Interim Report - 9 of 25

Economic background

The mainland China economy slowed in the first half of 2012. Annual GDP growth decelerated from 9.2% in 2011 to 7.6% in the second quarter of 2012, reflecting a downturn in demand for Chinese exports and a reduction in the pace of property construction following measures by the authorities to moderate activity in the property market after the rapid price rises in recent years. The slowdown eased inflationary pressures that had been building in 2011, and the annual rate of CPI inflation fell to 2.2% in June. In response to the escalation of the eurozone crisis, policymakers adopted more accommodative measures with cuts in the reserve ratio for banks and deposit and lending rates. A number of fiscal measures were also implemented to support activity such as faster approvals for infrastructure projects, tax incentives to buy energy-efficient home appliances and lower regulatory barriers for investment.

Japan's economy delivered robust growth during the first half of the year, with GDP expanding at almost 5% in the first three months alone on an annualised basis. Domestic demand, led by private consumption and government spending, mostly accounted for the strength. The Bank of Japan also loosened monetary policy by adopting a firmer inflation targeting regime and announcing a further expansion of its asset purchase programme. Economic momentum slowed slightly in the second quarter.

In the early months of 2012, GDP growth in Singapore remained robust, driven by investment and private consumption. In the second quarter, GDP growth eased as the eurozone crisis constrained external demand. Annual CPI inflation remained high at nearly 5%, prompting the Monetary Authority of Singapore to tighten monetary policy and strengthen its trade-weighted exchange rate. The recent slowdown in India's economy continued in the first quarter of 2012, with annual growth of GDP easing to 5.3% from 6.1% in the final quarter of 2011, the slowest rate since 2004. This reflected the lagged effect of monetary tightening by the Reserve Bank of India ('RBI') during 2011 to ease inflationary pressures, the slowdown in external demand and slow progress in key structural reforms. Inflation remained high, so the RBI were only able to cut the key policy rate by half a percentage point in April to 8%.

While the domestic economies in other parts of Asia remained largely firm, the slowdown in demand from mainland China and the West reduced the rate

Profit/(loss) before tax by country within global businesses

of GDP growth. In South Korea in the first half of the year, economic activity was supported by strong government spending and investment, but growth is expected to remain below the levels seen in 2011 as persistent global uncertainties weigh on domestic demand and external trade. Quarterly GDP growth accelerated in the first quarter of 2012 in the Philippines, rising by 6.4%. Recent export and remittance indicators suggested growth moderated in the second quarter in line with a slowing in the pace of world trade. Annual GDP growth in Vietnam accelerated in the second quarter but growth remained significantly below long-term trend rates. Domestic demand was relatively weak and headline inflation moderated to 6.9% in June. In Indonesia, the central bank cut its policy rate by 25bps in February to 5.75%, following concerns about the slowdown in global demand. However, first quarter GDP growth was robust at an annual rate of 6.3%. Domestic demand was also a significant driver of GDP growth in Malaysia. The same trends were apparent in Thailand. The economy recovered more strongly than expected in the first quarter in response to recovery efforts after 2011's floods.

Review of performance

Our operations in the Rest of Asia-Pacific region reported pre-tax profits of US$4.4bn compared with US$3.7bn in the first half of 2011, an increase of 17% or 18% on a constant currency basis. Reported profits included gains from the sale of our RBWM business in Thailand of US$108m, our GPB business in Japan of US$67m, and our interest in a property company in the Philippines of US$130m. These were partly offset by the non‑recurrence of an accounting gain arising from the dilution of our shareholding in Ping An in the first half of 2011, following its issue of share capital to a third party.

On an underlying basis, which excludes the above gains, pre-tax profit rose by 15%, reflecting strong growth in lending and deposit balances, coupled with improved liability spreads. These were offset by higher expenses, in part due to US$114m of restructuring costs arising from the ongoing strategic review of our businesses and support functions in the region, as well as higher loan impairment charges due to a small number of new individual charges in CMB and GB&M. Increased profits from our associates in mainland China also contributed to our improved profitability.

We maintained our focus on our key priority growth markets in the region. In mainland China, pre-tax profits grew due to higher net interest income from Balance Sheet Management activity, balance sheet growth and increased income from our associates. Loan and deposit growth, wider deposit spreads and higher trading income and significant cost reductions in RBWM contributed to improved profits in India. In Indonesia, a rise in pre-tax profit was driven by increased Rates trading activities following the country's credit ratings upgrade and growth in fee income. In Malaysia, profit growth was due to volume growth in commercial and residential mortgage lending. In Singapore, profit before tax grew on a strong contribution from higher trading revenues and a continued focus on trade‑related business. A specific loan impairment charge on a corporate customer resulted in a fall in profits in Australia, though this was partly offset by higher net interest income as a result of lending and deposit growth in both 2011 and the first half of 2012.

In RBWM, we focused on capturing wealth management opportunities in the region. We continued to expand our branch network in mainland China and Malaysia and launched initiatives to enhance our multi-channel capabilities including a mobile banking platform in Vietnam and expansion of our mobile functionality in mainland China, Australia and Singapore. We also carried out a detailed review of our loan approval process which reduced processing times. In Taiwan we launched Fundmax, a product that offers our customers the ability to invest in unit trusts with monthly management fees as an alternative to upfront fees.

In CMB, trade revenues grew as we capitalised on our global network to capture cross-border trade and capital flows, particularly with mainland China. Cross-border referrals between mainland China and the rest of the world increased by 11%. We were recognised as 'Financial institution of the year 2011' by the Brazil-China Chamber of Commerce for our contribution to the growth and development of the fast-growing South-South trade corridor.

In GB&M, we achieved record revenues on a reported basis and revenues from the collaboration between CMB and GB&M also increased as we enhanced sales coordination between the global businesses. We continued to be a key participant in the internationalisation of the renminbi and we received approval from the People's Bank of China to be a market maker for direct trading between the renminbi and the Japanese yen in mainland China's interbank market.

The following commentary is on a constant currency basis.

Net interest income increased by 17% due to higher average lending balances in CMB and GB&M, most notably in mainland China. Residential mortgage balances also grew, primarily in Singapore and Malaysia, driven by promotional campaigns.

This was partly offset by narrower asset spreads, particularly in RBWM, due to competitive pricing pressures in residential mortgage lending in a number of markets.

Customer deposit balances rose, notably in Payments and Cash Management from new mandates and deposit acquisition as customers made use of our comprehensive product offering. This reflected our strategy of supporting growth in customer lending with core funding.

Net interest income from Balance Sheet Management was higher in the first half of 2012 primarily in mainland China, reflecting growth in the overall investment portfolio.

Net fee income decreased marginally by 1%, most notably in RBWM due to lower fees in Japan following the discontinuation of our Premier business and in Singapore as a result of weak investor sentiment. This was partly offset by increased fee income from CMB due to higher remittance revenues.

Net trading income increased by 12% compared with the first half of 2011, mainly from Rates trading activities in a number of countries in the region due to a favourable movement in interest rates.

Net income from financial instruments designated at fair value rose by US$61m on the first half of 2011 to US$64m, driven by higher investment gains on assets held by the insurance business, primarily in Singapore, due to positive equity market movements during the first half of 2012. To the extent that these investment gains were attributed to policyholders of unit-linked insurance policies and insurance contracts with DPF, there was a corresponding increase in 'Net insurance claims incurred and movement in liabilities to policyholders'.

Gains from financial investments were US$25m compared with losses of US$22m in the first half of 2011, due to a disposal gain on investments managed by a private equity fund and a lower impairment loss on an equity investment in the first half of 2012 than in 2011 in GB&M.

Net earned insurance premiums increased by 16% to US$392m, primarily in Singapore, as a result of increased renewals and new business volumes. The growth in premiums resulted in a corresponding increase in 'Net insurance claims incurred and movement in liabilities to policyholders'.

Other operating income increased by US$193m, due to gains from the sale of our RBWM business in Thailand (US$108m), our GPB business in Japan (US$67m) and our interest in a property company in the Philippines (US$130m). These were partly offset by the non-recurrence of an accounting gain of US$181m arising from the dilution of our shareholding in Ping An following its issue of share capital to a third party in the first half of 2011.

Loan impairment charges and other credit risk provisionsincreased by US$197m as a result of an individually assessed impairment of a corporate exposure in Australia, individual loan impairment charges in India and New Zealand, and a credit risk provision on an available-for-sale debt security in GB&M.

Operating expenses increased by 4%, due to restructuring costs of US$114m incurred in several countries as part of the ongoing strategic review of our businesses and support functions in the region. This resulted in a net reduction of more than 4,800 staff numbers in the first half of 2012, which was offset by inflationary pressures and business growth, including branch expansion in mainland China and Malaysia. However, we continued to maintain a tight control on costs as part of the organisational effectiveness programme launched in 2011.

Share of profit from associates and joint ventures increased by 15%, driven by higher profits from BoCom as a result of loan growth and wider spreads. Fee income also increased from settlements and credit cards. The contribution from Industrial Bank rose as a result of strong growth in customer lending and a higher fee-based revenue, which was partly offset by a rise in operating expenses. Profits from Ping An were lower as increased income from the banking business following the consolidation of Shenzhen Development Bank and stable insurance income were more than offset by lower securities broking and underwriting income.

Profit before tax and balance sheet data - Rest of Asia-Pacific

Profit before tax and balance sheet data - Rest of Asia-Pacific (continued)