14.1% 15.8% 10.3% 16.6%


Table 10: Stress test of 11E provisioning as % of PPOP in various LGFV default scenarios: Even if 20% of LGFV loans default in 2011, and banks makes 50% provisioning on those default, total provisioning would still account for no more than 20% of PPOP in general

ICBC CCB ABC BOC BoComm CMB Citic Minsheng SPDB SPDB Huaxia SZDB Total

Base case 11.0% 11.9% 18.8% 14.0% 18.7% 12.4% 13.9% 18.1% 16.0% 13.1% 25.5% 21.9% 14.3% 10% LGFV loan 11.9% 12.5% 19.8% 15.1% 19.7% 13.8% 15.3% 19.2% 17.4% 14.7% 27.2% 23.0% 15.2% 15% LGFV loan 12.4% 12.8% 20.3% 15.6% 20.3% 14.5% 16.0% 19.7% 18.1% 15.5% 28.1% 23.5% 15.7% 20% LGFV loan 12.8% 13.1% 20.8% 16.1% 20.8% 15.2% 16.7% 20.3% 18.8% 16.3% 29.0% 24.0% 16.2%


0.6%0.7% 0.8%

1.1%

1.4%1.5% 1.4% 1.5%

2.0%

1.6%1.8%

2.0%2.1%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2009 2010 2011E 2012E

Medium JSBs State-controlled banks Listed banks avg.

83 83 79 80

77 75 70

75

63 64 63 59

54 53 51 53 53

0

5

10

15

20

25

30

35

30

40

50

60

70

80

90

1994 1996 1998 2000 2002 2004 2006 2008 2010

%

%

Loan/asset ratio (LHS) Loan growth (RHS)


21



Table 11 below illustrates the details of our stress test analysis, under Scenario 1.

Table 11: New key balance sheet metrics and impact relative to 2011 estimates, under stress test scenario 1: assuming 10% LGFV loans default within 1 year.

Rmb bn LGFV Assumed% of 11E Topline Credit

Credit cost

11E revised

11E earning

11E Revised

11E ROE

11E Equity

11E revised

11E revised

1Q11 New NPL loans impact charges impact Coverage impact 11E ROE Impact Impact CAR tier-1ICBC 510 51 0.7% 2.9 26 0.4% 171% (9%) 21.9% (1.8%) (1.7%) 12.2% 10.2%CCB 284 28 0.4% 1.6 14 0.2% 189% (6%) 21.8% (1.2%) (1.1%) 12.9% 10.3%ABC 390 39 0.7% 2.2 20 0.4% 172% (10%) 21.2% (2.1%) (1.9%) 11.8% 8.9%BOC 380 38 0.6% 2.2 19 0.3% 159% (11%) 16.6% (1.8%) (1.6%) 12.6% 9.7%BoComm 152 15 0.6% 0.9 8 0.3% 153% (11%) 18.6% (2.0%) (1.8%) 11.7% 8.9%CMB 130 13 0.8% 0.7 7 0.4% 181% (13%) 20.9% (2.8%) (2.5%) 11.6% 8.4%Citic 118 12 0.8% 0.7 6 0.4% 141% (14%) 17.7% (2.6%) (2.1%) 12.3% 9.7%Minsheng 77 8 0.6% 0.4 4 0.3% 190% (11%) 18.0% (2.1%) (1.8%) 12.4% 8.6%SPDB 100 10 0.8% 0.6 5 0.4% 192% (14%) 16.6% (2.4%) (2.1%) 13.4% 9.4%Huaxia 46 5 0.7% 0.3 2 0.4% 149% (20%) 13.5% (3.1%) (2.3%) 12.5% 9.1%SZDB 30 3 0.5% 0.2 2 0.3% 173% (11%) 18.8% (2.1%) (1.6%) 10.8% 7.6%Industrial 95 9 1.0% 0.5 5 0.5% 154% (15%) 18.9% (3.0%) (2.7%) 11.9% 8.5%Total 2,312 231 0.6% 12.7 116 0.3% 170% (10%) 19.9% (1.9%) (1.7%) 12.2% 9.1%

Source: Company data, J.P. Morgan estimates.

Table 12: Valuation of Chinese banks in various LGFV default scenarios

Source: J.P. Morgan estimates, Company data, Bloomberg. Valuations based on market closing prices as of 13 July 2011.

Strong earnings resilience against broader asset quality pressure

Devil’s argument from some investors would be that the deterioration in LGFV loans quality may come along with deterioration in some other sectors amid a weaker economy. We agree to large extent and we conduct stress tests assuming deterioration in industrial sectors combined with weak property market to address such concerns.

Methodology and key assumptions for stress tests on 2012 earnings We assume our 2011E earnings are fairly realistic given profit outlook and asset

quality outlook in 2011 are still very visible. Most investors would also agree

1Q11 % of Impact on 11E BVPS

LGFV loans 10 loans Scen. 1 Scen. 2 Scen. 3 Base case Scen. 1 Scen. 2 Scen. 3 Scen. 1 Scen. 2 Scen. 3 Base case Scen. 1 Scen. 2 Scen. 3

ICBC-H 510 7.5% (9%) (13%) (17%) 7.6x 8.3x 8.7x 9.1x (2%) (2%) (3%) 1.7x 1.7x 1.7x 1.7x

CCB-H 284 5.0% (6%) (9%) (12%) 7.2x 7.6x 7.9x 8.1x (1%) (2%) (2%) 1.5x 1.6x 1.6x 1.6x

ABC-H 390 7.9% (10%) (15%) (20%) 7.7x 8.6x 9.1x 9.7x (2%) (3%) (4%) 1.7x 1.7x 1.7x 1.8x

BOC-H 380 6.7% (11%) (16%) (21%) 6.5x 7.3x 7.8x 8.3x (2%) (2%) (3%) 1.1x 1.1x 1.2x 1.2x

BoComm-H 152 6.8% (11%) (16%) (21%) 6.1x 6.9x 7.3x 7.8x (2%) (3%) (4%) 1.2x 1.2x 1.2x 1.2x

CMB-H 130 9.1% (13%) (18%) (26%) 9.5x 10.9x 11.6x 12.8x (2%) (4%) (5%) 2.0x 2.0x 2.1x 2.1x

Citic-H 118 9.4% (14%) (20%) (28%) 5.6x 6.6x 7.0x 7.8x (2%) (3%) (4%) 1.0x 1.0x 1.0x 1.1x

Minsheng-H 77 7.3% (11%) (17%) (23%) 6.5x 7.4x 7.9x 8.4x (2%) (3%) (4%) 1.2x 1.2x 1.2x 1.2x

H-Share 2,042 7.0% (8%) (12%) (17%) 7.6x 8.3x 8.6x 9.1x (2%) (2%) (3%) 1.7x 1.7x 1.7x 1.7x

SPDB 100 8.7% (14%) (21%) (27%) 7.2x 8.4x 9.1x 9.9x (2%) (3%) (4%) 1.2x 1.3x 1.3x 1.3x

Huaxia 46 8.7% (20%) (30%) (40%) 8.6x 10.8x 12.3x 14.4x (2%) (3%) (5%) 1.2x 1.2x 1.3x 1.3x

SZDB 30 7.4% (11%) (16%) (22%) 7.5x 8.4x 9.0x 9.6x (2%) (2%) (3%) 1.5x 1.5x 1.5x 1.6x

ICBC-A 510 7.5% (9%) (13%) (17%) 7.1x 7.8x 8.2x 8.6x (2%) (2%) (3%) 1.6x 1.6x 1.6x 1.6x

CCB-A 284 5.0% (6%) (9%) (12%) 7.0x 7.4x 7.6x 7.9x (1%) (2%) (2%) 1.5x 1.5x 1.5x 1.5x

ABC-A 390 7.9% (10%) (15%) (20%) 6.4x 7.2x 7.6x 8.1x (2%) (3%) (4%) 1.4x 1.4x 1.5x 1.5x

BOC-A 380 6.7% (11%) (16%) (21%) 6.9x 7.8x 8.3x 8.8x (2%) (2%) (3%) 1.2x 1.2x 1.2x 1.2x

Bocomm-A 152 6.8% (11%) (16%) (21%) 6.2x 7.0x 7.4x 7.9x (2%) (3%) (4%) 1.2x 1.2x 1.2x 1.2x

CMB-A 130 9.1% (13%) (18%) (26%) 8.0x 9.2x 9.8x 10.8x (2%) (4%) (5%) 1.7x 1.8x 1.8x 1.9x

Citic-A 118 9.4% (14%) (20%) (28%) 6.7x 7.7x 8.3x 9.2x (2%) (3%) (4%) 1.2x 1.2x 1.2x 1.3x

Minsheng-A 77 7.3% (11%) (17%) (23%) 6.5x 7.3x 7.8x 8.4x (2%) (3%) (4%) 1.2x 1.2x 1.2x 1.2x

Industrial 95 11.1% (15%) (23%) (30%) 6.9x 8.1x 8.9x 9.9x (3%) (4%) (5%) 1.4x 1.4x 1.5x 1.5x

Total 2,218 7.1% (9%) (13%) (17%) 6.9x 7.6x 8.0x 8.4x (2%) (3%) (3%) 1.4x 1.4x 1.5x 1.5x

Impact on 11E EPS 11 PE in var. scenrios 11E PB in var. scenarios


22



broad deterioration is unlikely to happen in the remainder of 2011 given a still fairly strong economy, as 1H11 GDP growth remained 9.6%.

We assume our various key assumptions (loan growth at approximately 13%, modest 8-10bps NIM expansion, 22% non-interest income growth and 17% costs growth for the listed banks under coverage in aggregate) are valid, so that downside to earnings would come only from additional provisioning arising from additional new NPLs.

We assume for the additional NPLs in various stress test scenarios, banks make 50% provisioning on those new NPLs. In reality loss rates may vary and we believe 50% is indeed fairly conservative in view of collateral value and collection track record in the past 10 years.

We admit that in reality there could be some uncertainty to those assumptions but we think downside those assumptions are limited.

Table 13 shows for every additional 100bps of 11E outstanding loans to become NPL, roughly the downside to our current 2012 earnings is about 13% on average.

Table 13: Sensitivity of 2012 earnings downside to every 100bps additional NPLs (from 11E outs. loans)


Table 14 shows our current base-case assumptions, and implied asset quality deterioration need to take earnings down to various stress test scenarios.

Rmb mn

Every 1% 11E

loans to be

new NPL

Add.

provision

@ 50% loss

Additional

credit costs

Reduced

NII

NIM

impact

Est. 12E Op

ROA

New 12E Op.

ROA

Base case

12E

earnings

Downside

to 12E

earning

Downside

to 12E

BVS

12E base

case ROA

chg to

JPM 12E

ROA

base case

12E ROE

chg to

12E ROE

(bps)

BoComm-H 25,815 12,908 0.47% 1,549 0.03% 2.02% 2.00% 63,814 -14.4% -2.9% 1.31% -0.19% 21.7% (319)

ABC-H 56,313 28,156 0.47% 3,520 0.03% 2.06% 2.04% 174,539 -11.6% -2.7% 1.38% -0.16% 25.2% (296)

BOC-H 64,209 32,105 0.47% 3,765 0.03% 1.89% 1.85% 153,019 -14.9% -2.6% 1.17% -0.33% 18.9% (286)

CCB-H 64,319 32,159 0.47% 3,923 0.03% 2.32% 2.30% 205,170 -11.2% -2.4% 1.57% -0.18% 23.5% (266)

CMB-H 16,649 8,325 0.47% 982 0.03% 2.24% 2.21% 44,395 -13.4% -2.9% 1.52% -0.20% 24.3% (330)

ICBC-H 77,265 38,632 0.47% 4,636 0.03% 2.30% 2.28% 253,820 -10.9% -2.4% 1.59% -0.17% 23.8% (262)

Citic-H 14,637 7,319 0.47% 908 0.04% 2.19% 2.16% 36,644 -14.3% -2.5% 1.37% -0.20% 19.1% (277)

Minsheng-H 12,237 6,119 0.47% 832 0.04% 2.07% 2.04% 30,763 -14.4% -2.4% 1.31% -0.19% 19.0% (277)

Huaxia 6,152 3,076 0.47% 372 0.03% 1.31% 1.29% 9,701 -22.7% -3.1% 0.73% -0.16% 14.5% (334)

SPDB 13,290 6,645 0.47% 831 0.03% 1.46% 1.44% 30,974 -15.4% -2.7% 1.11% -0.17% 18.8% (294)

SZDB 6,367 3,183 0.46% 376 0.03% 1.67% 1.64% 12,833 -17.7% -3.2% 0.98% -0.17% 19.4% (350)

Industrial 9,955 4,978 0.47% 652 0.03% 1.69% 1.67% 27,425 -13.1% -2.7% 1.13% -0.15% 22.5% (298)

Total/Average 367,208 183,604 0.47% 22,603 0.03% 1.77% 1.74% 1,043,095 -12.6% -2.6% 1.04% -0.19% 22.2% (284)


23



Table 14: Our base case estimates

RmbmnShare price

12E EPS

(Rmb)

12E PE (x)

12E BVS

(Rmb)

12E PB (x)

12E earning growth

JPMe 12E ROE

12E new NPL

%11E loans

JPMe 12E NPL ratio

11E NPLs (Rmbmn)

JPMe 11E NPL ratio

11E credit costs

12E credit costs

BoCom-H 6.71 1.13 4.8 5.71 1.0 26% 21.7% 0.6% 1.1% 27,218 1.1% 0.72% 0.60%ABC-H 3.97 0.54 6.1 2.32 1.4 28% 25.2% 0.6% 1.4% 93,457 1.7% 0.76% 0.62%BOC-H 3.59 0.53 5.5 3.00 1.0 19% 18.9% 0.7% 1.0% 64,489 1.0% 0.46% 0.58%CCB-H 6.08 0.82 6.1 3.76 1.3 18% 23.5% 0.6% 1.0% 65,573 1.0% 0.51% 0.49%CMB-H 18.24 2.06 7.3 9.35 1.6 25% 24.3% 0.3% 0.6% 10,099 0.6% 0.40% 0.43%ICBC-H 5.63 0.72 6.4 3.29 1.4 19% 23.8% 0.7% 1.0% 75,525 1.0% 0.47% 0.45%Citic-H 4.63 0.78 4.8 4.41 0.9 21% 19.1% 0.5% 0.7% 9,038 0.6% 0.48% 0.61%Minsheng-H 7.04 1.01 5.7 5.73 1.2 27% 19.0% 0.4% 0.7% 7,775 0.6% 0.63% 0.63%Huaxia 11.06 1.42 7.8 10.35 1.1 28% 14.5% 0.8% 1.4% 10,209 1.7% 0.65% 0.68%SPDB 10.01 1.66 6.0 9.58 1.0 20% 18.8% 0.3% 0.5% 7,169 0.5% 0.53% 0.53%SZDB 17.54 2.50 7.0 14.14 1.2 32% 19.4% 0.5% 0.6% 3,753 0.6% 0.57% 0.76%Industrial 14.30 2.54 5.6 12.26 1.2 23% 22.5% 0.1% 0.4% 3,886 0.4% 0.47% 0.51%Total 6.1 1.2 22% 22.2% 0.6% 1.0% 378,192 1.0% 0.55% 0.54%

Source: J.P. Morgan estimates, Bloomberg. Valuations as of market closing prices on 13 July 2011.

Table 15: Scenario 1 (Flat earnings in 2012 vs. 2011E). On average NPL balance needs to grow by around 150% or annual gross NPL formation to reach about 200bps, assuming other assumptions are valid

12E NPL%

New NPLs as % of 11E loan

12E incr. in NPLs

% incr. vs. 11E NPLs

chg to 12E BVS est.

12E BV growth

12E PE

12E PB

12E ROE

Credit cost

Core tier-1

CAR

BoCom-H 2.4% 2.1% 41,629 153% -3.4% 16.4% 4.8 1.0 17.5% 1.35% 9.3% 11.7%ABC-H 3.1% 2.5% 101,273 108% -3.2% 16.1% 6.1 1.4 20.1% 1.46% 9.1% 12.5%BOC-H 2.0% 1.7% 80,045 124% -1.7% 13.8% 5.5 1.0 16.0% 1.17% 9.9% 12.3%CCB-H 2.3% 2.0% 98,541 150% -2.0% 13.7% 6.1 1.4 20.1% 1.21% 10.6% 13.1%CMB-H 2.0% 1.8% 27,443 272% -3.6% 18.7% 7.3 1.7 19.7% 1.19% 9.0% 12.0%ICBC-H 2.3% 2.2% 125,889 167% -2.2% 17.8% 6.4 1.4 20.2% 1.22% 11.2% 12.8%Citic-H 1.8% 1.7% 20,508 227% -2.3% 13.7% 4.8 0.9 15.9% 1.26% 9.7% 12.3%Minsheng-H 2.0% 1.9% 19,526 251% -3.0% 30.2% 5.7 1.3 15.3% 1.37% 9.9% 12.4%Huaxia 2.0% 1.5% 3,975 39% -1.8% 10.7% 7.8 1.1 12.3% 0.98% 9.3% 12.6%SPDB 1.5% 1.4% 14,937 208% -2.6% 15.9% 6.0 1.1 16.0% 1.05% 9.7% 14.6%SZDB 1.7% 1.9% 9,366 250% -3.8% 15.1% 7.0 1.3 15.1% 1.43% 7.4% 10.9%Industrial 1.6% 1.5% 14,522 374% -3.3% 16.1% 5.6 1.2 18.6% 1.20% 8.3% 11.3%Total 2.3% 2.0% 557,654 147% -2.5% 16.0% 6.1 1.2 17.2% 1.25% 9.4% 12.4%

Source: J.P. Morgan estimates, Bloomberg. Valuation as of market closing prices on 13 July 2011.

Table 16: Scenario 2 (2012 earnings to decline by 20% vs. 2011E). On average NPL balance need to more than triple, or annual gross NPL formation to surge to 330bps to get this scenario, assuming other assumptions are valid

12E NPL%


12E incr. in NPLs


chg to 12E BVS est.

12E BV growth

12E PE

12E PB

12E ROE

Credit cost

Core tier-1

CAR

BoCom-H 3.3% 3.2% 69,909 257% -6.0% 13.3% 6.1 1.0 14.2% 1.87% 9.0% 11.5%ABC-H 4.3% 3.9% 177,526 190% -5.5% 13.3% 7.6 1.5 16.3% 2.10% 8.9% 12.3%BOC-H 3.0% 2.9% 152,017 236% -3.6% 11.7% 6.9 1.0 12.9% 1.69% 9.7% 12.1%CCB-H 3.6% 3.5% 195,545 298% -4.3% 11.1% 7.6 1.4 16.2% 1.92% 10.4% 12.8%CMB-H 3.0% 3.0% 47,306 468% -6.4% 15.2% 9.1 1.7 16.0% 1.75% 8.7% 11.7%ICBC-H 3.7% 3.7% 245,042 324% -4.4% 15.1% 8.0 1.5 16.3% 1.95% 10.9% 12.6%Citic-H 2.8% 2.9% 37,353 413% -4.5% 11.1% 6.1 0.9 12.9% 1.80% 9.5% 12.1%Minsheng-H 2.9% 3.0% 32,956 424% -5.2% 27.2% 7.1 1.3 12.4% 1.88% 9.6% 12.2%Huaxia 2.7% 2.2% 8,552 84% -3.7% 8.6% 9.8 1.1 10.0% 1.33% 9.1% 12.5%SPDB 2.4% 2.5% 29,389 410% -5.2% 12.8% 2.9 1.1 13.0% 1.56% 9.4% 14.4%SZDB 2.5% 2.8% 14,842 396% -6.3% 12.2% 8.8 1.3 12.2% 1.82% 7.2% 10.8%Industrial 2.7% 2.7% 26,908 692% -6.1% 12.7% 7.0 1.2 15.1% 1.78% 8.1% 11.1%Total 3.4% 3.3% 1,037,346 274% -4.7% 13.3% 7.2 1.3 14.0% 1.87% 9.2% 12.2%

Source: J.P. Morgan estimates, Bloomberg. Valuation as of market closing prices on 13 July 2011.


24



Table 17: Scenario 3 (2012 earnings to decline by 30% vs. 2011E). On average NPL balance need to more than quadruple, or annual gross NPL formation to surge to 400bps to get this scenario, assuming other assumptions are valid

12E NPL%


12E incr. in NPLs


chg to 12E BVS est.

12E BV growth

12E PE

12E PB

12E ROE

Credit cost

Core tier-1

CAR


Source: J.P. Morgan estimates, Bloomberg. Valuation as of market close prices on 13 July 2011.

Table 18: Scenario 4 ( 2012 earnings to halve vs. 2011E). On average NPL balance need to increase by fivefold, or annual gross NPL formation to surge to nearly 500bps to get this scenario, assuming other assumptions are valid

12E NPL%


12E incr. in NPLs


chg to 12E BVS est.

12E BV growth

12E PE

12E PB

12E ROE

Credit cost

Core tier-1

CAR



Table 19: Scenario 5 (NPLs wipes of all profits in 2012 to zero). In aggregate NPL balance need to blow out and increased eight-fold, or NPL formation rate surging to 850bps to get this scenario, assuming other assumptions are valid.

12E NPL%


12E incr. in NPLs


chg to 12E BVS est.

12E BV growth

12E PE

12E PB

12E ROE

Credit cost

Core tier-1

CAR

BoCom-H 7.2% 7.6% 183,028 672% -16.3% 0.9% NM 1.2 - 3.61% 8.1% 10.6%ABC-H 9.1% 9.3% 482,536 516% -14.8% 2.2% NM 1.6 - 4.20% 8.0% 11.4%BOC-H 7.0% 7.3% 439,906 682% -10.8% 3.4% NM 1.1 - 3.39% 9.0% 11.4%CCB-H 9.0% 9.5% 583,559 890% -13.2% 0.8% NM 1.5 - 4.28% 9.4% 11.9%CMB-H 7.2% 7.8% 126,760 1255% -17.6% 1.4% NM 1.9 - 3.65% 7.6% 10.6%ICBC-H 9.2% 9.9% 721,655 956% -13.5% 4.2% NM 1.6 - 4.57% 9.8% 11.5%Citic-H 6.8% 7.5% 104,734 1159% -13.3% 0.9% NM 1.0 - 3.63% 8.7% 11.3%Minsheng-H 6.8% 7.4% 86,673 1115% -14.3% 15.1% NM 1.4 - 3.65% 8.8% 11.4%Huaxia 5.2% 5.2% 26,861 263% -11.2% 0.1% NM 1.2 - 2.36% 8.5% 11.9%SPDB 6.2% 6.8% 87,198 1216% -15.6% 0.3% NM 1.2 - 3.52% 8.4% 13.5%SZDB 5.4% 6.2% 36,746 979% -16.1% 0.5% NM 1.5 - 2.89% 6.5% 10.1%Industrial 7.1% 7.7% 76,454 1967% -17.6% -1.1% NM 1.4 - 3.77% 7.1% 10.1%Total 8.0% 8.5% 2,956,112 782% -16.7% 2.6% NM 1.4 - 3.40% 8.3% 11.3%


Strong earnings resilience against asset quality pressure

In our view, if the economy deteriorates notably, scenario 1 is more likely to happen. In our view, the worst-case scenario would be scenario 2 or 3, which already reflects very drastic deterioration in industrial sector and property sector and a significant


25



default rate in LGFV loans too. Note that even under those scenarios, Chinese banks may remain profitable, with most banks still achieving low teen to mid-teen percentage ROEs.

Looking at the current loan breakdown, we think it’s quite unlikely for sector NPL ratio to surge to double digits within 1 year. To illustrate our points, we randomly select one big state banks (CCB) and one medium-sized bank (Minsheng) to show what kind of annual NPL formation needed in various sectors in combination to get the NPL ratios under various scenarios highlighted above.

As seen in Table 18 below, in CCB’s case, if its 2012 earnings were to decline by 20%, which would imply a 17% ROE and 3.6% NPL ratio after almost 200bps credit costs (refer to Table 14), the implication on its NPL formation is that CCB will witness 8% of its 11E manufacturing loans, plus 8% 11E property corporate loans and 8% of 11E LGFV loans (in reality there are indeed some overlap between LGFV and property loans, i.e. the land reserve loans), plus about 2.7% of other less risk corporate loans (energy etc) and some personal loans to default within 2012. We believe it clearly requires a slump in the economy to materialize such degree of asset quality deterioration. Similarly we can conduct the same analysis on other banks such as Minsheng. The results indeed are not too different as shown in table below.

Table 20: What NPL ratios in various scenarios imply in terms of annual NPL formation in key areas that investors are concerned most-CCB case study

Rmb mn12E NPL

ratioGross new

NPLsProperty

NPLs% of prop. Dvelpmt

Manu NPLs

% of manu LGFV

% of LGFV

Other corp. NPLs

% of other corp.

Our base case 1.0% 37,651 6,527 1.5% 11,550 1.0% 5,680 2.0% 12,342 0.5%Flat vs. 2011E 2.3% 126,316 21,758 5.0% 57,750 5.0% 14,200 5.0% 31,056 1.2%Down by 20% 3.6% 223,319 34,812 8.0% 92,400 8.0% 22,720 8.0% 71,835 2.7%Down by 30% 4.3% 271,821 43,516 10.0% 115,500 10.0% 34,080 12.0% 77,173 2.9%Down by 50% 5.6% 368,825 65,273 15.0% 138,600 12.0% 42,600 15.0% 120,799 4.6%Breakeven 9.0% 611,334 87,031 20.0% 207,901 18.0% 56,800 20.0% 258,050 9.8%


Table 21: What NPL ratios in various scenarios imply in terms of annual NPL formation in key areas that investors are concerned most-Minsheng case study

Rmb mn12E NPL

ratioGross new

NPLsProperty

NPLs% of prop. Dvelpmt

Manu NPLs

% of manu LGFV

% of LGFV

Other corp. NPLs

% of other corp.

Our base case 0.7% 5,193 996 1.0% 317 1.0% 1,540 2.0% 1,521 0.3%Flat earning 2.0% 23,002 4,979 5.0% 1,586 5.0% 3,850 5.0% 11,769 2.0%Down by 20% 2.9% 36,432 7,966 8.0% 2,537 8.0% 6,160 8.0% 18,949 3.3%Down by 30% 3.4% 43,146 9,958 10.0% 3,171 10.0% 9,240 12.0% 19,958 3.4%Down by 50% 4.4% 56,576 14,937 15.0% 3,805 12.0% 11,550 15.0% 25,465 4.4%Breakeven 6.8% 90,149 19,916 20.0% 5,708 18.0% 15,400 20.0% 48,307 8.3%


Share price already priced in scenario of multiple-year prolong weakness

As Illustrated above, we may argue that it’s nearly impossible to get overall double digit NPL ratios on overall loan book. We think valuation has factored in a multi-year asset quality deterioration that leads to persistent earnings declines for 2-3 years. It also needs a multi-year recession and prolonged weakness in the Chinese economy to get double digit mid-teen or high teen percentage NPL ratios in key sectors that investors are concerned about. Even in such case, earnings might decline by 20-30% every year in the next 2-3 years so that troughs at about half of 2011E earnings. Even in this extreme scenario, the sector remains profitable, with high single digit ROE. Yet even under such scenario, PE on such trough earnings might still be reasonable at low to mid-teen times.


26



Valuations have far factored in an overly pessimistic economic outlook on China

Valuation implies very low long-term profitability

As Table 22 shows, assuming our 11.5-12% cost of equity and 5.5-6% LT growth rates applied for beyond 2013, the current valuation implies sector's long-term ROE is about 12% only, vs. currently about 22% estimated for 2011/2012. A long-term ROE at 12% implies that throughout a credit cycle, on average the sector's annual credit charges needs to be 140bps, almost doubling compared with the past 12 years' average annual credit costs. We also mentioned earlier even after a persistent 2-3 years profit shrinking due to huge pickup in NPLs to mid-teen percentage, ROE could remain at high single digit to about 10% at trough. Therefore, we believe a cycle average 12% may be overly pessimistic.

Table 22: The current valuation implies sustainable ROE at just 12-13% on average for the sector in the longer term

Price PE (x) PB (x) ROE Normalized Implied(LC) 11E 12E 11E 12E 11E 12E ROE COE LT Grth ROE COE

BoComm-H 6.71 6.1 4.8 1.2 1.0 19.6% 21.7% 15.2% 11.6% 5.5% 11.3% 15.7%ABC-H 3.97 7.7 6.1 1.7 1.4 23.3% 25.2% 15.8% 11.5% 5.5% 13.3% 13.4%BOC-H 3.59 6.5 5.5 1.1 1.0 18.4% 18.9% 13.9% 11.4% 5.3% 10.9% 14.6%CCB-H 6.08 7.2 6.1 1.5 1.3 23.0% 23.5% 17.0% 11.4% 5.5% 12.8% 14.7%CMB-H 18.24 9.5 7.5 2.0 1.6 24.2% 24.3% 17.4% 11.4% 5.8% 14.6% 13.1%ICBC-H 5.63 7.6 6.4 1.7 1.4 23.8% 23.8% 17.2% 11.4% 5.5% 13.2% 14.5%Citic-H 4.63 5.6 4.8 1.0 0.9 20.3% 19.1% 14.0% 11.5% 6.0% 10.6% 15.6%Minsheng-H 7.04 6.5 5.7 1.2 1.0 20.1% 19.0% 13.9% 11.5% 6.0% 11.8% 13.6%H-share banks 7.1 5.9 1.4 1.2 21.6% 21.9% 15.6% 11.4% 5.6% 12.3% 14.4%ABC-A 2.71 6.4 5.0 1.4 1.2 23.3% 25.2% 15.8% 11.5% 5.5% 11.8% 15.3%BOC-A 3.13 6.9 5.9 1.2 1.0 18.4% 18.9% 13.9% 11.4% 5.3% 11.3% 13.9%CMB-A 13.08 8.0 6.4 1.7 1.4 24.2% 24.3% 17.4% 11.4% 5.5% 13.5% 14.2%Huaxia 11.06 8.6 7.8 1.2 1.1 16.6% 14.5% 13.3% 11.6% 5.8% 12.6% 12.3%Minsheng-A 5.74 6.5 5.7 1.2 1.0 20.1% 19.0% 13.9% 11.5% 6.0% 11.7% 13.6%SPDB 10.01 7.2 6.0 1.2 1.0 19.0% 18.8% 14.1% 11.6% 6.0% 12.2% 13.3%SZDB 17.54 7.5 6.9 1.5 1.2 20.1% 19.0% 13.7% 11.6% 6.0% 13.3% 12.0%ICBC-A 4.34 7.1 6.0 1.6 1.3 23.8% 23.8% 17.2% 11.4% 6.0% 12.5% 15.2%BoComm-A 5.57 6.2 4.9 1.2 1.0 19.6% 21.7% 15.2% 11.6% 5.5% 11.4% 15.6%Citic-A 4.48 6.7 5.7 1.2 1.0 20.3% 19.1% 14.0% 11.5% 6.0% 11.6% 13.9%Industrial 14.30 6.9 5.6 1.4 1.2 22.1% 22.6% 14.0% 11.7% 6.0% 12.5% 13.0%A-share banks 7.1 6.0 1.3 1.1 20.5% 20.4% 14.8% 11.5% 5.8% 12.2% 13.8%Sector avg. 7.1 6.0 1.4 1.2 20.9% 20.9% 15.1% 11.5% 5.7% 12.3% 14.1%

Source: J.P. Morgan estimates, Bloomberg.

Valuation are close to floor franchise value

Lastly, we believe valuation metrics are close to the embedded franchise value of the listed banks. We don't think virtually all the banks will survive even in very adverse economic downturn. In general, even for troubled banks with heavy NPL burden, which PE firms may turn over for maximum upside potential once they make successful business turnarounds, a 3-4x price to PPOP may still be regarded as very attractive levels. This is especially the case given that we believe the sector may remain fairly profitable even in scenarios with heavy NPLs in key areas that investors worried most.

Current valuations are largely trough valuations and have

factored in a very pessimistic

outlook on the sector, in our view


27



Figure 21: Price to PPOP are close to historical trough

Source: J.P. Morgan estimates, Bloomberg. Valuations as of market close price as of 13 July

2011.

Figure 22: Stocks are trading at almost floor franchise value: market cap to deposits are at about 10% on average

Source: J.P. Morgan estimates, Bloomberg. Valuations as of market close price as of 13 July

2011.

Valuation is also below 1std deviation to historical 6-year mean

Based on JP Morgan estimates, the current 12M forward valuations of ABC-H, Minsheng-H, BoComm-H, and most A-shares are very close to historical troughsseen only during the most panic days in Global Financial Crisis in 4Q08. All H-shares and nearly half of A-share banks are trading below 1 standard deviation below the six-year mean average. In absolute terms, 12M forward PB quite a number of banks are trading close to 1x book. These all imply a very favorable risk-reward profile we think.

Table 23: 12M forward valuation metrics comparison: Current vs. historical trading range

Source: J.P. Morgan estimates, Bloomberg. Valuations as of market close price as of 13 July 2011.

Confident in sectors' fundamental outlook, near-term stocks rangebound

From both a fundamental outlook and valuation perspective, we maintain our positive view on the sector, both in the medium term and longer term. We firmly believe investors have been overly pessimistic on China's macro outlook. We believe

6.4

5.4 5.4 5.0 5.1 4.8 4.9 4.7 4.7 4.6 4.6 4.5 4.4 4.2 4.1 4.0 4.0 3.9 3.8

-

1.0

2.0

3.0

4.0

5.0

6.0

7.0

CM

B-H

ICB

C-H

CM

B-A

CC

B-H

AB

C-H

Hua

xia

ICB

C-A

CC

B-A

SZ

DB

SP

DB

Indu

stria

l

BO

C-A

BO

C-H

Min

sh

eng

H

AB

C-A

Min

she

ng A

BoC

om

-H

BoC

om

m-A

Citic

-H

x

11E 12E

15%13% 13% 12%

14%12% 12%

10% 11% 11% 10% 10% 10% 10% 10% 9% 9% 9% 8%

0%

2%

4%

6%

8%

10%

12%

14%

16%

CM

B-H

ICB

C-H

CM

B-A

CC

B-H

Min

she

ng-

H

ICB

C-A

CC

B-A

AB

C-H

Ind

ustri

al

Citi

c-H

BO

C-A

BO

C-H

SZ

DB

SP

DB

Min

she

ng A

Bo

Com

-H

BoC

om

m-A

AB

C-A

Hu

axia

x

11E 12E

Company name

Mean PB Mean PE PB PE PB PE PB PE PB PE PB PE PB PE

ABC-H 1.7 7.8 1.5 6.8 12% 16% 4% 8% 1.9 9.0 1.5 6.8 -1% 0%

BoComm-H 1.8 10.4 1.0 4.9 87% 114% 30% 44% 3.5 18.7 0.9 4.8 -7% -2%

BOC-H 1.6 10.5 1.0 6.0 49% 76% 10% 13% 2.4 18.3 0.8 5.0 -26% -16%

CCB-H 2.1 11.1 1.4 6.6 45% 69% 12% 24% 3.7 19.1 1.0 5.4 -26% -17%

CMB-H 2.9 13.1 1.8 8.0 67% 63% 4% 16% 6.4 24.9 1.4 7.1 -20% -12%

ICBC-H 2.1 11.3 1.5 6.9 41% 64% 12% 16% 3.6 20.2 1.2 6.4 -18% -7%

Citic-H 1.4 9.5 0.9 5.2 84% 117% 5% 3% 2.7 23.3 0.7 4.9 -27% -6%

Minsheng-H 1.3 7.3 1.1 6.1 92% 92% 5% 4% 1.7 9.8 1.1 5.9 -2% -4%

H-share banks 2.0 10.5 1.4 6.5 44% 64% 11% 17% 3.3 18.0 1.1 5.9 -18% -10%

ABC-A 1.4 6.4 1.3 5.6 10% 14% 4% 6% 1.6 7.4 1.2 5.6 -1% -1%

BOC-A 2.0 13.8 1.1 6.3 84% 117% 18% 21% 4.0 29.2 1.1 6.3 0% 0%

CMB-A 2.9 13.5 1.5 7.0 92% 92% -14% 13% 7.8 30.3 1.5 6.9 -3% -1%

Huaxia 1.9 14.2 1.1 8.2 71% 73% 0% -8% 4.7 36.9 1.1 7.9 -3% -4%

Minsheng-A 2.0 12.7 1.1 6.0 81% 111% -11% -13% 4.9 34.2 1.0 5.6 -6% -7%

SPDB 2.6 12.3 1.1 6.5 129% 88% -8% 15% 7.2 26.2 1.1 5.7 -3% -13%

SZDB 2.6 20.7 1.3 7.2 93% 189% -8% n.a. 6.8 153.2 1.2 5.8 -8% -18%

ICBC-A 2.4 12.9 1.4 6.5 69% 99% 9% 13% 4.8 26.8 1.4 6.5 0% 0%

Industrial 2.6 11.8 1.3 6.2 107% 91% -11% -9% 7.3 31.3 1.1 4.9 -14% -21%

A-share banks 2.3 12.6 1.3 6.4 75% 96% 6% 12% 4.8 28.6 1.3 6.3 -2% -2%

Historical Current (13 July) Hisotical Peak Historical Trough Downside to trough% upside to mean upside (downside) to -1 stdv


28



many overseas investors have limited understanding on China in general and have relied on some sensational media report as their information source.

Having said that, we believe in the near term stocks may only trade in a range-bound pattern. Since future can not be proven until time proves it, sentiment can hardly improve when there is uncertainty in the economy, and some share overhang specifically in a few stocks will linger in the next few months. We also see no positive catalyst that can boost sentiment on the sector in the short-term. Meanwhile, global financial markets may also remain volatile in view of the adverse development in some European countries’ government debt issues. While the problems are mainly in Developed Markets indeed, emerging markets may still be hit equally or even more as more funds may flow back to developed countries. Clearly from top down perspective, investors naturally are cautious. On the other hand, we see strong downside support from already very low valuation metrics and good dividend yields in bigger banks.

We still look for 20-30% upside to be achieved likely in late 3Q11 or early 4Q11. We believe as the CPI trends down likely toward the end of 3Q10, and with still fairly strong 1H11 profit numbers, we believe sentiment may improve modestly.

From a 6-12M perspective, we reiterate our view that within H-shares we generallyprefer some medium-sized banks with larger PB/ROE mismatch. At current levels, these include Minsheng-H, Citic-H and BoComm-H at current levels. Having said that, we acknowledge high level of risk aversion among equity investors. We thus recommend balancing portfolios with some exposure to larger state banks which have stronger balance sheets and higher operating profitability to withstand extreme economic downturn. We recommend ICBC-H. With stocks trading down to almost 1x 12M forward PB,we think BOC-H is a deep value holding in the longer term, although we think in the short term it still may not outperform peers given a less attractive NIM outlook until the US enters rate hike cycle. While CCB-H, ABC-H and CMB-H may still deliver a very solid operating performance, share overhang may limit the share price performance in the short term.

Figure 23: 11E PB vs. 11E ROE charts

Source: J.P. Morgan estimates, Bloomberg. Valuations as of market close prices on 13 July 2011.

BOC-A

BoComm-A

CCB-AHuaxia Minsheng-ASPDB

SZDB ICBC-A

Citic-ABOC-H

BoComm-H

CCB-H

ICBC-H

Citic-H

Minsheng-H

CMB-H

CMB-A

ABC-H

Industrial-A

0.80

1.00

1.20

1.40

1.60

1.80

2.00

2.20

16.0% 18.0% 20.0% 22.0% 24.0%

11E

PB

11E ROE


29



Companies Recommended in This Report (all prices in this report as of market close on 14 July 2011)Agricultural Bank of China - H (1288.HK/HK$3.96/Neutral), Bank of China - H (3988.HK/HK$3.55/Neutral), China Citic Bank - H Share (0998.HK/HK$4.58/Overweight), China Construction Bank (0939.HK/HK$6.03/Overweight), China Merchants Bank - H (3968.HK/HK$18.04/Neutral), China Minsheng Banking - H (1988.HK/HK$7.07/Overweight), Industrial and Commercial Bank of China - H (1398.HK/HK$5.64/Overweight)

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Coverage Universe: Chen, Samuel: Agricultural Bank of China - H (1288.HK), Bank of China - A (601988.SS), Bank of China - H (3988.HK), Bank of Communications Co (3328.HK), China Citic Bank - H Share (0998.HK), China Construction Bank (0939.HK), China Merchants Bank - H (3968.HK), China Merchants Bank Co., Ltd - A (600036.SS), China Minsheng Banking - A (600016.SS), China Minsheng Banking - H (1988.HK), Industrial and Commercial Bank of China - A (601398.SS), Industrial and Commercial Bank of China - H (1398.HK), Noah Holdings Ltd (NOAH)

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Country and Region Specific Disclosures U.K. and European Economic Area (EEA): Unless specified to the contrary, issued and approved for distribution in the U.K. and the EEA by JPMSL. Investment research issued by JPMSL has been prepared in accordance with JPMSL's policies for managing conflicts of interest arising as a result of publication and distribution of investment research. Many European regulators require a firm to establish, implement and maintain such a policy. This report has been issued in the U.K. only to persons of a kind described in Article 19 (5), 38, 47 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (all such persons being referred to as "relevant persons"). This document must not be acted on or relied on by persons who are not relevant persons. Any investment or investment activity to which this document relates is only available to relevant persons and will be engaged in only with relevant persons. In other EEA countries, the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction. Australia: This material is issued and distributed by JPMSAL in Australia to "wholesale clients" only. JPMSAL does not issue or distribute this material to "retail clients". The recipient of this material must not distribute it to any third party or outside Australia without the prior written consent of JPMSAL. For the purposes of this paragraph the terms "wholesale client" and "retail client" have the meanings given to them in section 761G ofthe Corporations Act 2001. Germany: This material is distributed in Germany by J.P. Morgan Securities Ltd., Frankfurt Branch and J.P.Morgan Chase Bank, N.A., Frankfurt Branch which are regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht. Hong Kong: The 1% ownership disclosure as of the previous month end satisfies the requirements under Paragraph 16.5(a) of the Hong Kong Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission. (For research published within the first ten days of the month, the disclosure may be based on the month end data from two months prior.) J.P. Morgan Broking (Hong Kong) Limited is the liquidity provider/market maker for derivative warrants, callable bull bear contracts and stock options listed on the Stock Exchange of Hong Kong Limited. An updated list can be found on HKEx website: http://www.hkex.com.hk. Japan: There is a risk that a loss may occur due to a change in the price of the shares in the case of share trading, and that a loss may occur due to the exchange rate in the case of foreign share trading. In the case of share trading, JPMorgan Securities Japan Co., Ltd., will be receiving a brokerage fee and consumption tax (shouhizei) calculated by multiplying the executed price by the commission rate which was individually agreed between JPMorgan Securities Japan Co., Ltd., and the customer in advance. Financial Instruments Firms: JPMorgan Securities Japan Co., Ltd., Kanto Local Finance Bureau (kinsho) No. 82 Participating Association / Japan Securities Dealers Association, The Financial Futures Association of Japan. Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul Branch. Singapore: JPMSS and/or its affiliates may have a holding in any of the securities discussed in this report; for securities where the holding is 1% or greater, the specific holding is disclosed in the Important Disclosures section above. India: For private circulation only, not for sale. Pakistan: For private circulation only, not for sale. New Zealand: This material is issued and distributed by JPMSAL in New Zealand only to persons whose principal business is the investment of money or who, in the course of and for the purposes of their business, habitually invest money. JPMSAL does not issue or distribute this material to members of "the public" as determined in accordance with section 3 of the Securities Act 1978. The recipient of this material must not distribute it to any third party or outside New Zealand without the prior written consent of JPMSAL. Canada: The information contained herein is not, and under no circumstances is to be construed as, a prospectus, an advertisement, a public offering, an offer to sell securities described herein, or solicitation of an offer to buy securities described herein, in Canada or any province or territory thereof. Any offer or sale of the securities described herein in Canada will be made only under an exemption from the


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requirements to file a prospectus with the relevant Canadian securities regulators and only by a dealer properly registered under applicable securities laws or, alternatively, pursuant to an exemption from the dealer registration requirement in the relevant province or territory of Canada in which such offer or sale is made. The information contained herein is under no circumstances to be construed as investment advice in any province or territory of Canada and is not tailored to the needs of the recipient. To the extent that the information contained herein references securities of an issuer incorporated, formed or created under the laws of Canada or a province or territory of Canada, any trades in such securities must be conducted through a dealer registered in Canada. No securities commission or similar regulatory authority in Canada has reviewed or in any way passed judgment upon these materials, the information contained herein or the merits of the securities described herein, and any representation to the contrary is an offence. Dubai: This report has been issued to persons regarded as professional clients as defined under the DFSA rules.

General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMS and/or its affiliates and the analyst's involvement with the issuer that is the subject of the research. All pricing is as of the close of market for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMS distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise.

"Other Disclosures" last revised June 13, 2011.

Copyright 2011 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan. #$J&098$#*P


60756520 JP Morgan China Banks

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