Citi - Asian Credit Outlook 2012

Citigroup Global Markets Asia Limited Fixed Income Credit Analysis • Credit Sector Specialists

December 15, 2011

Asian Credit Outlook 2012 Wake-Up Call from the West

For specific trade ideas associated with this sector review, please contact: Asian Credit Overall - [email protected] Banks – [email protected] Investment-Grade Corporates – [email protected]; [email protected] High-Yield China – [email protected] High-Yield Indonesia – [email protected]

Themes Headwinds from Europe will intensify

Beyond the Europe question, growth is an issue

In Asia, Chinese property the biggest “risk from within”: a hard landing

We expect policy to be effective: timing the cycle a central theme

Conditions will deteriorate further before policy action is initiated

Asian credit spreads are cheap to fundamentals

Asian corporates offer value versus the US in high-grade, while banks offer little value versus DM peers

Supply pipeline will shift to Greater China high-grade and banks

Recommendations Stay in high-grade quasi-sovereign power and energy credits for now

Within IG, avoid real estate, autos, steel, as well as banks in India and China

Avoid distressed and short-dated illiquids except in most-own sectors

Tactical shift into high-yield over next six months

Within high-yield, thermal coal is a must-own and power is defensive

Within China high-yield, prefer cement, selective in property, avoid forestry, pipes and steel sectors

Asia Credit Sector Specialists

Citigroup Sales and Trading

December 15, 2011 Asian Credit Outlook 2012

Citigroup Global Markets Asia Limited Fixed Income Credit Analysis • Credit Sector Specialists 2

Contents

Asian Credit Outlook 2012 ............................................................................................................................4 Wake Up Call from the West....................................................................................................................... 4 Asia: Landing the Blimp ............................................................................................................................... 4 Putting it all together: Outlook and Investment Strategy ........................................................................ 5 Fundamentals................................................................................................................................................ 7

Binary risk against a backdrop of declining growth........................................................................... 7 Polarization over China: a shock from within?................................................................................... 8 Banking system: liquidity and asset quality ........................................................................................ 9 Corporate earnings and leverage ...................................................................................................... 10 Ratings and default risk: how cheap are we relative to fundamentals?....................................... 10

Technical Picture ........................................................................................................................................ 11 How contagious is Europe’s cold?..................................................................................................... 11 Opportunity of the decade: Issuers will make concessions ........................................................... 12 Logjam in the pipeline? ....................................................................................................................... 12

Banks ................................................................................................................................................................14 At the Mercy of their Global Peers ........................................................................................................... 14 Asian bank themes for 2012: .................................................................................................................... 15 Theme #1: Global trends to be the main driver of Asian bank bond performance ........................... 16 Theme #2: Disequilibrium between supply and demand dynamics .................................................... 19 Theme #3: The paradigm shift – a change in prevailing market practices ........................................ 21 Theme #4: Fundamentals to remain stable with a bias towards deterioration .................................. 23

Investment-Grade Corporates....................................................................................................................27 Investment Strategy.................................................................................................................................... 27 Leverage and Fundamentals .................................................................................................................... 27

Country-level analysis: high-grade looks in good shape................................................................ 27 Leverage versus margins.................................................................................................................... 28

Market structure and technicals................................................................................................................ 29 Chinese quasi-sovereigns join the fray ............................................................................................. 29 Record year of high-grade corporate issuance lies ahead ............................................................ 29

Valuations .................................................................................................................................................... 31 Relative value within Asia: spot the difference ................................................................................ 31 Credit Curves in Asia ........................................................................................................................... 31 Finding value: comparison with US investment-grade ................................................................... 32

Focus on Fundamentals: Hong Kong Property approaches the tipping point................................... 33 Macro fundamentals: tied to China.................................................................................................... 33 Tipping point in Hong Kong property? .............................................................................................. 33 Supply-side mechanics: policy risk for developers ......................................................................... 35 Demand-side mechanics: the role of Chinese buyers .................................................................... 36

High-Yield – China.........................................................................................................................................38 Overview ...................................................................................................................................................... 38

Supply forecast ..................................................................................................................................... 38 Chinese Property – Variation .................................................................................................................... 38



Chapter 1: A long and cold winter...................................................................................................... 39 Chapter 2: If winter comes, can spring be far behind?................................................................... 42 Chapter 3: Battle for survival: heralding of a new world order? .................................................... 43

China industrials.......................................................................................................................................... 44 Fundamentals remain acceptable...................................................................................................... 44 Corporate governance: textbook versus reality ............................................................................... 46

High-Yield – Indonesia .................................................................................................................................47 Market Performance and Investment Strategy....................................................................................... 47 Growth trajectory barely dented ............................................................................................................... 47 Supply: Another lean year ahead ............................................................................................................. 48 Liquidity and Fundamentals ...................................................................................................................... 49



Asian Credit Outlook 2012

Wake Up Call from the West From early ‘2009 to early ‘2011, markets were in an unrelenting rebound with only the occasional stinging reminder of the paralyzing catastrophe that had occurred a year earlier. In ‘2011, the message received was that ‘2008 really happened: it was not a dream, and there is no silver- bullet in the firing chamber. Complacent markets were battered as growth expectations in the developed world went into free-fall and Europe’s plans to defer its leverage crisis backfired spectacularly.

No doubt there are many lessons yet to be learnt, but when all is said and done the following three will surely appear on the list: (1) Quantitative easing is not an effective remedy for a choking case of leverage, only a temporary anesthetic, (2) Without a properly-functioning transmission of credit into the economy the diversion of excess liquidity into financial assets and commodities will turn the anesthetic rather poisonous, in the absence of wage growth or job creation, and (3) austerity does not work, since it weakens repayment capacity and is not a substitute for structural reforms that will take years to implement effectively. Yet these seem precisely the sorts of policy prescriptions that are now being reinforced in Europe. Further, the undercurrent of resentment both in the core (against fiscal transfers) and in the periphery’s “beneficiaries” (against austerity) is an existential threat to the union which so far has been reflected in social outcry and a rightward shift in the political landscape. Our economists’ and strategists’ base case does not include a disorderly set of defaults and break-up of the Euro-zone, but the risk of these events occurring can no longer be ignored.

With Europe taking centre stage, it is difficult to feel optimistic about prospects in the first half of next year except perhaps to the extent that fixed income will benefit from the rate environment. Markets were far too late to price in the extent to which national politics, and not collective action, would drive the sequence of events in Europe as our Global Macro and Credit Strategy teams had warned at the beginning of the year. With the scale of the problem now better-dimensioned and a greater sense of urgency among policy-makers, one might expect tail risk in funding markets to diminish. Focusing on this narrow aspect risks missing the greater picture, since beyond the binary question of whether Europe can avoid a meltdown, what emerges is a grim picture of developed-world growth. The ramifications for Asia will probably become clearer in the months ahead, but the massive downward swing in ‘2012 growth projections during the course of this year shows the genuine academic challenges in anticipating the growth implications of one of the broadest-based slowdowns we have encountered. Put simply, this downward set of adjustments has already wiped almost US$700bn off G3 economic growth expectations for ‘2012 since the beginning of this year and may not be at the point of reversal quite yet.

Asia: Landing the Blimp This leaves Asian credit in a precarious position since Asia-ex-Japan’s fundamentals, while substantially better than the developed world, do have their own vulnerabilities. First, the good news: sovereign fundamentals and fiscal flexibility are strong, external vulnerability is lower than in 2008, banking sector leverage is manageable with credit penetration still low in many countries, and corporate credit is fairly solid throughout high-grade and even in most of high-yield barring some very real shareholder issues. The bad news is the more sanguine growth outlook for Asia is contingent on assumptions about China’s ability to avoid a hard landing. Can China manage the transition to a lower-growth trajectory at a time when policy flexibility is limited on the monetary front by simmering inflationary pressures? According to our economists, the larger risks to China’s economy come from within, with the largest by far being that of a retrenchment in property investment. This is central to



outlook for Asian corporate credit, since unless a freefall in property prices is avoided, China’s ability to avoid a hard landing will be compromised and this will have implications across Asia. Not only is property over one-quarter of GDP, it is also a principal store of personal wealth (accounting for 65%), and is intertwined both with asset quality in the banking system and local government revenues. So the key question is as property prices decline more sharply, will the government’s inevitable policy response (presumably in removing the home purchase restrictions among other property-specific measures) actually stimulate transaction volume? Could we go into a freefall scenario of cataclysmic proportions?

We think not. Essentially, we continue to believe that given nominal wage growth is expected by our economists to average nearly 12% over the next two years amid lack of alternative investment channels, property will remain a principal store of value for the foreseeable future. This will be buttressed by longer-term end-user and upgrader demand from urbanization trends that still have further to run. Seeing rental yields of close to 1% is a concern further out but without a liberalization of cross-border investment channels or reversal of the savings rate, its difficult to see how this on its own can crater the property sector. The former would require a substantial reinforcement of vulnerabilities in the banking system as a prerequisite, and the latter won’t happen until the population has aged past a tipping that is some way off.

Putting it all together: Outlook and Investment Strategy We think ‘2012 will be another year of macro/beta dominating credit/alpha. While we will seek to trade momentum in benchmark names from week to week, our medium-term view from here on Asian credit spreads is negative. We have retraced much of the mid-year widening in vulnerable sectors such as banks and private sector cyclical and high-yield corporates. Where we go from here depends firstly on the evolving fate of the European Union and broader developed market growth story, and secondly on China-specific risks. If Europe is in for twelve months of weak commitments and even weaker growth, this may be a pathetic outcome but as long as tail risk in the financial system is contained this will be more or less in line with consensus. China on the other hand has created such polarization in investor sentiment that its fate should emerge as an equally significant driver at the margin. If it resolves its real estate issues this may restore confidence to China’s growth trajectory. What this means for spreads is we first go wider as Europe’s sovereign and banking crisis intensifies further and alarm bells in China’s property market begin to sound louder. As policy action is taken in China and begins to take effect, markets will recover provided that tail risk in Europe is contained. We are definitely wide to fundamentals and actual default risk, which means we will revisit these levels later in the year. The correct strategy is to lurk in high-grade for now, watch markets potentially weaken over the next 3-6 months, and then shift tactically into seemingly vulnerable high-yield and illiquid sectors. If past years are any guide, our full-year prognosis may well be telescoped into the six-months ahead.

In terms of US$-supply, we are expecting ‘2012 to come in at US$59.1bn across sovereigns, banks and corporates, but with a higher concentration of high-grade (68% including banks) versus high-yield (19%) because of (1) heavy refinancing requirements in the banking sector, (2) further issuance out of Greater China from Chinese quasi-sovereigns and refinancing from syndicated loan markets in Hong Kong, and (3) constraints in high-yield in the early part of the year. This compares with US$60.8bn in ‘2011 (55% banks and high-grade, 30% high-yield and 15% sovereigns).

We recommend core positioning in defensive high-grade sectors with good secondary market liquidity such as Korean and Chinese quasi-sovereigns. Given that funds flow will eventually follow the tilting of the global economy in Asia’s favour and cash positions are high, we don’t see supply pipeline in these fundamentally strong sectors as a huge technical concern. Private-sector corporates, especially



those in the steel, automotive and real estate sectors, will struggle as they offer limited value versus quasi-sovereigns. We are negative on banks given the global industry backdrop and downside risks in China. Another potential drag could come from Indian banks, which are grappling with a challenging environment amid slowing growth and structurally high inflation.

In high-yield, we think opportunities will come further out given near-term deterioration in Chinese property sector fundamentals and recommend remaining light or restricting positioning to must-own sectors such as Indonesian coal. Once we have observed not only a policy response but an early-stage stabilization in transaction volumes within Chinese property, this will confirm that a hard landing is to be avoided. If that happens, the rest of Asian corporate fundamentals will follow. The rest of high-yield looks in good shape given involvement of fiscally robust sovereigns in the power sector, and natural resources credits that are in better shape than ever. Investment-grade corporates are also well-positioned from a liquidity standpoint, and our estimates suggest fundamentals have only deteriorated slightly in ‘2011. We will increase risk positioning at that stage, subject to developments in Europe, and expect this tactical shift to occur some time in the second quarter.

The key pitfalls to avoid would include getting drawn in by short-term improvements in technicals as the macroeconomic backdrop goes through its usual oscillations. We recognize that investment strategy will need to more short-term in nature, but relative value trading must not be allowed to obscure inconsistencies in overall market valuations. In short, this is (again) not going to be a year for relative value trades. We also think short-dated, high-yielding or illiquid carry trades with refinancing risk should be avoided given technical risks to the downside, unless the industry fundamentals are so compelling that the possibility of funding availability drying up is remote. There is also a decent chance that liquidity pressure from the sizeable maturities in the syndicated loan markets (from which European banks will be withdrawing) will create a greater fear factor in high-yield and illiquids than in investment-grade. Finally, we expect the bar to be raised with respect to shareholder risk, cross-border recovery expectations and track record in the context of this year’s tumultuous reversal of fortunes in the newly emerged Chinese industrial space.



Fundamentals

Binary risk against a backdrop of declining growth On the surface, Asian economic fundamentals are expected by our economists1 to weaken going into ‘2012, but appear relatively healthy from the perspectives of system-wide leverage, external vulnerability and growth trajectory. However, central to this prognosis is an assumption that China is able to anchor the region by avoiding a hard landing, and its capacity to do so is partially constrained by limitations on policy flexibility and the risk of a domestic shock that could emanate from property sector investment. While a hard landing is not our base case, domestic pressures in China will probably be as dominant a driver of Asian credit performance as developed-world factors, since the outlook for China is still a source of polarized views, while the consensus is already very wide with regards developed-world weakness. This potentially makes Chinese property credit a much more of a leading indicator of regional credit performance than it has been before.

Leverage: Sovereign leverage is generally below 45% debt/GDP across most economies, including China, even after including local-government debt. Banking system leverage is also manageable with credit penetration at or below 120% everywhere except in Hong Kong, and well below 100% across much of South and South-East Asia.

Growth: As for growth, the significant reduction in G3 growth expectations through most of ‘2011 could well reverberate through the early part of next year, suggesting Asia’s growth trajectory may remain in flux. Overall, our economists are expecting slower growth with divergent trends within the region. While Singapore, Hong Kong and Taiwan are relatively more exposed to external demand, domestic factors are expected to be a larger factor in China, India and Indonesia, while fiscal policy support will partially cushion collateral damage in China, Korea, Malaysia, Philippines and Thailand.

Figure 1. Evolution of ‘2012F GDP growth for US, Europe & Japan Figure 2. Evolution of ‘2012F GDP growth for major AXJ* economies

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Source: CIRA Source: CIRA *Asia ex-Japan; Note: Indonesia: 6.3% (fr. 6.5% as of Jan-11)

Inflation & Policy Flexibility: As our economists point out, policy flexibility may be much more constrained in response to a growth shock this time around, despite the fact the external vulnerability has improved. The central point is that with the output gap either positive or modestly negative in the more vulnerable economies, core inflation will remain sticky. Furthermore, the outlook on commodity prices and capital flows is uncertain and most policy rates (or their proxies) are historically low both on a nominal and real basis, all of which indicates that there is limited room for easing. This concern appears manageable given the capacity for fiscal policy flexibility

1 See “Asia Macro and Strategy Outlook”, Johanna Chua & AP Economics Team, CIRA – 29 November 2011



particularly in China. Where we do see vulnerability and rating pressure is in India, where policy flexibility has been hamstrung by structurally high inflation against a backdrop of slowing growth.

Figure 3. Output Gap in Asian Economic Blocks Figure 4. FX Reserve coverage of short-term debt by remaining maturity

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Source: International Montery Fund, World Economic Outlook, Sep-2011 Source: International Montery Fund, World Economic Outlook, Sep-2011

External Vulnerability: Korea and Indonesia remain relatively more vulnerable within the region, particularly if European bank deleveraging has significant capital flow implications. However, the magnitude of vulnerability has reduced on account of stronger FX reserve coverage and, in Korea’s case, de-levering of the banking system. A related concern in ‘2008 was the scale of Korea’s contingent liabilities at the quasi-sovereign leverage, and from the perspective of refinancing risk in public markets we see limited public bond maturities out of the sector in ‘2012.

Polarization over China: a shock from within? While a divergence of views over Chinese property has been a common theme over the last few years, this year we saw a significant polarization in views at a macroeconomic level. Local government debt figures emerged and created concern about asset quality in the banking system, an aggressive tightening in liquidity created stress in the SME sector, and the scale of off balance-sheet lending was larger than anyone had anticipated. In addition, slowing transaction volumes in the property sector and evidence of liquidity stress in the vast ocean of small-scale property developers has intensified sector-specific concerns. These “sector-specific” concerns in the property sector are doubling up as the most significant risk at a macroeconomic level given :

1) Contribution: its sizeable contribution to the economy: estimated by our economists at 25.8% of GDP in 2010 including an 18% indirect contribution through investment,

2) Local Governments: its linkages into local government revenue generation, which it emerged has an estimated debt stock (i.e. local government debt) of Rmb10.7trn or 27% of GDP as of end-2010; taking aggregate sovereign debt/GDP to over 40%.

3) Asset Quality: its potential impact on asset quality in the banking system, given the above debt stock and concern that tight liquidity conditions are causing an acceleration in defaults in small and medium-sized corporates. Note that our economists believe that, “China cannot cut rates, and may need to hike deposit rates gradually (we expect 25bps in 2012F) to address financial stability risks from persistently negative real deposit rates”2.

2 See “Asia Macro and Strategy Outlook”, Johanna Chua & AP Economics Team, CIRA – 29 November 2011



With all this to worry about onshore and limited room for monetary easing, our economists note that China has greater vulnerability to a domestic shock than an external shock next year. However, it remains our house view that China avoids a hard landing by way of fiscal stimulus and property-specific policy relaxation, starting with an easing of home-purchase restrictions. On the fiscal side though, a key factor to watch will be whether fiscal stimulus again exacerbates concern about capital allocation imbalances that will backfire in the medium-term, either through the banking system (as we have already observed) or through the channeling of investment into unproductive assets.

In the property sector specifically (and therefore at the macroeconomic level as well), we are not taking the doomsday view as we do believe a relaxation in property-specific measures will be effective in stimulating demand. That is really the key question here. Firstly, urbanization and upgrading demand is a long-term driver of demand that essentially provides the baseload. Secondly, we doubt property investments, which account for 65% of personal wealth, will be supplanted as a principal store of value anytime soon. Certainly the factors needed to reverse its role as an key investment channel are not expect to materialize anytime soon, namely 1) a liberalization of cross-border investment channels or 2) a drawdown in aggregate savings due to demographic factors.

Banking system: liquidity and asset quality We expect Asian bank fundamentals to deteriorate in ‘2012 given pressures on domestic liquidity as funding requirements are diverted from offshore to local markets, and on asset quality given the rapid expansion of credit in recent years. Having said that, we aren’t expecting major deterioration in fundamentals except in India, where sovereign fundamentals look vulnerable and liquidity and asset quality stress in the banking system looks a major challenge from an operational standpoint.

The Chinese banking system will also remain a key focus for the reasons highlighted in the preceding section, with rapid credit growth both on- and off-balance sheet creating the potential for meaningful deterioration in asset quality. The resultant regulatory constraints will continue to manifest themselves in declining credit availability to the corporate sector, and thus we remain cognizant of second-order effects in the Chinese corporate sector as well. China stands out in Figure 6 below, which shows that it has among the higher credit penetration (i.e. system leverage) ratios in the region and yet is growing at the fastest pace. While this does not take account of holdings of real estate and other household/financial assets, it does underline the risks emanating from that sector.

Overall, liquidity metrics across Asian banking systems have weakened but are mostly at 70%-85% in terms of loan-to-deposit ratios (“LDR’s”). Korea remains above 100% but regulators are addressing this vulnerability through policy-directed shrinkage of LDR’s. Note that several banking systems have been upgraded due to higher sovereign support assumptions (at S&P) and this will probably support ratings across the region even in the face of some slippage in fundamentals, with the exception of countries with downside risks at the sovereign level (India and China).



Figure 5. Asian Banking System Liquidity: Loans/Deposits by Country Figure 6. Asian Banking Systems: Credit multipliers vs. credit penetration

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Source: CEIC, CIRA, Citi Source: CEIC, CIRA, Citi

Corporate earnings and leverage In investment-grade, we have analyzed the aggregated financial metrics of the bond issuer universe across the three key markets: Korea, Hong Kong and China. Credit quality across high-grade issuers appears relatively stable, although we are relatively more negative on the Hong Kong fundamentals given the concentration of property developers and trading companies. In high-yield, fundamentals appear strongest in Indonesia, where natural resource credits maintain robust cashflow coverage metrics and power sector names are supported by a sovereign on an upgrade trajectory. Chinese high-yield issuers are also in acceptable financial condition. Property developers are under greater liquidity stress, but given the bond issuer universe contains the largest and best-capitalized developers in the broader industry, with liquidity positions enhanced by large-scale capital raising in early ‘2010, we aren’t expecting major issues fundamentally. As for the industrial names, there is greater divergence in credit trends, with our views being most positive in cement, neutral in coking coal, and negative in forestry names, plastic pipes and steel/materials

Ratings and default risk: how cheap are we relative to fundamentals? The distribution of rating actions below (Figure 7, shown for Moody’s) appears to confirm that the pace of deterioration in fundamentals is not a major cause for concern at this stage. What’s more, Moody’s projection of an Asian high-yield default rate of under 2% in ‘2012 for Asia appears lower than current market levels imply. Based on our crude estimate of the market-implied 1-year default rate based on both a 40% and 60% rate of recovery, the market appears to be implying between an 8% and 12% rate of default in the high-yield sector. Thus we believe that spreads appear definitely cheap to fundamentals, but are being constrained by macro and technical factors (next section).



Figure 7. Asia* Rating Actions Distribution: Moody’s Investor Service Figure 8. Asian High-Yield: Market-implied3 versus actual default rates*

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Source: Moody’s Investor Service, Citi; *excludes Japan Source: Moody’s Investor Service, JPMorgan, Citi; *’11/’12 is Moody’s forecast

Technical Picture

How contagious is Europe’s cold? According to our equity research division4, European banks will likely withdraw from US$-denominated corporate and investment banking activities. Hong Kong and Singapore feature prominently in the list of countries most exposed to a potential pullback in European bank lending, with total claims on the non-bank private sector estimated at close to 100% and 45% of GDP respectively (see Figure 9). However, their analysis also shows that UK banks dominate Europe’s claims in Asia, and these banks are not expected to delever their balance sheets. With non-UK banks accounting for less than a fifth of foreign bank claims to Asia our equity analysts expect Japanese and Australian banks to step into gaps left by the withdrawal of European banks’ lending capacity, with room as well for regional banks notwithstanding modest liquidity pressures.

We have also attempted to estimate the total stock of US$-denominated syndicated loans to Asian corporates with any level of European participation (defined as excluding the UK). Figure 10 shows the figures, totaling nearly US$159bn (or US$256bn including other currencies), of which US$27bn is maturing next year. These figures are very large in the context of our issuance estimates for this year, suggesting upside risk to our estimates particularly in high-grade markets such as Singapore, Hong Kong and Korea. However, note that European lenders’ share of these syndicated transactions is not 100%, since the majority of these transactions are club deals, often with five or more lenders, and often with the European lenders in the minority. In addition, we may not see uniform deleveraging across all European banks, since there may be some variation in the extent of liquidity retrenchment from Swiss banks, versus German and French banks for example. We also agree with our equity analyst remarks about potential opportunities for competitors, since the total syndicated loan stock with European bank participation is not excessive either in relation to regional banking systems, or to Japanese or Australian banks should they intend to take up the slack.

3 Using a simplified methodology to estimate implied 1-year default rates, using (Credit Spread bps) = (1 – Recovery Rate %) x probability of default %

4 See “Half The World – Global Implications of European Bank Deleveraging”, Ronit Ghose, Ignacio Moreno et al. – 11 November 2011



Figure 9. European bank claims on Asian non-bank private sector Figure 10. Estimate of syndicated loans to Asian corporates with European

bank participation (excluding UK banks)

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Opportunity of the decade: Issuers will make concessions Against a developed-markets backdrop that is likely to sustain elevated levels of volatility, we expect issuers to take advantage of intermittent periods of market stability in the early months of the year. As shown in Figure 11, while spreads may not necessarily be any lower than they were pre-crisis, record low U.S. Treasury yields have brought absolute yields in Asian high-grade to their lowest levels in some time. The potential for high-grade issuers to make new issue concessions without significantly impacting funding costs may constrain secondary market performance and exacerbate volatility. We also expect the trend towards longer-dated issuance to continue (see Figure 12), and this could well reverse the inversion of the 5s10s Asian credit curve as supply in the 10-year sector increases to meet long-term demand from regional real-money.

Figure 11. JACI Index Weighted Average Yield (%) and Spread (bps) Figure 12. JACI Index Weighted Average Duration (Years)

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Logjam in the pipeline? Issuance reached US$60.8bn in ‘2011, consistent with our forecast of US$61.0bn at the beginning of the year but with significant underestimation of high-yield supply made up for less-than-expected issuance in the banks and sovereign space. This represented a decline of 13.3% yoy in overall issuance, with the sharpest overall decline coming in the banks space (down 34.7% yoy). Volatility clearly kept investors on the sidelines in the second half of the year, which accounted for only 25.9% of full-year issuance (and just 6.6% for the high-yield segment). We expect that continued market



volatility against a weakening growth backdrop will prevent a repeat of the unfettered deployment into high-yield that we saw in early 2010, therefore our gross issuance estimate for ‘2012 anticipates a marked shift towards investment-grade, declining overall by 2.7% yoy to US$59.1bn (see Figure 13).

The majority of this decline is coming from high-yield (US$11.0bn from US$18.2bn), which we expect will struggle given increased focus on structural and cross-border subordination concerns given the series of defaults in the newly-emerged Chinese industrial space. Chinese industrials, or more accurately non-property issuers, accounted for about one-third of the US$21.4bn in Chinese high-yield issuance over the last two years. The hurdle for similar issuers with a limited track record has been raised considerably. Bouts of favourable technicals do open the door to higher-risk sectors, but even if this opportunity arises we think the bad memories of ‘2011 may take longer than usual to fade away. In addition, there will be less refinancing issuance from major high-yield quasi-sovereigns.

In high-grade, we expect US$23.0bn in corporate and US$17.5bn in bank issuance. On the corporate side, overall refinancing requirements seem unusually low at sub-US$10bn this year. This appears to be a function of very low high-grade corporate issuance back in 2007 (just US$3.1bn), as that year’s issuance was completely dominated by banks (accounting for 59.1%). Chinese quasi-sovereigns (US$10.0bn) will be a major factor and we suspect the transactions will be sizeable. The other major sector will be Hong Kong, which we estimate at US$8.0bn. This incorporates some front-loading of ‘2013 maturities and refinancing demand from syndicated loans maturing in ‘2012, which we estimate at around US$6bn based on available data. Banks will find ‘2012 tricky given the heavy US$17.2bn in refinancing requirements (US$8.8bn in Korea and US$3.2bn in India). In fact, for banks, we expect next year to see the highest level of US$-bond maturities until ‘2016 as shown below in Figure 14.

Figure 13. Asian US$-issuance with ‘2012 Forecast Figure 14. Asian US$- bonds: maturity profile*

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chart in order (from bottom): Sovereigns, Banks, IG Corp and HY Corp

Source: Dealogic, Bloomberg, Citi; *excl. privates, domestics & corporate FRN’s

Note: Bank sub-debts and capital securities shown by initial call date



Banks

At the Mercy of their Global Peers Given the fragile state of the global banking system with European sovereign and banking system problems at the forefront of concern, Asian banks will not decouple and are at the mercy of their global peers. Asian bank spreads widened along with the global banking sector in 2H11 as European concerns escalated, with Citi’s ABBI Financials index widening up to 211bp. Currently, the index has retraced 22% of October’s wide levels to finish the year around 166bp wider, while single name cash bonds and CDS have retracted around 40-45%. However, despite this spread widening, Asian bank spreads remained rich relative to US and European peers throughout the year. Citi’s base case is that there will not be a disorderly default of a European sovereign and it is unlikely that there will be a breakup of the Euro Area. However, the probability of these scenarios materializing is no longer nil, and our European economist expects the European sovereign and banking crisis to intensify even further in 2012. Additionally, while domestic fundamentals are stable reflected by current ratings and spreads, fundamentals in select countries, such as India and China, will continue to deteriorate. Given that the European banking crisis is expected to intensify further coupled with fundamental deterioration in select Asian banking systems and a sizeable new issue pipeline, we remain cautious on Asian bank spreads through at least 1H12. Asian bank themes for 2012 include: 1) global trends to be the main driver of Asian bank bond performance; 2) disequilibrium between supply and demand dynamics; 3) the paradigm shift - a change in prevailing market practices; and 4) fundamentals to remain stable with a bias towards deterioration.

Figure 15. Asian Banks – ABBI Financials Index (OAS, bp) Figure 16. Asian Banks – Spread Retracement Analysis

200

250

300

350

400

450

500

3-Jan 3-Mar 3-May 3-Jul 3-Sep 3-Nov

166bp wider yoy

Instrument

Beg Aug

Beg Oct

Beg Dec

Beg Oct - Beg Aug

Beg Dec - Beg Oct

% Retrace-ment

IndiciesAsia iTraxx 115 266 197 151 (69) 46%Europe Senior Financials 185 304 267 119 (37) 31%Europe Sub Financials 309 550 477 241 (73) 30%Citi ABBI Financials 283 479 435 196 (44) 22%Cash Bonds (Bid I-spread)

INDKOR 4.375% 2015 144 324 193 180 (131) 73%WOORIB 4.750% 2016 186 437 267 251 (170) 68%SHNHAN 4.375% 2015 168 435 265 267 (170) 64%BBLTB 3.250% 2015 161 385 247 224 (138) 62%WOORIB 6.208% 2037 500 734 594 234 (140) 60%CITNAT 3.625% 2017 175 363 255 188 (108) 58%WOORIB 5.875% 2021 257 507 368 250 (139) 56%NACF 3.500% 2017 185 361 269 176 (92) 52%ICBCAS 5.125% 2020 210 335 283 125 (52) 41%BCHINA 5.550% 2020 235 385 325 150 (60) 40%CINDBK 6.875% 2020 328 565 475 237 (91) 38%KDB 3.250% 2016 142 305 245 163 (60) 37%BNKEA 6.125% 2020 264 480 404 216 (76) 35%DAHSIN 6.625% 2020 280 485 420 205 (65) 32%SBIIN 4.500% 2015 223 441 384 218 (57) 26%ICICI 5.000% 2016 279 485 456 206 (29) 14%ICICI 5.750% 2020 277 485 469 208 (16) 8%CDS (5-year)

Shinhan 140 281 192 141 (90) 63%KDB 113 270 182 157 (88) 56%Bank of China 152 343 256 191 (87) 46%ICICI 238 499 398 261 (101) 39%SBI 189 397 327 208 (70) 34%DBS (sub) 86 140 130 54 (10) 19%

Source: Citi, Yieldbook, As of December 5, 2011 Source: Citi, Bloomberg, As of December 5, 2011



Asian bank themes for 2012: Global trends to be the main driver of Asian bank bond performance: Asian banks trade rich

relative to global peers and will not decouple. The three main global banking system trends that will impact Asian banks include: 1) bank funding stress will remain high, and European balance sheet retrenchment will create funding problems in Asia; 2) the global economic outlook remains challenging particularly for the US and Europe, as well as Asian countries such as China and India; and 3) the technical landscape - balance sheet retrenchment will also impact primary and secondary markets.

Figure 17. Asian Banks – Global 5-year senior cash bond relative value (Rating vs. Mid Z-spread, bp)

KDB 17

ICICI 16

SHNHAN 16

SBIIN 15

BOBIN 16

AXSBIN 16

SCBTB 16BCHINA 16 HLBKMK 16

WOORIB 16GS 16

MS 16BAC 16

JPM 16WFC 16

CBAAU 16NAB 16

BACR 16

LLOYDS 16

STANLN 16

RBS 16

BNP 16

SOCGEN 16

ACAFP 15

BNS 16

HSBC 16

SUMIBK 16

CS 16

UBS 17

MQGAU 17

NOMURA 16

ISPIM 15

SANTAN 16

DANBNK 16

RABOBK 15

INTNED 16

-

100

200

300

400

500

600

700

800

900

Mid Z-Spread (bp)

Aa3/AA- A3/A-

Source: Citi, Bloomberg, Moody’s, S&P, As of December 6, 2011

Disequilibrium between supply and demand dynamics: Asian banks issued US$15.5bn in 2011 versus US$23.9bn in 2010 and US$14.4bn in 2009. Given that Asian banks have US$17.2bn of debt maturing in 2012, we expect 2012 issuance to be US$17-18bn. Most of the issuance will be out of Korea and in the form of 5 and 10-year senior bonds with a few capital security issuances. New-style securities in the US$ market, including loss-absorbing Tier2s, are more likely to come in the later part of 2H12, if at all.

The paradigm shift - a change in prevailing market practices: We are currently living in a new world where covered bonds are the new senior bonds, senior bonds can face losses, Tier2s are the new Tier1s, and exchanging old-style capital securities instead of calling them on the initial call date is starting to become prevailing market practice. We do not expect European exchange offers to negatively impact Asian capital securities in 2012, and we expect all Asian banks to call their capital securities next year. However, Asian banks, particularly in India, may eventually adopt these market practices. Therefore, it is critical that investors are aware of where they are on the new capital structure and how much they should be paid for this risk.

Fundamentals to remain stable with a bias towards deterioration: Asian bank fundamentals remain solid relative to global peers, which is reflected by Asian bank spreads and ratings. However, Asian banks began to see some fundamental deterioration during 2011, and we believe that this trend will continue in 2012 in light of a challenging global macro outlook. While most banks will maintain their current ratings, which are supported by strong government and group support, we expect that some countries, such as India, will experience downward rating pressure.



Theme #1: Global trends to be the main driver of Asian bank bond performance The three main global banking system trends that will impact Asian banks include: 1) bank funding stress will remain high, and European balance sheet retrenchment will create funding problems in Asia; 2) the global economic outlook remains challenging particularly for the US and Europe, as well as Asian countries such as China and India; and 3) the technical landscape – European balance sheet retrenchment will also impact primary and secondary markets.

1. Bank funding stress will remain high, and European balance sheet retrenchment will create funding problems in Asia. Bank funding stress is high as the Euribor – OIS 3 month spread, the measure of interbank funding versus the risk-free rate, is currently around 1% and is on the rise. Citi’s European economist is forecasting the EU sovereign debt and banking crisis to further intensity in 2012, therefore, we believe funding stress will continue throughout 2012 and will put pressure on the global banking system.

Figure 18. Asian Banks – Euribor-OIS and Libor-OIS Spreads (%) Figure 19. Asian Banks – European and US Foreign Claims

-

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11

Euribor - OIS

Libor - OIS

%

-

50

100

150

200

250

300

350

400

PH TH ID MY IN SG KR CH HK

0%

20%

40%

60%

80%

100%

120%

140%

160%Total EU Bank Exposure (US$bn)

Total US Bank Exposure (US$bn)

Total EU Expsoure (as a % of 2011F GDP)

Total US Exposure (as a % of 2011F GDP)

Source: Citi, Bloomberg, As of December 10, 2011 Source: Citi, BIS; Data represents the consolidated EU & US bank foreign claims

On the positive side, Asian banks have limited direct exposure to Europe, particularly to countries of concern. European claims account for less than 6% of total assets in Hong Kong and less than 1% of total assets in China and Korea. Indian banks do not have any significant exposures, and only ICICI has $5.1bn of assets in the UK. In Singapore, both DBS and UOB have around S$2.1bn of EU exposure with no exposure to the peripherals. On the other hand, however, Western European banks account for 49% of global banking assets, European banks deploy about one-third of their balance-sheets outside of Europe, and select European banks are pulling out of non-core markets, therefore, Asian banks will be negatively impacted by European balance sheet deleveraging. According to the BIS, consolidated European banking claims or European bank claims on the non-bank private sector (as a % of GDP) is the highest in Hong Kong, followed by Singapore and Malaysia. However, this is somewhat mitigated by the fact that the majority of European exposure comes from UK banks, including HSBC and Standard Chartered, while French and German banks make up the majority of the remainder. In the recent BIS Quarterly Review, the BIS highlighted that “Asia-Pacific is the emerging market region most vulnerable to sudden capital withdrawals through the banking system.” To come to this conclusion, the BIS analyzes four main areas including: 1) short-term international claims relative to total international lending measures, 2) the share of cross-border lending in total foreign lending, 3) the proportion of cross-border claims held in the form of tradable debt



securities, and 4) foreign bank participation rate. Asia-Pacific appears the region most exposed to sudden withdrawals since 63% of all international claims have a maturity of less than one year and cross-border claims represent 52% of all foreign lending to the area. Points three and four are less of a concern in Asia. Additionally, European banks have been active in the syndicated loan market particularly in shipping and trade finance as well as general corporate lending. A pull back in this market would negatively impact Asian credit as it would translate into lower credit availability, pressure on growth, pressure on the Asian banks to step-up and fill the void, and potentially put pressure on asset quality. However, select regional Asian banks may be able to fill the void and gain market share on the back of this deleveraging.

Figure 20. Asian Banks – Nationality of EU banking claims Figure 21. Asian Banks – GDP Growth and Forecasts (%, yoy)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

PH SG ID KR IN CH TW TH MY HK

UK Banks German Banks Dutch BanksFrench Banks Swiss Banks Other EU Banks

3.0%4.0%

8.4%

7.0%

3.0%4.0%

5.0%

3.5%

6.3%

3.7%

0%

2%

4%

6%

8%

10%

12%

14%

16%

SG TW CH IN TH PH MY HK ID KR

2010 (%, yoy)

2011E (%, yoy)

2012E (%, yoy)

Source: BIS, CIRA Source: Citi, CEIC, CIRA

2. The global economic outlook remains challenging particularly for the US and Europe, as

well as Asian countries such as China and India. Citi’s European economist is expecting the European crisis to intensify further, requiring more substantial ECB involvement to prevent multiple sovereign defaults. Citi believes EU GDP will contract to 1.2% in 2012 and drop to 1.0% in 2013. China is also a critical factor within Asia and while Citi’s economist forecasts FY12 GDP of 8.4%, a sharper than expected decline is a major risk. This challenging economic outlook will weigh on Asian bank earnings.

In addition, US-dollar trade finance lending is an area of concern, particularly since Hong Kong and Singapore banks have been active in this lending segment, which has driven up funding costs and FC LDRs. In Hong Kong, foreign currency loans now make up over one-half of overall credit growth. Using the IMF’s Global Integrated Monetary and Fiscal model, the IMF estimated that financial and trade spill over effects from a crisis in Europe, could put downward pressure on Hong Kong causing GDP to decline 4-4½ percentage points and Hong Kong to fall back into a recession. While intra-Asian trade is not as much of a concern, Hong Kong trade activity remains skewed towards China, Europe, US and Japan. On the back of the bleak growth outlook, trade with these countries will inevitably slow first leading to lower bank profitability, however, could translate into liquidity and asset quality problems.



Figure 22. Asian Banks – HK Bank LC and FC Trade Finance Lending Figure 23. Asian Banks – Contribution to HK Bank Credit Growth (%, yoy)

25

45

65

85

105

125

145

165

185

205

225

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

HK Trade Finance (HK$)

HK Trade Finance (Foreign Currency)

HK$bn

Source: Citi, CEIC, CIRA Source: IMF

3. The technical landscape – European balance sheet retrenchment will also impact primary and secondary markets. The foreign capital inflow into Asia back in 2008 was caused by quantitative easing, and in turn, a weak US$. However, now that risk aversion has heightened, the US-dollar is appreciating, and Asian BOP surpluses will decline, it will be tougher to attract international capital into Asia. Emerging markets were adversely affected in August and September 2011, with investors withdrawing US$25bn from EM funds, according to the BIS.

Global investors have historically played a critical role in Asian bank primary markets. We’ve analyzed Citi led global benchmark 5 and 5½ year fixed rate senior bond deals issued from 2007-2011 out of well-known credits including the Korean policy and commercial banks and Indian banks such as SBI and ICICI. These stringent parameters only allow for a small data sample, but eliminates one-off factors that would cause investors to participate more or less than usual.

Our primary issuance findings include:

a. US participation: Back in 2007, US investors were the main participants in these Asian bank deals with allocations peaking around 60%, given the yield pick-up investors were receiving at that time for moving into Asia. However, as Asian bond yields became less attractive relative to global peers, US allocations subsequently declined to around 30%. Overall, there is an incentive for banks to give larger allocations to strong US accounts. However, from our findings, we believe that US allocations as a percentage of the total deal size are higher than US investors indicated interest as a percentage of the total order book.

b. Asian participation: While US investors have been pulling back from these deals, Asian investors have been filling the void. Asian investor allocations were just under 30% in 2007, however, allocations increased to 60-70% in 2011. Also, we believe that Asian investors interest in deals marginally exceeds current allocations.

c. European participation: In 2007, European investors were allocated around 20-30% of

Asian bank deals. European allocations subsequently declined to under 10% in 2010, and temporarily spiked before returning back around 10%. In light of the European situation, we expect participation to remain low at around 10% or even lower. Additionally, looking at participation of questionable European banks, the participation rate is already very low at this stage.



Figure 24. Asian Banks – Asia vs. US allocation in new Asian bank deals Figure 25. Asian Banks – European participation in new Asian bank deals

0%

10%

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30%

40%

50%

60%

70%

80%


US ALLOCATION

ASIA ALLOCATION

0%

5%

10%

15%

20%

25%

30%

35%


European banks (% of total deal)

EUROPE ALLOCATION

Source: Citi; Note: The sample includes 5 & 5½ year senior RegS/144A fixed rated bonds.

d. Conclusion: From our analysis we’ve concluded that: 1) US investor participation is declining and is unlikely to increase at this time, 2) Asian investors will continue to participate, but participation is already at all time highs and it is uncertain if Asian investors have the capacity to participate further, and 3) European interest is already low, and is expected to remain low or decrease even further. Therefore the question remains, who is going to fill the void if global investors retreat from Asia?

Our secondary market findings include:

Asian investor participation in Asian bank deals has not only increased in primary deals, but has also increased in the secondary market. Over time we’ve seen the main holders of Asian bank benchmark bonds switch hands from US investors back into Asia. Overall, global credit investors are retreating back to their home markets especially when its more economical to do so.

a. US and European investors are sticking with their core markets. In the secondary market, US bank bonds trade wider than similar-rated Asian peers. Therefore, US investors are happy sticking with their own banks, which are in better fundamental shape, albeit still stressed, post the GFC. Since problems are closer to home, European investors are comfortable holding covered and senior bonds of high-quality European banks, since yields are at least somewhat compensating investors for taking banking system risk. As a result, global investors are unlikely to meaningfully buy Asian bank bonds in the secondary market in the near-term.

b. Asian bank bonds have previously benefited from equity participation. During the GFC, equity investors were particularly interested in Tier1 capital securities that were offering equity like returns in the credit space. According to our equity colleagues, there is little equity interest in credit given the relatively lacklustre yields. If equity investors are crossing over into credit at all, they are putting their funds into US, not Asian, credit. Therefore, it is unlikely that we will find support from these cross-over players this time around.

Theme #2: Disequilibrium between supply and demand dynamics While demand for Asian bank bonds is a concern, the new issue supply pipeline remains large. In 2011, Asian banks issued US$15.5bn vs US$23.9bn in 2010 and US$14.4bn in 2009. Around 61% of issuance came in the first half, while capital markets periodically shut in 2H11. Korea was the most



active with issuance constituting 52% of total issuance compared to 39% last year given that stronger Korean banks were able to price deals in fragile markets and the FSC required banks to secure proper funding in advance. Indian bank issuance increased to 28% from 23% with multiple inaugural issues, while Hong Kong/China issuance declined to 13% from 24% and SE Asian issuance declined to 7% from 14%.

Figure 26. Asian Banks – Asian US$ Issuance and Forecast (US$bn) Figure 27. Asian Banks – Asian 2011 US$ Issuance By Country (%)

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2005 2006 2007 2008 2009 2010 2011 2012

0%

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20%

30%

40%

50%

60%

70%

80%Asian bank US$ issuance (US$bn)

Total Asian US$ issuance (US$bn)

Bank issuance (as a % of total issuance) 28%

2%

3%

2%

13%

52%

India South Korea MalaysiaThailand Philippines Hong Kong/

Source: Citi, Dealogic, Bloomberg Source: Citi, Dealogic, Bloomberg

We expect 2012 Asian bank issuance to be US$17-18bn. Asian banks have US$17.2bn dollar-bonds maturing next year due to the large amount of 5-year senior bonds and capital securities with 5-year calls issued back in 2007. We expect US$7-8bn from Korea since Korea has US$8.8bn maturing next year. Indian bank issuance will be US$4-4.5bn due to lower US$ funding costs compared to the domestic market, raising funds for offshore lending, and sizeable refinancing needs for ICICI. Issuance could be larger, but Indian banks are price sensitive and fundamentals are deteriorating, therefore, it may be challenging to price new deals. Hong Kong/Chinese bank issuance is expected to be around US$3bn as the banks will continue issuing senior bonds and/or LT2s and potentially re-tap recent deals. Southeast Asian issuance will come back with bond issues from countries including Singapore, Thailand and Malaysia.

Figure 28. Asian Banks – Asian US$ Debt Maturity Profile (US$bn) Figure 29. Asian Banks – Bank capital callable in 2012

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2012 2014 2016 2018 2020 2022 2024 2026 2028

Country

Amt Out

(US$m) Type Call Date Country

BUSAN 200 LT2 14‐Mar‐12 KR

BNKEA GBP300 UT2 21‐Mar‐12 HK

HANABK 500 LT2 12‐Apr‐12 KR

MAYMK 300 LT2 (FRN) 25‐Apr‐12 MY

NACF 500 LT2 26‐Apr‐12 KR

DBS 1,500 LT2 (FRN) 16‐May‐12 SG

DBS 500 LT2 16‐May‐12 SG

CINDBK 250 UT2 31‐May‐12 HK

PBKMK 400 LT2 20‐Jun‐12 MY

BNKEA 600 LT2 (FRN) 22‐Jun‐12 HK

HANSEN 300 LT2 6‐Jul‐12 HK

DAHSIN 150 LT2 18‐Aug‐12 HK

BUSAN 250 LT2 30‐Oct‐12 KR

CINDBK 250 LT2 12‐Dec‐12 HK

HANABK 200 Tier1 17‐Dec‐12 KR

Total 6,380 Source: Citi, Dealogic, Bloomberg; Deals under US$100m were excluded Source: Citi, Dealogic, Bloomberg



Most of the issuance will be 5 or 5½ year senior bonds, however, more banks will consider issuing 10-year bonds given the attractive funding cost. In 2011, KEXIM, KOFC, Bank of India and ICBC all issued 10-year senior bonds. Given the shortage of longer duration bonds and the regional demand for this paper, the 10-year sector continues to trade rich relative to the short-end of the curve. However, as new issuance continues to materialize, we expect the technicals to eventually unwind. Some regulators have been promoting the use of covered bonds instead of senior bonds, however, Asian issuers do not seem too keen on issuing covered bonds at this time.

Figure 30. Asian Banks – Cash bond curve (Modified Duration, years, versus Mid I-spread, bp)

EIBKOR 15EIBKOR 15 KDB 16

KDB 15

KDB 17

INDKOR 15 INDKOR 16

NACF 16 NACF 17

CITNAT 17SHNHAN 16

HANABK 15

HANABK 16 HANABK 17

ICICI 16

SBIIN 15

BOBIN 16

BOIIN 15

CANARA 16UNBKIN 16

IOBIN 16SNDBIN 16

AXSBIN 16

SBIIN 14

SCBTB 16

BCHINA 16

BBLTB 15HLBKMK 16

ICICI 20 BOIIN 21

ICBC 21

EIBKOR 21KOFCOR 21

DBSSP 15

100

200

300

400

500

2 3 4 5 6 7 8

Mid I -Spread (bp)

Modified Duration

Source: Citi, Bloomberg, Moody’s, S&P, As of December 6, 2011

Capital security issuance will be limited. Last year banks priced only US$1bn of Tier2s. Woori’s US$500m bullet LT2 replaced half of its US$1bn LT2 that was called in 2011, and Bank of East Asia received special HKMA approval to issue a LT2 with a call and coupon reset after 5½ years, since it has over US$1bn of Tier2s callable in 2012. Asian banks have around US$5.9bn of US$ securities with effective maturity dates in 2012, therefore, banks will continue to consider issuing older-style Tier2s even though they start amortizing in 2013. Nonetheless, issuance in this sector will be limited. Asian banks have also been considering US$ loss-absorbing LT2s for some time now, however, the funding costs have not made sense. Issuance in this sector is more likely to come in the later part of 2012, if at all. Select Asian banks will likely follow ICBC Asia’s lead and issue loss absorbing Tier2s in the CNH space given the attractive funding cost from the issuer’s perspective. We also expect non-Chinese Asian banks to issue senior bonds in the CNH space, and ICICI Bank has been exploring this option after IDBI Bank’s inaugural issue in the CNH market.

Theme #3: The paradigm shift – a change in prevailing market practices We are currently living in a new world where covered bonds are the new senior bonds, senior bonds can face losses, Tier2s are the new Tier1s, and exchanging old-style capital securities is starting to become the prevailing market practice. These new exchange offers out of Europe are monumental because they are being done by strong national champion banks for both regulatory and economic reasons at the expense of bondholders. Future call decisions will be made based on economic reasons for both newly-issued and currently outstanding instruments, therefore, these exchange offers are signaling that banks have changed their call strategy. Additionally, banks are taking advantage of weak market conditions for economic benefit. Given this change, investors must be aware of where they are on the new capital structure and how much they should be paid for this risk.



We do not expect these practices to negatively impact Asian bank capital in 2012, which includes both Bank of East Asia and DBS which have US$1-2bn callable, respectively. The main reasons for calling include: 1) most Asian banks have a small amount of capital securities outstanding; 2) Asian banks are well capitalized with high core Tier1 ratios; 3) Asia is adopting Basel III at a slower pace; 4) there is little economic incentive to exchange; 5) Asian banks are not looking at exchange offers at this time; and 6) Asian investors are not ready to accept these types of practices as witnessed by ICICI Bank UK's unsuccessful exchange offer this year and Woori Bank’s LT2 non-call following Deutsche Bank’s infamous LT2 non-call, which subsequently caused problems for the bank. However, Asian banks may eventually adopt these practices. As long as prevailing market practices continue to evolve in Europe, Asian banks will explore options along the same lines. Asian banks have already unsuccessfully attempted to follow Europe’s lead, and at some point, these attempts may become successful. Indian banks are the most likely candidates to adopt European market practices, since Indian banks tend to push the boundaries and funding costs are cheaper in the US$ market than in the local markets. Due to Basel III’s amortization schedule, European banks are tendering bullet Tier2s. Hong Kong banks were the most active in issuing bullet LT2s back in 2010, while select Thai banks such as Bangkok Bank and Kasikornbank also have bullet LT2s outstanding. Asian banks are unlikely to tender their bullet bonds in 2012 since: 1) most of these bonds still receive significant capital qualification; 2) the dollar prices are around par or higher, presenting little economic benefit to tender; and 3) given fragile markets, it is expensive to replace these securities and Asian banks like to maintain high capital ratios. Nevertheless, banks may tender these LT2s at some point in the future before maturity. Select investors are questioning if Basel III will go into effect as planned. We believe that Basel III’s capital requirements and amortization schedule will still go into effect in 2013. On the other hand, other parts of Basel III including liquidity requirements may get pushed back and/or amended, and recent headlines suggest that highly rated corporates may now be eligible for the bank’s liquidity portfolios. While Asian banks have been slow to act, they continue to make progress towards adopting Basel III. Surprisingly China already released a Basel III draft for public consultation and Singapore has announced capital requirements more onerous than Basel III. We expect to hear from other Asian regulators in 2012.

Figure 31. Asian Banks – 10-year bullet LT2 Amortization Schedule Figure 32. Asian Banks – Progress in adopting Basel III

0%

20%

40%

60%

80%

100%

120%

2011 2013 2014 2015 2016 2017 2018 2019 2020 2021 2020

Current amortization schedule

Basel I I I amortization schedule

Contribution to Tier2 capital (%)

Basel II Basel 2.5 Basel III

Australia 4 3 1

China 4 4 2Hong Kong 4 2 1

India 4 4 1

Indonesia 3 1 1

Korea 4 2 1Singapore 4 3 & 4 1

UK 4 2 2

US 4 1 & 2 1

EU 4 4 2Japan 4 3 1

Key: 1 draft regulation not published

2 draft regulation published

3 final rule published4 final rule in force

Source: BIS, Citi Source: BIS, Citi



Theme #4: Fundamentals to remain stable with a bias towards deterioration Fundamentals remain solid, which is reflected by most Asian bank ratings holding a stable outlook and Asian bank spreads trading rich relative to DM peers. Asia’s rating outperformance during S&P’s methodology revision emphasizes Asia’s relative strength, as most Asian bank ratings remained unchanged or were upgraded one notch due to stable fundamentals, but more importantly, continued strong government support. On the other hand, global peers have experienced multiple rating downgrades from both Moody’s and S&P throughout the year. We believe that current Asian bank spreads and ratings reflect their credit profiles. However, fundamentals have started to deteriorate, which we believe will continue in 2012 and may cause downward rating and spread pressure in 2012.

Figure 33. Asian Banks – S&P Bank Rating Changes of Major Asia-Pacific Banks

Organization

Moody's Rating

Moody's BFSR

Moody's BCA

Moody'sOutlook

New S&P Rating

Previous Rating

New SACP

New S&P Outlook

PreviousOutlook Country

New BICRA

Previous BICRA

BOC A1 D Ba2 Stable A A- bbb- Stable Stable CN 5 6ICBC A1 D+ Ba1 Stable A A bbb Stable Stable CN 5 6BOCHK Aa3 C+ A2 Stable A+ A- a Stable Positive HK 2 2BNKEA A2 C- Baa2 Stable A A- bbb+ Stable Stable HK 2 2AXSBIN Baa2 C- Baa2 Stable BBB- BBB- bbb- Stable Stable IN 5 6BOIIN Baa2 D+ Ba1 Stable BBB- BBB- bbb- Stable Stable IN 5 6ICICI Baa2 C- Baa2 Stable BBB- BBB- bbb Stable Stable IN 5 6IDBI Baa3 D- Ba3 Stable BBB- BBB- bb+ Stable Stable IN 5 6IOBIN Baa3 D Ba2 Stable BBB- BBB- bb+ Stable Stable IN 5 6SBIIN Baa2 D+ Baa3 Stable BBB- BBB- bbb Stable Stable IN 5 6SNDBIN Baa2 D+ Ba1 Stable BBB- BBB- bb+ Stable Stable IN 5 6UNDKBIN Baa2 D+ Ba1 Stable BBB- BBB- bbb- Stable Stable IN 5 6Maybank A3 C A3 Stable A- A- a- Stable Stable MY 4 4DBS Aa1 B Aa3 Stable AA- AA- a Stable Stable SG 2 2OCBC Aa1 B Aa3 Stable AA- A+ a Stable Stable SG 2 2UOB Aa1 B Aa3 Stable AA- A+ a- Stable Stable SG 2 2Hana A1 C- Baa1 Stable A A- bbb+ Stable Stable KR 3 4IBK A1 D+ Baa3 Stable A A bbb Stable Stable KR 3 4Kookmin A1 C- Baa1 Stable A A a- Stable Stable KR 3 4KDB A1 D Ba2 Stable A A bbb- Negative Negative KR 3 4KEB A1 C- Baa2 Positive BBB+ BBB+ bbb Wath Pos Stable KR 3 4NACF A1 D+ Ba1 Stable A A bbb Stable Stable KR 3 4Shinhan A1 C- Baa1 Stable A A- bbb+ Stable Stable KR 3 4Woori A1 C- Baa2 Stable A- A- bbb Stable Stable KR 3 4BBLTB Baa1 C- Baa2 Stable BBB+ BBB+ bbb Stable Stable TH 5 6SCBTB Baa1 C- Baa2 Stable BBB+ BBB+ bbb Stable Stable TH 5 6

Source: Citi, S&P, Moody’s; yellow denotes unchanged rating, light green denotes a one notch upgrade, bright green denotes a two notch upgrade

Fundamentals will continue to see pockets of stress in 2012 on the back of a challenging global macro outlook. Our economist forecasts lower GDP growth in Asia, which in turn, will cause lower loan growth in the mid-single digits to the high-teens. Given lower growth, our economist expects rates to stabilize with select easing measures in certain countries. These policy rate cuts could be negative for net-interest margins as it puts pressure on asset yields. These factors coupled with higher credit costs on the back of asset quality deterioration will all weigh on bank earnings.



Figure 34. Asian Banks – Rates and 2012 Rate Forecasts Figure 35. Asian Banks – 3Q11 Loan versus Deposit Growth (%, yoy)

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

1QFY

10

2QFY

10

3QFY

10

4QFY

10

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11

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11

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1E

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12E

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2E

4QFY

12E

CH IN ID SK MY PH TW TH

16.0%

21.9%

19.6%

25.2%

7.0%

13.8%

21.7%

24.0%

7.9%

17.4%

13.1%

8.7%

17.4%

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8.7%

12.6%

8.8%

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CH HK IN ID KR MY PH SG TW TH

3Q11 Loan growth (%, yoy) 3Q11 Deposit growth (%, yoy)

Source: Citi, CIRA, CEIC Source: Citi, CIRA, CEIC

Loan growth outpaced deposit growth in all Asian countries during 2011 aside from Korea, where local regulation required banks to reduce their local currency LDRs. Strong loan demand combined with a tapering off of deposit growth led to an increase in LDRs, particularly in countries such as Hong Kong. We expect LDRs to continue increasing in 2012 as domestic liquidity remains tight and international liquidity is withdrawn from the system.

Figure 36. Asian Banks – Loan-to-deposit ratio (%) Figure 37. Asian Banks – Hong Kong Loan-to-Deposit Ratios (%)

20%

40%

60%

80%

100%

120%

CH HK IN ID KR MY PH SG TW TH

3QFY10 4QFY10

1QFY11 2QFY11

3QFY11

Source: Citi, CIRA, CEIC Source: IMF

We are negative on Chinese and Hong Kong banks, due to the expected deterioration of the banks’ fundamentals and uncertainty of off-balance sheet lending practices in China. China is heading into a soft patch in 2012, therefore, the RRR was cut for the first time in three years signaling that China is starting an easing policy cycle. According to the IMF, the top risks for the Chinese banking system include: 1) the impact of sharp credit expansion on banks’ asset quality, 2) the rise of off-balance sheet exposures and lending outside the formal banking sector, 3) the relatively high level of real estate prices, and 4) the increase in imbalances due to the current economic growth pattern. Given these concerns, Hong Kong’s increased external banking claims to China is a main source of



concern along with exposure to the property market, a global slowdown and trade finance lending, tightening liquidity, etc. The decline in China’s NPL ratio from 8.9% in 2005 to 1.1% in 2010 was the result of rapid credit expansion and an NPL carve-out from one of the major banks, however, this rapid credit growth raises the risk of asset quality deterioration since credit may be directed to less productive investments and the Chinese banks have limited ability to apply prudent risk management, since they still dominate financial intermediation on behalf of the government. We expect that NPLs will increase going forward which will impair the banks’ profitability and capital positions, and the main areas of concern include SME, real estate and local government loans which constitute around 45% of gross loans. While the banking sector’s direct exposure to the real estate sector is moderate, around 20% of total banking system’s loans, the indirect exposure is much higher as 30-45% of total loans are backed by collateral, the majority which is real estate. Therefore, real estate exposure will continue to be at the forefront of concern. Also the increasing shift of risks off-balance sheet, including wealth management products, augment the banks’ credit risk exposure. Not only is this exposure not transparent, but it could undermine monetary policy effectiveness in a severe scenario, and the banks do not provide sufficient provisions and capital for off-balance sheet lending, which distorts fundamental credit ratios. Due to regulatory forbearance, asset quality stresses may not necessarily come through in the NPL figures, but these stresses will manifest themselves first as liquidity stress.

Figure 38. Asian Banks – HK Banks external claims (% of total) Figure 39. Asian Banks – Indian Bank Asset Quality

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100%NPLs - PSB

NPLs - Private Sector Banks

NPL growth - Private SectorBanks (%, yoy)NPL growth - PSB (%, yoy)

Source: IMF Source: Citi, CEIC

We are negative on Indian banks due to the challenging operating environment which will adversely impact capital, asset quality and profitability. Asset quality is expected to deteriorate in 2012 driven by high interest rates and slowing economic growth. There will be an increase in restructured loans and computed based NPL recognition increasing NPLs declared. SMEs and utilities, both power and airlines, are the sectors under the most pressure. Retail loans may be negatively impacted due to recent monetary tightening. Given this deterioration, provisions will remain elevated which will hurt profitability along with an expected decline in net-interest-margins and treasury income. Capital ratios have been deteriorating and are weaker than global peers. According to Moody's stress test, in an adverse scenario with system NPLs increasing to 7% from the current mid-5% level, core Tier1 ratios would be relatively unchanged at 9.5%. However, in a highly adverse scenario with system gross NPLs increasing to 12%, core Tier1 ratios would decline to 5.6%. We expect the government will at least recapitalize the major public sector banks, which provides some support.



Figure 40. Asian Banks – Indian bank ratings and support uplift by Moody’s Figure 41. Asian Banks – Korea External Debt Analysis

Banks

Moody's Rating Outlook BFSR BCA

Notch Uplift

S&PRating

Public Sector Banks

State Bank of India Baa2 Stable D+ Baa3 1 BBB-

Punjab National Bank Baa2 Stable D+ Baa3 1 NR

Bank of Baroda Baa2 Stable D+ Ba1 2 BBB-

Bank of India Baa2 Stable D+ Ba1 2 BBB-

Canara Bank Baa2 Stable D+ Baa3 1 BBB-

IDBI Bank Baa3 Stable D- Ba3 3 BBB-

Union Bank of India Baa2 Stable D+ Ba1 2 BBB-

Central Bank of India Baa3 Stable D- Ba3 3 NR

Indian Overseas Bank Baa3 Stable D Ba2 2 BBB-

Syndicate Bank Baa2 Stable D+ Ba1 2 BBB-

Oriental Bank of Comm Baa2 Negative D+ Ba1 2 NR

Private Sector Banks

ICICI Bank Baa2 Stable C- Baa2 0 BBB-

HDFC Bank Baa2 Stable C- Baa2 0 BBB-

Axis Bank Baa2 Stable C- Baa2 0 BBB-

Yes Bank Baa3 Stable D+ Ba1 1 NR

20%

30%

40%

50%

60%

70%

80%

2005 2006 2007 2008 2009 2010 2011F 2012F

External Debt (as apercentage of GDP)

ST External Debt (as apercentage ofinternational reserves)

Source: Citi, Moody’s, S&P Source: BOK, CIRA

Ratings will come under pressure – BFSR downgrades first, but potential issuer rating downgrades. Moody’s is likely to downgrade the BFSR ratings of Indian banks on the back of fundamental deterioration, similar to SBI’s BFSR downgrade in 2011. However, Indian bank issuer ratings may benefit from up to 3 notches of government support, and most Indian banks, aside from IDBI Bank and Central Bank of India, have room for their BFSRs to be downgraded while maintaining issuer ratings. While not our base case, there is a risk that Moody’s downgrades the Indian sovereign rating in 2012. If this happens, Indian bank issuer ratings would be subsequently downgraded. Overall, Indian banks will face downward rating pressure in 2012. We prefer Korean quasi-sovereign banks. We are more constructive on Korea, particularly the policy banks, given that the banking system is currently stable and better positioned compared to 4Q08. External debt as a percentage of GDP is expected to be 34% in FY12, short-term external debt as a percentage of internal reserves is around 45% in FY11 and FY12E, LDRs have declined, asset quality problems in the project finance segment are largely behind us, and the banks no longer have structural or product problems such as KIKOs or future shipping options that were problematic in 2008. We prefer quasi-sovereigns to the commercial banks since the quasi-sovereign bonds offer better value, the quasi-sovereigns are strongly supported by the government, and the commercial banks have larger refinancing needs in 2012 than usual. While issuance will remain high, liquidity is sufficient over the next few months, and the major Korean banks secured around US$2.4bn of committed credit lines and tapped international capital markets. However, Korean banks do get funding from European banks that may come under stress. In a worst case scenario situation, we believe that the banks would be able to secure liquidity from the government or central bank as well as issue government guaranteed bonds similar to the financial crisis.

The focus is on deleveraging and decelerating, while depressed margins and deteriorating asset quality is largely behind us. Loan growth will continue to be muted and the banks are focusing on increasing deposits to bring down LDRs. Korean banks spent the past few years cleaning up loans to concerning sectors including project finance, shipping and shipbuilding sectors. Therefore, while the banks might continue to some pressure in the SMEs segment, a large portion of their problematic assets have already been taken care of. The property sector needs to be monitored carefully as select retail loans may come under pressure. Given that both household debt to GDP and disposable income remains elevated and the majority of mortgage loans are floating rate interest only instruments, this is a main area of concern. However, the household cooling measured implement by the regulators in 2011 should help ease some of these concerns.



Investment-Grade Corporates

Investment Strategy Investment-grade credit is looking in good shape fundamentally, and despite a sizeable pipeline of US$23.0bn according to our estimates for ‘2012, should outperform high-yield in the early part of the year as the more defensive play. Given the cash that is being kept out of the Asian game by the macro volatility, we think that higher-rated issuers in fundamentally sound sectors such as power and oil & gas will be well received by a jittery market with few alternatives. Credit quality appears to be on average better in Hong Kong than Korea, however this is made up for higher quasi-sovereign participation in the Korean bond market. China’s fundamentals are strongest, since that sector is dominated by quasi-sovereign issuers in fundamentally strong industries. We recommend positioning in defensive quasi-sovereign power and oil & gas credits and taking advantage of new issue opportunities to stay defensive in advance of a tactical shift down the credit curve later in the year. This is supported by our analysis of relative value within Asia, which suggests that private sector credits in real estate and cyclical industries such as automotives and steel, offer less compelling value given the importance of earnings stability this year.

We also compared valuations with the US, which show that the AA-rated sector is the most attractive, due to the presence of high-rated quasi-sovereigns in the Chinese oil and gas sector. We would target these names for longer-term value. A-rated credits appear to offer poorest value versus the US (as they trade flat), however this is deceptive as Asian A-rated credits are on average 2 years shorter in effective duration than the single-A tranche of the US high-grade corporate index (4.5 versus 6.5 years). In addition, the range of A-rated credits is much broader than other rating buckets within Asian high-grade, given it constitutes the largest component of Asian high-grade corporate credit at 58.1% of total, and we think there are still defensive opportunities in the quasi-sovereign power sector therein.

Figure 42. Asian Investment-Grade: Spread Performance of Asia’s ABBI versus the US BIG Corporate Index

0

100

200

300

400

Jan-10 Jul-10 Jan-11 Jul-11

bps

ABBI IG Corp [Rating A-, Duration 4.7y]

US BIG Corp [Rating A-, Duration 6.7y]

Source: Yieldbook, Bloomberg, Citi

Leverage and Fundamentals

Country-level analysis: high-grade looks in good shape In the below charts, we have calculated aggregated ratios for listed US$-bond issuers across the Chinese, Hong Kong and Korean sectors. Note that we have excluded unlisted quasi-sovereign and



private-sector issuers given the lack of quarterly disclosure and, for quasi-sovereigns, the dependency on sovereign credit-worthiness.

China understandably has the strongest ratios, given the contribution of government-owned (but HK-listed) bond issuers in the oil & gas space, where credit ratings are among the highest across all of high-grade.

Hong Kong metrics are skewed by trading businesses, which contributed 58% of sales and have unusually low margins by high-grade standards. The metrics nevertheless show that the pace of deterioration in profitability is modest and leverage is slightly lower as of 1H11 than during FY10, thanks to a 43% contribution to EBITDA from the property sector.

In Korea, which is dominated by corporates with a weakening industry backdrop (steel and automotives account for 51% of the EBITDA of our sample set), there is a noticeable decline in interest coverage as leverage crept up slightly, but profitability is still relatively stable.

Figure 43. Aggregated Corporate Ratios: China* Figure 44. Aggregated Corporate Ratios: HK* Figure 45. Aggregated Corporate Ratios: Korea*

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3

6

9

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FY10 9M11

0%

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Debt/EBITDA

EBITDA/Int

EBITDA % RHS

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Source: Bloomberg, Citi,; *Ratios are aggregated for all listed US$-bond issuers, i.e. excludes unlisted corporates/quasi-sovereigns

Leverage versus margins The below charts plot leverage as measured by net debt/EBITDA against EBITDA margins. There seem to be clear differences between the three sectors that appear to be a function of the level of quasi-sovereign involvement in the credit space. In China, which is heavily skewed in favour of quasi-sovereigns, the credit metrics are all over the place. In Korea, the credit metrics appear to be generally of lower quality than in Hong Kong, since the distribution of corporates appears to be generally lower in the chart, indicating lower profitability relative to the Hong Kong corporates, but with a critical mass further to the left, indicating lower leverage. This is an interesting contrast to the previous analysis that appears to show that on an aggregated basis, Hong Kong’s metrics are generally weaker than Korea’s. This is because credit quality is on average better in Hong Kong than in Korea, but is skewed by the presence of higher-levered trading companies which have below-average margins. This makes sense, since Korea’s corporates have less dependency on financial metrics to drive credit quality, given the higher participation of quasi-sovereign issuers.



Figure 46. Net Debt/EBITDA versus EBITDA Margin %: By Issuer Figure 47. Maturity Profile of US$-bonds outstanding

MCC

CHIBEICLPHKCG

CHIOLI

BeiEnt

Zijin

CNOOC

CRP HenLndSwire

Hutch

NWD

Noble

PCCWSHK

HKL

Kerry

LiFng

HSteelSKI Lotte

SKBB

Posco

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KiaKOGAS

HynMtr KEPCO

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Source: Loanconnector, Citi Source: Dealogic, Bloomberg, Citi

Market structure and technicals

Chinese quasi-sovereigns join the fray This year’s total investment-grade issuance of US$17.8bn represented a decline of 16.3% yoy to US$17.8bn, largely driven by a sharp decline from Hong Kong to just US$1.4bn, after printing US$8.6bn in ‘2010 and US$7.1bn in ‘2009. We did not see repeat of last year’s aggressive issuance by heavyweight conglomerates and property issuers. This was made up for by robust issuance out of the China (US$8.9bn), primarily from oil & gas, municipal government and other state-owned issuers. The other major issuance market, South Korea, printed US$5.3bn in deals of which just under half (43.8%) came from the quasi-sovereign sector.

Figure 48. New Issue Breakdown by Country: 2005-2011 Figure 49. Asian Investment-Grade: Country Breakdown

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25

2005 2006 2007 2008 2009 2010 2011

China Hong Kong India Malaysia

Singapore South Korea Others

US$ bnOthers

IndiaSing

China South Korea

Hong Kong

Malaysia

Source: Dealogic, Bloomberg, Citi Source: Dealogic, Bloomberg, Citi

Record year of high-grade corporate issuance lies ahead We expect a 29.0% yoy increase in high-grade corporate issuance to US$23.0bn, based on:

(1) Jittery Markets: We expect high-yield issuance to remain out of favour in the early part of the year given macro factors and weak technicals. This environment should favour high-rated issuers in Asia with quasi-sovereign linkages or solid industry positioning, and since we expect cash



positions to be high going into next year, we believe this will provide a relatively defensive way of deploying into the market while avoiding the potential volatility of high-yield.

(2) China’s cash-hungry corporates: We believe China will continue to be a major factor and are projecting a further increase to US$10.0bn in new supply out of China (+12.0% yoy). We expect the Chinese high-grade corporates that tap the market to have extremely robust market position in their respective industries, strong sovereign linkage, or be in sectors that are globally favoured, such as oil & gas and maybe even power,

(3) Hong Kong: refinancing early: This will be the other major sector, accounting for about US$8.0bbn (+493.6% yoy) in potential supply. The reason we have assumed such a large increase is to do with pre-funding of the US$5.6bn in refinancing requirements from ‘2013, with some incremental buffer to account for refinancing demand from syndicated loan markets as European banks pull out. As shown below (Figure 50), Hong Kong has the largest share of US$-denominated syndicated loans maturing in ‘2012 that have European bank participation (defined as excluding UK banks). We estimate this at about US$6bn but suspect the real figure could be larger than this.

What about refinancing requirements in the public bond markets? As shown in Figure 51, refinancing requirements seem unusually low at sub-US$5bn this year. At first glance it appears that this is too low and can’t possibly be right. Our detailed investigation revealed that this appears to be a function of very low high-grade corporate issuance back in 2007 (just US$3.1bn), as that year’s issuance was completely dominated by banks (accounting for 59.1%). Thus five years on, there is a lull in refinancing requirement which will pick up going into the ‘2013-2016 period before going quiet again in ‘2017/’2018.

Figure 50. Syndicated Loan maturities with European Bank Participation

(excludes UK Banks)

Figure 51. Maturity Profile of US$-bonds outstanding

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HK SG KR CN Other ID TH IN TW

US$ bn

All Currencies

US$-denominated due beyond '2012

US$-denominated due in '2012

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12 13 14 15 16 17 18 19 20 21 22+

US$ bn

Source: Loanconnector, Citi Source: Dealogic, Bloomberg, Citi



Valuations

Relative value within Asia: spot the difference The below Figure 52 shows the distribution of Asian high-grade credits from the three key sectors: Korea, Hong Kong and China. This reveals some interesting patterns. Korean credits tend to be shorter in duration on average, and this is probably due to the high concentration of shorter-dated paper from the quasi-sovereigns. This will clearly get lengthened out in the coming years, and thus we would expect the 10-year sector to become larger and potentially reverse the current inversion of the credit curve. Korean credits also appear to be in a tight spread range, reflecting both the presence of quasi-sovereigns, and the fact that private sector corporates are trading too tight as a sector.

Hong Kong credits, which are generally private-sector names, show a much broader distribution of spread and duration profile. Given Hong Kong credits are trading largely in line with Korean credits, and are exposed to the cyclical property sector, we expect Hong Kong to underperform fundamentally.

Chinese corporates, being the newest of the three sectors to gain critical mass, has a much less developed credit curve. As shown at the 7-8-year point on the duration curve, the credits appear to be spread out vertically across a wide range of spread points. This reflects the fact that despite being a sector of largely quasi-sovereign issuers, the range of ratings is fairly wide, due to the different levels of quasi-sovereign issuers within the nebulous infrastructure of the state. Here, we recommend sticking to the higher-rated issuers, but suspect the lower-rated names are probably trading too wide relative to the level of sovereign support they would likely receive in the event of distress.

Figure 52. Relative Value within Asian high-grade

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Hong Kong China KoreaZ-spread (bps)

Modified Duration (years)

Source: Bloomberg, Companies, Citi

Credit Curves in Asia As shown below, Asia’s credit curves look anything but normal, but credit spreads effectively inverted beyond 10-years due to limited supply against heavy demand from regional real money investors. We expect the credit curve to normalize going forward given issuers should be looking to price in the 10-year segment given the limited additional funding cost on account of the curve inversion (which offsets the positive slope of the 5s10s U.S. treasury curve).



Figure 53. Credit curves in Asian high-grade

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350

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Z-spread (bps)

Modified Duration (years)

CNPC

Posco

Hutch

Petronas

GS Caltex

Kepco

Source: Bloomberg, Citi

Finding value: comparison with US investment-grade As far as relative value against the United States is concerned, the pickup is greatest in the AAA and AA-rated space. The AAA-pickup is not too relevant given the lack of AAA-bonds in Asia, while the AA-pickup clearly reflects the underperformance of Chinese AA-rated oil & gas quasi-sovereigns, which have been punished by the broader negativity on China. Clearly there is value here. The BBB-rated sector does not come off as particularly attractive when compared with the pickup available in AAA/AA rated credits, however it is nevertheless positive. The A-rated sector appears to offer the poorest value relative to the US, however this is where the majority of Asian investment-grade corporate bonds are. A-rated corporates make up 58.1% of the ABBI high-grade corporate index, which has an average ABBI rating of A-.

Figure 54. Relative value – Asia’s ABBI vs US’ BIG index

-1

0

1

2


Yield to Maturity Differential (Asia - US) (%)

BBB

AAA

A

AA

Source: Yieldbook, Citi



The below charts compare the pickup for moving down the credit curve in US credit (represented by the US BIG index) versus the similar pickup in Asia (represented by the Asia ABBI index). The first thing that is immediately obvious is that the AA-rated credits in the US trade much tighter than in Asia, thus the pickup to single-A is much more substantial even though A-rated credits trade across the two regions. The pickup to BBB-rated credit is more substantial in Asia, thus again AA-credit comes out looking best here (constitutes just 8% of Asian bonds though).

Figure 55. Relative Value by Ratings Distribution: US BIG Figure 56. Relative Value by Ratings Distribution: Asia ABBI

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BBBAAA

Yield to Maturity (%)

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BBBAAA

Yield to Maturity (%)

Source: Yieldbook, Citi Source: Yieldbook, Citi

Focus on Fundamentals: Hong Kong Property approaches the tipping point

Macro fundamentals: tied to China Citi’s economists revised Hong Kong’s GDP forecast to 5.0% for 2011 and 3.5% for 2012, down from 5.6% and 4.5% earlier in the year in light of lower merchandise exports and the wealth destruction effect due to the Europe crisis. This is more conservative than IMF’s forecast of 5.75% and 4.0% respectively. As Hong Kong operates under an open economy without an independent monetary system, its economy will be highly susceptible to shocks in external demand led by the Europe crisis. The transmission mechanism will be through external trade, trade financing and the funding channels (discussed in the Banks section above).

On the positive side, Hong Kong has one of the healthiest fiscal balance sheets in the world. Very low debt levels, coupled with sizeable fiscal reserves and a robust and well-managed banking system are key strengths. Our economists forecast government debt/GDP at 2% for 2012. A key risk at the macro level is Hong Kong’s linkage with China’s economy. Chinese buyers have contributed to substantial retail and property demand, while trade linkages are also extremely strong. According to IMF’s latest report, a halving of growth in China would put Hong Kong into a “sustained downturn with close to zero growth for the next two years”, and Hong Kong’s sovereign upgrades in 4Q10 were linked to China’s ratings.

Tipping point in Hong Kong property? The Hong Kong properties market has been a responsive indicator to the economic landscape, usually with a six month lag. Historically, the property cycle in Hong Kong is shorter than that in other cities. Since 1994, Hong Kong has experienced four significant downturns while New York, London, Beijing have only experienced one. Hong Kong’s open economy, lack of independent monetary system due to the currency peg, cultural demand for home ownership and low-tax system have contributed to the frequency and severity of property cycles. We expect downside risk in ‘2012. We



expect the retail and office retail segments to outperform that of residential. A 10-15% drop in residential property prices would not surprise us, whereas rental income should hold up well. We believe property issuers with high proportion of rental income will outperform.

Mixed signals tending towards downside risk

Several indicators suggest consolidation in property prices, including the government’s commitment to increasing land supply, wealth effects from volatility in global equities, weak property turnover in the secondary market, capital raising activities by developers, accelerated pre-sales of primary properties and 4Q land auction/tenders missing estimates. We are comfortable with credit risk of Hong Kong developers, but believe the foundations of a downtrend have already been laid and will weigh on credit metrics in the year ahead.

Figure 57. Hong Kong Property: Monthly Transaction Volume and Prices

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96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

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HK Property Transaction Volume (LHS)HK Property Prices (RHS)

Source: Centaline, Hong Kong Land Registry

Tipping point?

The weekly transaction volume of Hong Kong’s top 35 housing estates has dropped to around 100 units recently, matching the 2008 crisis level. Total property transaction rebounded slightly from a 32-month low of 5,675 unit transactions for HK$27.5bn in the month of October. The latest Centa-City Leading Index was 98.13, down 2.6% from the peak at Jun-11 which had nearly reached the pre-Asian-crisis peak of 102.93, from Oct-97. HIBOR-linked home mortgages registered a substantial decline from >90% of new mortgages in 4Q10-1Q11 to 46% over the last 6 months. This reflects less willingness to lend on the part of banks in a low margin business. Negative equity cases rose to 1,653 (HK$4.1bn) for 3Q11. While still low at 0.5% of total outstanding value of mortgage loans, is at its highest level since 2Q09.

Policy risk will be a major source of volatility since Chief Executive Donald Tsang reintroduced the Home Ownership Scheme (having rejected it a year earlier). Financial secretary John Tsang mentioned the possibility of policy easing in early December, following a mere 2.6% drop of property prices, which was denied by Donald Tsang a day later. With the change of office in July-12, we expect new policies to be introduced, skewed to the downside. We believe a sharper downtrend in property prices will need to be in full evidence before the “government’s put” comes into play.

“Pre-sale rush” an indicator of downtrend?

With a pipeline of 834 units from seven projects, and another 5,211 units from nine properties already in the primary market, the bar has been set rather high given the downside risk to prices. Developers have brought pre-sale marketing forward by a month in some cases, and cut prices by 10-15% below



initial estimates in others, in order to stimulate demand. Together with a 2.6-year low in residential property transaction volume, we believe this is a clear indicator of weak markets ahead.

Figure 58. Hong Kong Property: Primary Market

Project Developer ASP(HK$/sqf) Units Sold

1 La Splendeur Cheung Kong/Nan Fung/MTRC 5000-6000 1168 1078

2 Marinella K Wah/Sino Land/Nan Fung 19000-20000 411 290

3 The Wings SHK 8000-13000 1028 925

4 One Mayfair Sino Land 17000-19000 120 86

5 The Warren Wing Tai Properties ~20000 103 41

6 Festival City III Cheung Kong 8000-10000 1536 250

7 Providence Bay Sino Land/Nan Fung/K Wah/Wing Tai 15000-20000 482 156

8 One Wanchai Chinese Estates Holdings 18000-20000 237 13

9 The Altitude Kerry Properties/Peterson 19000 126 14

5211 2853 Source: Companies, Citi

Pre-emptive fund-raising?

Hong Kong property companies raised raised US$1.2bn in bonds (across all currencies) and US$158 in equity (at a deep discount) in 4Q11. It is interesting to observe that issuance increased qoq, peaking in 4Q11 amid turbulent financial markets and in spite of relatively benign immediate funding needs. What concerns us most is not the developers’ actual liquidity requirements, which we believe are relatively low in the immediate term. We are more concerned about what this implies about developers’ expectations about the market outlook and future access to funding channels, given the timing of fund-raising in such difficult markets and with no apparent funding or investment requirements.

Supply-side mechanics: policy risk for developers In the latest policy address announced in October, HK Chief Executive Donald Tsang announced the government’s continued commitment to increase supply of residential units. A target was set to supply approximately 20,000 private units, 5,000 home ownership scheme (“HOS”) units and 15,000 public rental housing (“PRH”) units per year. Eligibility for PRH and HOS is available to a 3-person income below HK$16,000 and household income below HK$30,000 respectively. As the wealth gap persists in Hong Kong and new properties are sold as luxury flats regardless of size, the market is highly segmented. Hence, we believe impact to private property sales from PRH supply is non-existent and that from HOS is minor. For HOS units, a rough price estimate for a 500 sq ft unit is around HK$2mn, for which pre-sales will not start until 2014/2015. The unit price is lower than most new property prices in the market which is usually above HK$3mn. However, we are concerned about ongoing private units land supply and policy risk in the medium term.

Supply risk in the property market

For private units, government-initiated land sales coupled with the Application List system is designed to ensure a smooth pipeline of land supply for development according to the policy address. One concern we have is that the government’s launches of land auctions are evenly spaced out and hence are irrespective of market conditions. The last three land auctions, namely those of the Nam Cheong site, North Point Oil Street and Shatin Site 56A, were concluded at levels below initial market estimates. Given that it is difficult for large-scale developers to miss the opportunity to bid for



landmark sites such as West Rail Nam Cheong, there is a risk that developers acquire too much land too early in the current property down-cycle.

Policy risk

With regards policy risk, we are concerned with the increasingly swift execution of strict policy measures such as Special Stamp Duty and the quick policy reversal from affirming no HOS supply to fully resuming HOS housing within a year. If the government adopts interventions which are less laissez-faire (restricting purchase) in favor of more laissez-faire policies (increasing supply) following developments in China, we see greater policy uncertainty in the medium-term to the property price trajectory, with risk to the downside. Both potential candidates for the ‘2012 Chief Executive election, CY Leung and Henry Tang, are proposing housing policy measures above and beyond what is already in place, the former favors a strict control over unit growth while the latter, reclamation and peripheral land use. Investors should be watchful in how this plays out in the medium-term.

Figure 59. Selected property measures implemented in Hong Kong

Date Policy Details 8/13/2010 Restrict all confirmor transactions in new primary projects Banning the sale of property to a sub-purchaser before the legal completion

of the original sale 10/13/2010 "My home purchase Scheme" Subsidizing purchase of government housing with up to 50% of rents paid

prior to purchase 10/13/2010 Banned property investment option for Capital Investment

Immigration Scheme Investing in properties ceases to be an option for investment immigration into Hong Kong Additional Stamp Duty for short term property investors Property resold within 6 months has to pay a 15% stamp duty on value of transaction Property resold within 6-12 months has to pay a 10% stamp duty on value of transaction

11/19/2010

Reducing secondary market churn - Additional Stamp Duty for resale

Property resold within 12-24 months has to pay a 5% stamp duty on value of transaction

3/8/2011 Set maximum flat sizes in new land supply Restrict sizes of newly built units Maximum loan value from banks is restricted 50% max. LTV for homes of HK$10mn above 60% for flats valued between HK$7-10mn 70% for those below HK$7mn capped at HK$4.2mn Additional 10% for mortgage applicants whose principle income is not from HK 50% for all non-residential properties

6/10/2011

Tightening Mortgage - LTV Ratio (Tightening first started in Oct 09)

Maximum LTV ratio for mortgage is 40% of borrower's net worth 10/12/2011 Resumption of Home Ownership Scheme (HOS) - Government

subsidized housing Providing 17000 units of HOS housing starting 2016-2017 for families with household income less than HK$30000/mth

10/12/2011 Increase supply of Public Rental Housing (PRH) Providing 75000 units for the next five years for families with income less than HK$8740/mth (1 person family)

10/12/2011 Refine "My home purchase Scheme" Purchase price look-back option for rental buyers 10/12/2011 Reinforce land supply Supplying 20000 units to private developers every year on average along

with 15000 PRH

Source: Hong Kong Government, Citi

Demand-side mechanics: the role of Chinese buyers We see housing demand originating from a) organic growth of households and b) Chinese purchases after speculative demand ebbs. With the implementation of additional stamp duty for property resale within 2 years of purchase starting Nov 2010, there were only 5 cases of speculative resale transactions up to Nov-11. Interestingly, some of these transactions were sold at a loss on top of the additional stamp duty. According to our equity colleagues, growth of households through marriages and population growth should amount to 31,000 per year according to a 10-year average household formation rate of 1.32% p.a.. On the other hand, Chinese individuals continue to be net buyers of HK properties due to 1) channeling of excess liquidity into investment vehicles, 2) home purchase for babies born in HK, and 3) purchase of holiday homes. In 3Q11, 50% of the purchase notional for



primary properties in 3Q11 came from Chinese buyers (Oriental Daily, Centaline), registering a net take-up of 9.5% (12.5% bought and 3.0% sold), up from a 4-year average of 5-6%. This translates to roughly 9,000 units in demand per year. While we do not see a change in long-term demand from Chinese buyers for Hong Kong properties due to structural migration, we are cautious of the short-term risks.

Demand risk from China

Firstly, the spike in applications before the window of opportunity closed for investment immigration through property purchase last October would translate to demand up to 3Q11, which represents a 12-month deadline within which transactions must be completed. We do not have a precise estimate for the drop in transaction volume but we doubt that the net take-up of 9.5% will be sustained. Secondly, Hong Kong properties have been serving as an investment channel for Chinese savings given purchase restrictions in the property market in China. With the Chinese property sector facing an extremely challenging outlook, price cuts and potential policy loosening could keep capital onshore and ease the demand for HK properties. Thirdly, we see an increased correlation between equities and property demand. Amidst the recent equity market weakness since August, Hong Kong has seen purchase rescission cases for luxury flats, some of which involved Chinese buyers. In the latest quarter there was one case at Olympic city, one at Wong Tai Sin and five at Kowloon Town, with buyers forsaking deposits ranging from HK$2.5m to HK$4.1m. Other than one-off cases, property prices historically have a 6-month lag to equity performance. With a gradual sell-off in global indices, we take caution in the lagged effect to follow.



High-Yield – China

Overview Technicals rule the market. Despite higher historical default rates, weaker corporate governance, a shorter track record and inferior asset coverage ratios, Chinese industrials appear to be a lower-beta sector and have always been trading at a premium to property sector credits, despite a significant selloff from issuance levels. Technicals will remain weak for Chinese property as the sector continues to be heavily exposed to negative headlines. In addition, potential issuance will also weigh on technicals once the market normalizes. While non-property issuance is even more opportunistic, it has less sector concentration, is relatively easier for investors to differentiate and provides much-needed diversification in the China high-yield space. While we tend to argue Chinese property bonds should theoretically trade through industrial names based on default probability and recovery prospects, in reality property bonds will probably continue to trade at a discount for a prolonged period.

Supply forecast Supply will be contingent on market conditions, while we believe a big pipeline has been built up after a dead 2H11. Under current market conditions, we doubt there will be any appetite for high-yield in the near term. Meanwhile, issuers are hesitant to print at current levels unless they are desperate for funding. Another relevant factor is the rapidly expanding CNH market, which will absorb part of the supply requirements of the sector. Therefore, to put a figure to it, we estimate close to US$7bn in supply, as we assume the market will remain closed at least in the first quarter, with issuance picking up in the second half, should market normalize.

Chinese Property – Variation Chinese property bonds were down as much as 30pt from the highs of the year, with the fall beginning on the back of tightening measures on all possible aspects: demand, supply, land purchases and bank lending to developers. In 2012 and going forward, we see a set of variations on the theme that property remains one of the most important sectors for Chinese economy.

With a year-end rally, the upside-downside on property bonds at the current level looks less favorable for investors. We see greater likelihood of downward pressure in the direction of the 2008 lows than of positive catalysts materializing, as the global macro and property sector outlook are not necessarily any better than in 2008. It is likely that property bonds will take another leg lower in 2012 before any sustainable rebound. Therefore, for the first half of 2012, we continue to play on the defensive side by focusing on BB names while picking up only a couple of high-quality B names to enhance return.



Figure 60. ABBI China Property Index Historical Performance

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Chapter 1: A long and cold winter Missing 2011 sales targets has clearly become a reality for most developers, which should be neither surprising, nor a key focus. Instead, the focus should shift to how much worse the situation can get and when potentially the turning point may arrive.

Figure 61. National Property Transaction Volume and ASP

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Our recent trip to China showed that there has not been official large-scale price cuts yet, because (1) for projects that have already obtained sales permits, it is difficult to change prices. Hence, for those projects, developers intend to offer promotions with all the flexibility on site. This means actual average selling prices (“ASPs”) could be much lower than those recorded on the government’s website; (2) Home purchase restrictions (“HPR”) makes price cuts less effective given the decline in eligible purchasing power in the market. A few smart developers seized the first-mover advantage by offering competitive pricings on new launches before their competitors, while the rest are less willing to cut if limited demand has already been satisfied; (3) good-quality projects can still sell well even without price cuts or promotions; and (4) Developers are reluctant to cut ASPs on existing projects or new phases of existing projects, as they may not want to offend their old customers.

There are reports of dramatic price cuts in certain cities. Clearly suicidal price cuts are not the broader trend and should not become the trend, or else the game will be up for the entire sector. Those dramatic cuts are only happening in certain projects or areas that were highly speculative due to specific reasons. For example, Beijing Tongzhou was trading extremely expensive on speculation that the local government would relocate there. Realistically, we think developers can tolerate 10%-15% real discount without a significant impact on net margin due to the offsetting Land Appreciation Tax (“LAT”) savings.

This is not encouraging. Resistance to price cuts can only lengthen the winter period. We believe the physical market in 4Q11 should see a low-teens year-on-year transaction volume decline, particularly with a high base in 2010. The huge jump in December sales witnessed every year will likely be maintained but to a much lesser extent. Overall, 2011 still likely sees nationwide transaction volume up by a low-single-digit percentage owing to a good performance in the first half.

We expect further volume declines due to both seasonality and a high base in early 2011. However, we may not see the 20% nationwide yoy decline we saw in 2008, as (1) the volume decline has been partially absorbed in second half of 2011 when policy tightening measures were intensified; and (2) developers have started price cuts in 4Q, which to some extent should support transaction volume.

2012 won’t be the year of property-mania that 2009 was owing to the existence of HPR and tight mortgage policies. While volumes will recover to some extent as prices fall, the eligible buying power in the market will be quickly absorbed by the early round of price promotions, hence making a rebound unsustainable.

We expect transaction volumes to bottom out first in tier 1 and key tier 2 cities, as developers start to cut prices more aggressively and earlier in tier 1 and key tier 2 cities than lower-tier cities. For example, Bejing has seen a 10% ASP decline since August, Shanghai 12% and Shenzhen 9%. Certainly, the price corrections were also partially attributable to different sales mix. In comparison, lower-tier cities may either start or continue to see downward pressure in both price and volume.

Figure 62. Beijing Transaction Volume and ASP Figure 63. Shanghai Transaction Volume and ASP

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Figure 64. Guangzhou Transaction Volume and ASP Figure 65. Shenzhen Transaction Volume and ASP

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It’s a policy solo!

Macro monetary environment may ease but administrative control on property will persist… Property sector control is more than just an economic issue. Controlling the property sector has become the government’s tool, particularly this time, to balance public opinions and ensure social stability. Historically, it has always been a policy-driven sector.

Without a mature social housing system to complement private housing supply, the government has no option but to use administrative measures to curb skyrocketing property prices to partially alleviate discontent from low-to-middle income consumers, particularly at a time with high inflation and food prices. Without a satisfactory price correction, the government/party may lose face and popularity.

The property market has just started to see some effect from the tightening measures. If the government were to relax measures aimed at cooling the market, housing prices will likely see a retaliatory price rebound, which clearly is not what the government wants.

… until … Clearly, the government does not want a collapse of the sector either given its broader ramifications on the economy. Relaxation of the restrictive policies depends on whether the government believes it has solid achievements to show its people.

(1) ASP decline recorded by National Bureau of Statistics (NBS). It is the central government’s decision on how much the price should drop. What we know from the recent high government officials’ publicity is that the October price correction recorded by the NBS remains insignificant and unsatisfactory.

In our view, of the 70 cities that NBS tracks, if more than 80% see month-on month price corrections for consecutive six months with a cumulative year-on-year price correction of 10-15% on the index, we probably will see a high chance of policy relaxation.

(2) the completion and launching schedule of social housing. Social housing is essential to balance demand and supply in the property market and to avoid social unrest from unhappiness stemming from increasing income inequality and a lack of social safety-net for lower-income citizens. Once social housing is ready, the government can leave the private-sector housing to follow market trends instead of using administrative measures to deliberately curb prices.

China’s official target was to start construction of 10m units of social housing. According to the latest figures released by the Ministry of Housing and Urban-Rural Development (“MoHURD”), 3m units each will be delivered in 2011 and 2012, and the 2013 number depends on the availability on funding. While the number looks quite insignificant compared with normal housing, it is more



like a gesture than anything else at this stage, as the government has some grounds to gradually replace administrative measures by long-term market measures such as property tax.

(3) significant decline in new housing starts and real-estate investment that pressure the overall economy to the downside amid global macro weakness.

Chapter 2: If winter comes, can spring be far behind? 2012 is definitely tough for developers, but it is not the end of the world. Looking deeper into the cause of the tough situation, we see HPR as the killer. The HPR have been proved to be the most effective way to cool down the sector so far in the history of China’s property sector, as it directly suppresses real demand and hence makes price cuts less effective. Coupled with tight mortgage and banking loans controls, which further tie the hands of the buyers and squeeze the developers’ liquidity, the sector has no way out.

However, the sector is sitting on a seesaw rather than a slide. As discussed in the previous chapter, dawn will emerge from the darkest moment. Looking behind the immediate term, HPR should not stay in place forever and will eventually be replaced by market-based long-term measures such as property tax, once it is ready for the transition.

With increasing contribution to GDP and its broad ramification on the society, the property sector is simply too important to fail at the moment. We believe the property sector will remain central for a decent period of time. From a mid-term perspective, the sector will become healthier with structural problems gradually solved by social housing, more comprehensive taxation and credit system and industrial consolidation.

Figure 66. GDP Contribution from China Property Sector

Source: NBS, CIRA

Too early to worry about oversupply. Some investors are concerned about the oversupply in the sector by looking at the gap between GFA under construction and GFA sold, which is roughly 5 times. Apart from that, there are reports of low vacancy and ghost towns. We can take a deeper look at the supply and demand dynamics.

The demand side is quite simple, with three key source of demand: first home buyers on the back of urbanization and formation of new households in the cities, upgraders and investment demand.

On the supply side, first of all, supply won’t jump significantly given land supply constraints, as the government has set the red mark for farmland of not less than 1.8bn hectare.



Secondly, in the short run, developers can adjust construction rates under differring market conditions. In a sluggish market like this year and next, we have already see developers slowing down construction.

Thirdly, the existing inventories can hardly be defined as true supply at the moment as properties are in a format of capital reservoir for Chinese people, given a lack of other investment alternatives. The holders won’t easily dump during market downturns, until either there are other better investment alternatives, or the expectation on property appreciation is completely reversed. As discussed earlier in “Polarization over China: Shock from Within?”, any liberalization of cross-border investment channels would likely first require a reform of the banking system, which isn’t likely especially in the light of the asset quality issues that came to light this year. With local governments so dependent on land sales revenues, if such a liberalization were to accelerate a decline in property prices for instance, this would cause a ripple effect into the banking system which has local government debt amounting to 27% of GDP on its balance sheet.

Figure 67. Asset breakdown of personal wealth - US/EU Figure 68. Asset breakdown of personal wealth - China

Insurance, equity, bond,

60%

Real Estate, 20%

Others, 20%

Insurance, equity, bond, 15%

Real Estate, 65%

Others, 25%

Source: World bank, Citi Source: World bank, Citi

Fourthly, social welfare housing: this may be a less straightforward issue. While the government aims to offer 20m units next year to the market, how much of that can actually be calculated as “real” supply remains unclear. We have already heard in certain cities that lower-income groups are not willing to accept the social housing provided by the government for various reasons.

According to our equity analysts’ calculation, there will be an annual 800-850 msm GFA demand compared with 900-1,130 msm GFA of supply on a national basis. We don’t think this is extremely unhealthy, nor do we think this signals a sector meltdown due to oversupply. As a matter of fact, certain cities do have oversupply problems, while some other cities have quite favorable dynamics. Hence, oversupply is not a nationwide problem.

Chapter 3: Battle for survival: heralding of a new world order?

Bankruptcy risks far-fetched for developers under our coverage. The property sector is generally a safer sector than industrials in terms of default risk due to sector-specific features. The listed developers under our coverage are actually the better-capitalized players in the industry, compared with A-share-listed and private names. All our developers have gone through the last market downturn and learnt to be relatively less aggressive. Hence, this time, developers have maintained a better liquidity position. Even for names like with heightened liquidity concerns in the market, we see low probability of bankruptcy, given their vast liquid asset base and deep roots in the local society.

In relative terms, the smaller property credits have a higher probability of going under this time. But again, we still see their chance of survival as high, as they still have assets on their balance sheet to liquidate. Hence, there is very low probability that developers under our coverage will go under. And we believe the repayment of the ‘2012 bonds by developers will be a boost to market sentiments.



Nevertheless, managing a crisis will not necessarily ensure long-term survival, as questions will remain over whether there is a sustainable competitive advantage. That’s why we need to differentiate and pick up the long-term winners.

The rule of games have changed. Unlike many years ago, property development has now become a highly capital-intensive business and is not as lucrative as before. Developers have to pay large amounts to acquire a piece of land; the presales cycles are lengthened, particularly in certain big cities; construction loans are much more strictly monitored; developers have heavy tax burdens with business tax, LAT and corporate income tax, accounting for almost 50% of the total sales.

In the foreseeable future, we believe land prices and tax burdens will remain high for the sector. At the same time, property price will be controlled by either administrative measures and/or market-based measures to crack down on speculators. Hence, not only are the barriers to entry much higher and stricter, but consolidation will occur as developers with less financial flexibility, limited geographic exposure and development resources will be eventually squeezed out of the market.

Pick up the long-term winners. During the consolidation period, which may take some time, developers that are best positioned for the long term are those that (1) have a clear market strategy rather than being opportunistic and speculative; (2) have ample development resources for the years to come; (3) are able to develop different products, from commercial to residential, from high-end to mass market and have high standard for quality regardless of products; (4) have diversified geographic exposure or a dominant position in the regional home market with selective diversification; and (5) have strong balance sheet and disciplined financial management.

China industrials

Fundamentals remain acceptable China’s non-property sector have gained traction in 2011 and now accounts for 37% of total China issuance. With great industry diversity, non-property sector issuance appears to be more opportunistic. The sector fell from well-loved to badly-beaten through the course of this year owing to outbursts of corporate governance issues in the forestry sector, which heightened concerns over sponsor risk, accounting standards/fraud, structural subordination, transparency and a lack of track record.

We believe the performance of industrial bonds in 2012 largely relies on a top-down view of (1) fundamental and, (2) macro vulnerability. On the fundamental side, we expect two factors to be the differentiating variables: liquidity and leverage. We use cash on hand to ST debt as a proxy for liquidity and total debt/EBITDA for leverage. Certainly, there are other fundamental indications, but we think for ‘2012, liquidity an leverage are the two most important determinants. In terms of macro vulnerability, the key factors will be cyclicality of the industry, indirect/direct exposure to the property sector, exposure to exports, sensitivity to China domestic economic slowdown and pricing power (or market share).

The good news is companies with vulnerability to both fundamental and macro variables are in the minority, thanks to the timely fund raising done in early ‘2011. As a matter of fact, the majority of Chinese industrial names have ample liquidities to weather through ‘2012 despite mounting macro uncertainties.

Meanwhile, our bottom-up analysis on these non-property sectors makes us conservative on 1H12 as we see little near-term catalysts. However, there can be sector rotation opportunities as short-term performance may not correctly speak to the mid to long-term perspectives. We see long opportunities in cement and coal credits should the market sell off more on negative industry headlines such as price declines and margin squeeze, while short opportunities in the steel sector, which probably will see a bottoming-out of profitability as early as in Chinese New Year, that may not be sustainable in the medium-term, in our view.



Figure 69. Chinese Industrial Sectors: The lowdown

Industry

Positives Negatives Positives Negatives

Cement Demand outpaces supply

ASP should fall due to weak seasonality; Weakening profitability in 1H12 due to high base Further sector consolidation

Policy overhang on suspended infrastructure projects; Further macro economic downside

Coking coalLogistic bottleneck will support ASP

Demand from steel sector shrinks

Closure of small mines and higher safety standard to cap supply

Frequent accidents cause production disruption

SteelIron ore and coking coal prices coming down

ASP continues to fall and havor around bottom on weak PMI

Construction of social housing may speed up

Poor outlook for downstream industries such as auto, ship building, machinery and etc

Oil & GasBetter US economic data supports crude ASP

Higher than expected inventory; New resources tax in China hurts profitability

Geopolitical tensions surrounding Iran and a possible disruption of exports

Higher resources tax probably won't be offset by lower windfall tax

Construction equipment Improving credit environment

Sales volume should fall due to weak seasonality; Chinese players lack competitive advantage other than more favorable pricing

Construction of social housing may speed up FAI growth decelerates

MSG

Corn price stabilization and ASP hikes partially alleviate margin squeeze

Leading players stay on the peak of capex and hence FCF will maintain negative

Further industry consolidation; New VAT tax policy on agriculture product processing enterprises may roll out to a boarder industry base

Corn price volatilities; Policy overhang on corn processing companies; Better margins allure new players into the market

SolarThe pace of ASP decline slows down significantly

The sector will continue to report losses in 1Q12 at least; Further inventory writedown on falling ASPs; GM to decline further to burn inventory

Falling PV prices may stimulate demand; The prospect of lower subsidies next year may drive demand in the last months of 2011

China demand growth not enough to offset European decline; More bankruptcies in this sector furhter drag down sentiments

TextileCotton price should find a support at Rmb19k/ton

Final products ASP will continue to fall due to lagging effect; RMB appreciation does not bode well

Domestic demand may gradually pick up and partially offset the export decline

Demand from US/EU slows down further; Competition from other Asian countries

Certainties Uncertainties

Source: Citi

Cement. Cement remains our favorite industry in ‘2012. Despite short-term headwinds, the sector is least exposed to external markets, and should benefit immediately from any fiscal stimulus should China go into a deeper economic slowdown.

Our equity analysts project demand growth of 5.8% and supply growth of 4.6%. Hence, we should see improvement in the demand/supply balance in 2012. As a result, cement makers should be able to keep a flat profit-per-ton in 2012 on an annualized basis. Volume growth from both organic and acquisitions should drive earnings.

However, near-term headline risks remain. We see fiercer challenges in the first quarter of 2012. Weakening demand, unfavorable seasonality and uncertain policies will produce negative headlines.

Coking coal. China’s coking coal prices remain relatively resilient on the back of supply constraints and logistical bottlenecks, and have only started to retreat recently due to weakening crude steel output growth. Coking coal prices will remain under pressure in the immediate quarter due to steel production cuts and high coke and coking coal inventory.

Nevertheless, we expect coking coal prices to rebound in the latter half of 2012 along with our expectation of improvement on steel output. Besides, we think the downside on coking coal prices is well supported by logistical bottlenecks which will not be resolved until 2014, despite production reactivation in Shanxi province.



Steel. Steel is our least-favored sector in 2012 within basic materials. Sluggish demand, an input margin squeeze, oversupply and homogeneity of production have hurt steel-makers’ P&L. The sector seems to be caught in a catch-22: higher input prices erode margins while lower input prices typically coincide with a weak demand outlook. Only if demand improves so much that steel-makers can pass through rising material costs, would profitability improve.

In the next six months, steel prices should consolidate and profitability may hit a trough on the back of restocking and a decline in iron ore and coking coal prices. Long products may outperform as construction should find a seasonal bottom after Chinese New Year, while flat products will continue to suffer, echoing weak PMI data.

Corporate governance: textbook versus reality

Valuing sponsor risk is not an easy task in China. Sponsor risk is crucial for China credits, as most privately-owned enterprises are under the key man’s control. The subordination issue, capacity and willingness to service debt, as well as potential recovery prospects once a company gets into trouble, rely significantly on the major shareholders’ creditworthiness.

Historical defaults in the China industrial space can be attributable to fundamental deterioration, sponsor/major shareholders’ intention to default, or both. The fundamental reasons are relatively easier to predict while sponsor risk is hard to detect. Given China’s vast geographic expanse and relatively short history of private businesses, there isn’t enough track record, nor any easy way to check the sponsor’s background to form any firm opinion on creditworthiness at the shareholder level.

In this context, it is difficult to differentiate China credits by sponsor risks. Besides, there exist some “China” factors, which serve as red flags in more mature economies but can be quite common in China, such as short listing history, concentration of shareholdings, operating with uncompleted licenses in certain industries and some “relationships” factors. We are not saying investors should not be concerned about those aspects. Instead, we think those aspects should be analyzed on an ad-hoc basis.

So what are the practical “red flags” investors should watch out for a potential corporate governance issue or fraud from the very beginning?

(1) Low-value add but extraordinarily high profit margins compared with peers;

(2) Simple business with extremely high profitability but no competitors;

(3) Listing in an irrelevant country with auditors signing in a different country to key business operations;

(4) A very lucrative business that generates consistently negative free cashflow and unreasonably high capex;

(5) High relevance of major shareholders’ private business

(6) The industry itself is opaque with little public information

The six points above are clearly only a starting point. In this respect, we maintain our reservations on the forestry names, the plastic pipe sector and materials.



High-Yield – Indonesia

Market Performance and Investment Strategy Indonesian credit had a volatile year, but was relatively better-behaved in comparison with its peers in Chinese high-yield. Sovereign fundamentals remained robust and although the upgrade trajectory into investment-grade may be delayed slightly in to ‘2013, Indonesia is still appears to have already entered investment-grade territory on many metrics. Leverage both at the sovereign level and within the banking system remains low, while banking system liquidity is acceptable at just over 80% in loans-to-deposits. Corporate fundamentals and liquidity metrics look fine, although it is likely that the size of some of the issuers (and not their financial metrics) may prove to be constraints in terms of following the sovereign’s trajectory into investment-grade. Shareholder risk is of course another critical factor to consider.

We are recommending light positioning in high-yield given that even Indonesian credit sees large volatility during periods of market stress (see Figure 70). However, it consistently outperforms the rest of the high-yield space (see Figure 71). Therefore, within high-yield, we maintain that Indonesian credit is the best sector to be positioned in. Very limited issuance among private-sector corporates has substantially reduced duration in the sector (thus less volatility) and has also provided a strong technical base particularly in the natural resources credits. Within Indonesia, we prefer coal players as a must-own sector, and also see power-sector credits as a core holding as well.

Figure 70. Volatility ranges for Indonesian corporate on-the-run bonds Figure 71. Indonesian credit versus Asian high-yield

0

20

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60

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120

ISA

T

BR

AU

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LIPP

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$-price

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20


Yield %

ABBI HY Corporates

ABBI HY Corporates - Indonesia

Source: Bloomberg, Citi Source: Citi, Yieldbook

Growth trajectory barely dented The large volatility in the global macro landscape has done little to dent Indonesia’s solid fundamentals, although we are expecting a modest reduction in growth from the ‘2011 figure of 6.5% and see inflation remaining a risk given the potential for energy subsidy reforms, according to our economist5. Even where risks were taken, with a more aggressive easing stance taken than anywhere else in Asia, things seem to have worked out reasonably well. Growth remains strong projected at 6.3% in ‘2012, a reduction of just 0.2%-pt from forecasts made at the beginning of the year. Inflation pressure has remained benign, running at 4.5% (‘2011E), despite 75bp easing in policy rates and a fairly significant expansion in money supply. Leverage both at the sovereign level and in the banking system are extremely low, with external debt/GDP estimated at 29.1% and credit 5 See “Asia Macro and Strategy Outlook”, Indonesia section, Helmi Arman and Brian Tan – 29 November 2011



penetration is barely above 30% (although we presume some of this leverage is actually offshore the Singapore banking system which is at a still-manageable 126.3%; figures as of 3Q11).

External vulnerability has always been the Achilles’ heel of Indonesian markets, be they currency, local government bond or external credit markets. On that front, Indonesia will always be at risk of capital withdrawal from the region, whatever its metrics may look like, since policy credibility take many years of consistency to establish even though things are on the right track. For what it’s worth though, external vulnerability looks much lower than it did in ‘2007, with FX reserves at US$117.1bn as of 2011E (versus US$56.9bn), representing 10 months of import cover (versus 8 months) and 1.8x coverage of short-term debt by remaining maturity (versus 1.3x).

Figure 72. External debt to GDP Ratio Figure 73. FX reserves coverage of short-term debt by remaining maturity

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2005 2006 2007 2008 2009 2010 2011E 2012F-

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FX Reserve Coverage (x)

Source: CIRA Source: CIRA

Supply: Another lean year ahead Availability of credit is adequate through the banking system, which as mentioned above is one of the most underleveraged in the region, and the 2009 change in withholding tax legislation withdrawing eligibility of offshore special purpose vehicles from a 10% exemption, making offshore bonds costlier. As a result, external issuance out of the corporate sector has dried up. While we understand there were also practical constraints related to archaic stock exchange regulations that are now being modified, in truth we do not expect this to have much of an impact. Essentially, the flow of financial capital into Indonesia has only intensified over the last few years as investors sought sheltered investments in domestically-driven economies with low growth vulnerability. In addition, Indonesia’s concentration in commodities is a major advantage, since it is positioned at the lowest end of the volatility spectrum of the broader commodity space. Thermal coal plays into a very robust power demand theme in India and China, and agricultural commodities are also oriented towards relatively inelastic segments of food consumption.

All of which means that with no quasi-sovereign supply coming up for refinancing next year, supply could again be abysmally low. We are projecting US$2.0bn in ‘2012, versus US$2.9bn this year (of which US$2.5bn was from quasi-sovereigns). Refinancing requirements in ‘2012 amount to about US$800m external bond markets, of which about two-thirds will probably be paid down or defaulted upon (i.e. will not come through to the bond market for refinancing).



Figure 74. US$-bond issuance trends Figure 75. Maturity profile of US$ corporate bonds outstanding

3.8

2.2

3.83.4

2.92.0

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'06 '07 '08 '09 '10 '11* '12F

US$ bn

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US$ bn

Source: Citi, Bloomberg, Dealogic Source: Citi, Bloomberg, Dealogic

Liquidity and Fundamentals Based on chart below, the majority of issuers in the sector have annualized EBITDA that is sufficient to cover current debt, and is supported by cash balances in many cases. We are generally sanguine on the fundamentals of the Indonesian private-sector corporates given the majority of issuance is in the natural resources and power space. In power, quasi-sovereign support remains a key element even for private-sector players, given the offtake agreements with the state-owned electric utility. In the coal sector, we believe demand-supply fundamentals will remain tight due to (1) the frequent occurrence of supply disruptions in the global thermal coal trade, (2) rising energy intensity in China (hard landing or not) and India and (3) Indonesia’s dominant role as the largest supplier of thermal coal in the seaborne market. We expect contract prices to continue to outpace inflation in extraction, mining and logistics costs such that EBITDA margins will expand further on a per-MT basis.

Figure 76. Indonesian private-sector corporates: Cash & EBITDA (YTD annualized) versus Current Debt as of most recent reported financials

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0.5

1.0

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ADRO BRAU ISAT BUMI LPKR GJTL CIKL* STAR TPIA BTEL* BLTA

Coal Coal Telecom Coal Property Tires Power Power Petro Telecom Shipping

Cash + EBITDA - Current Debt Cash + EBITDA Current DebtUS$ bn

Source: Citi, Companies, Bloomberg; *BTEL and CIKL are based on 1H11 information

In terms of leverage, the majority of corporate issuers are at or below 3x, which correctly reflects the fact that shareholder risk and not financial risk, is the key driver of yields in Indonesia except in very extreme cases. Many Indonesian corporates have financial metrics that could be considered at or above the BBB-range, however aside from governance concerns another key constraint is the aggregate size of some of the issuers in terms of asset base and market capitalization. This is why many will not benefit directly from the sovereign upgrade when it occurs in terms of rating action.



Figure 77. Net Debt/EBITDA of Indonesian private-sector corporates Figure 78. Net Debt/EBITDA versus EBITDA margin for Indonesian private-

sector corporates

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Ship Telco Pow Coal Coal Telco Tires Petro Pow Coal Prop Coal

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Net Debt / EBITDA x

Source: Citi, Companies, Bloomberg Source: Citi, Companies, Bloomberg



Credit Sector Specialists

Umar Manzoor, CFA (852) 2501-2355 [email protected]

Hong Kong

Jenny Zeng, CFA (852) 2501-8314 [email protected]

Hong Kong

Dana Kulik (852) 2501-8227 [email protected]

Hong Kong

George Fong (852) 2501-2562 [email protected]

Hong Kong

Citigroup Global Markets Asia Limited Fixed Income Credit Analysis • Credit Sector Specialists

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