The curious case of interbank rate spikes and yield curve inversion in China
Unlike other countries, Chinese banks are less affected by the term structure of the yield curves as both loans and deposits are priced against the PBOC's benchmark rates and there exists no direct transmission between SHIBOR and the borrowing cost prevalent in the shadow banking system, except for commercial papers and bank acceptance, which we estimate contribute 15% of the outstanding total social financing (TSF). Although we expect the spikes in SHIBOR to be temporary, history shows that even a persistent yield curve inversion, as seen July 2011 to June 2012, would not affect earnings, as NPAT of H-share banks rose 18.3% yoy in the period, when 3M SHIBOR averaged 5.5%, leading to an average yield curve inversion of 1.8%. Overall, the H-share listed banks are small net lenders to the money markets, with net lending making up just 0.2% of their average interest yielding assets (AIYA). While the big four banks have the lowest gross interbank borrowing, MSB and BoCom are the most exposed.

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Despite the sharp spikes in SHIBOR, the PBOC does not believe there to be a structural abnormality in the money market, with only a minimal increase in interest creating a burden on corporates (DBe: 23bps more if the 3m SHIBOR stays at the current level in the next 12m), explaining the lack of immediate policy intervention to regulate the market. On our estimates, the H-share listed Chinese banks trade at 0.9x 2013E P/B, 5x 2013E P/E, with ROAE of 19.3%, and the low valuation should compensate investors for the mounting short-term headwinds. Our top picks are the big four Chinese banks and we see the normalization of SHIBOR as a positive catalyst. Key downside risks: weaker-than-expected economic growth and deteriorating sector liquidity. (See pages 9-11 for valuation and risk detail.)

Eoin Treacy's view While it is probably correct to point out that the linkages between Chinese interbank rates and bank funding are not as robust as in more developed markets, there is little doubt that the spike in SHIBOR has had a deleterious effect on investor sentiment.

The PBOC has made clear it is willing to intervene to avert a disorderly outcome, but it is also intent on squeezing the shadow banking sector in an effort to force participants to come on balance sheet. 3-month SHIBOR has paused in its advance but will need to compress further to suggest interbank stress is easing.

I have added the new Offshore CNH Interbank Rate, which was initiated on Tuesday, to the Chart Library. It has fallen 40 basis points over the last three sessions.

Veteran China watchers will be familiar with the persistent hikes to the banking sector's reserve requirements from 2006 so that the level still stands at 20%. P/E ratios for China's Hong Kong listed banks are now in low single figures suggesting close to a worst case scenario has been priced in and that investors are unwilling to give them the benefit of the doubt. Concurrently, yields in excess of 5% are evident on five of the seven I monitor. Here is a table with some of the relevant valuations.

One of the more important fundamental metrics for the banking sector, in my opinion, is loan loss cover. As speculation about the scale of the challenge they face mounts, it is worth highlighting that Bank of Communications has the lowest loan loss coverage at 38% while China Citic Bank has the highest at 114%. China Construction Bank represents the median at 55%. By way of comparison the USA's Wells Fargo has a loan loss coverage of 4%.

All of these shares have returned to test previous areas of support and have at least paused. There is potential for an additional bounce as short-term oversold conditions are unwound but some additional clarity on the PBOC's intentions will probably be required to act as a catalyst for a return to medium-term demand dominance.