<p>Taiwan Banks Sector<br/>FORECAST REDUCTION<br/>No room for error<br/>■<br/>Our economist’s recent downgrade of Taiwan’s GDP forecast to -7.2%<br/>for 2009 (from -1.1%) suggests the operating environment for Taiwan<br/>banks will be much tougher than expected. The backdrop is likely to be<br/>even more difficult for state banks, given lack of operating flexibility<br/>and government pressure to lend and participate in national services.<br/>■<br/>We expect banks to see a loan contraction of 1.8% this year despite<br/>already taking into account some positive support from a pick-up in<br/>government spending later this year. The likely scenario of a prolonged<br/>record low interest rate environment is set to drive NIMs to their lowest<br/>level of just 1.55% in 2009 thereby creating more top-line pressure.<br/>■<br/>Credit costs are lurking and we expect this to surge in 2H09 to 221 bps<br/>for this year, mainly driven by a pick-up in corporate credit costs to<br/>450 bps, with state banks expected to be most affected given their<br/>large corporate/SME exposure. The credit cost shock in 2H09-1H10 will<br/>result in negative profits for all banks in FY09-10.<br/>■<br/>Clearly, the pressure on most financials is not just a P&L issue, but will<br/>have a balance sheet impact. In particular, many state banks’ low tier-1<br/>ratios are vulnerable to negative shocks likely in 2H09. We estimate<br/>that seven banks we cover (out of 13) will see tier-1 ratios fall below 7%<br/>by end-2009 and face pressure to inject new capital.<br/>■<br/>We continue to UNDERWEIGHT the sector and would avoid state banks.<br/>We downgrade Hua Nan, First and CHB to an UNDERPERFORM. We<br/>also downgrade Fubon to a NEUTRAL but it remains our relative pick.</p><p></p><p></p><p> <br/></p><p></p>