Interim Report - 9 of 28

Economic background

Hong Kong's annual rate of real GDP growth slowed to 2.5% in the first quarter of 2014 from 2.9% at the end of 2013. The slowdown was broadly based, although there was a particularly sharp fall in the exports of goods. Private consumption held up relatively better, benefiting from a strong labour market as the headline rate of unemployment fell to the lowest level seen since the 1990s. In mainland China, economic activity slowed at the start of 2014. Real GDP grew by 7.4% in the first quarter of 2014 compared with a year ago, down from 7.7% in the fourth quarter of 2013 and slightly lower than the government's official target of 7.5% for 2014 as a whole. In response, the government announced a number of stimulus measures in early 2014 and the annual rate of GDP growth rose to 7.5% in the second quarter. Inflationary pressures remained subdued, with CPI inflation falling from 2.9% at the end of 2013 to 2.3% in June 2014. Producer prices continued their fall of the past two years.

Economic growth in Japan picked up sharply in the first quarter, thanks to a rise in spending in the run up to the 1 April 2014 increase in consumption tax, with strong consumer spending and robust business investment. Excluding the volatile fresh foods component and VAT increase, CPI inflation was 1.4% in June, in line with the Bank of Japan's forecasts. The central bank continued its purchases of 6-8 trillion yen a month as part of its monetary easing programme.

The region saw considerable political change in the first half of 2014. In India, the BJP-led NDA opposition won a decisive victory in the national elections, leading to hopes that the strong mandate will revive growth through structural reforms. In Indonesia, growth slowed in the first quarter of 2014 as previous rate rises restrained economic activity. Elsewhere, growth remained robust and central banks were increasingly concerned about rising inflationary pressure, while the central banks in Malaysia and Singapore indicated they may need to tighten monetary policy further.

Financial overview

Our operations in Asia reported a pre-tax profit of US$7.9bn compared with US$9.3bn, a decrease of 15% or 14% on a constant currency basis. This was driven by the non-recurrence of the accounting gain of US$1.1bn on the reclassification of Industrial Bank and the gain on disposal of our investment in Bao Viet Holdings of US$104m.

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

On an underlying basis, which excludes the gains noted above, profit before tax in the first half of 2014 was marginally lower. It included a gain of US$428m in Hong Kong on the sale of our investment in Bank of Shanghai and an adverse DVA of US$53m, which compared with a net gain of US$553m on the completion of the sale of our investment in Ping An and a favourable DVA of US$112m in the first half of 2013. Excluding these items, profit before tax increased, as higher net interest income in Hong Kong and mainland China was partly offset by higher operating expenses.

Country business highlights

We continued to focus on our strategic priorities for Asia, using our international network to connect customers across borders. We progressed with the closure of non-core operations, completed the sale of our investment in Bank of Shanghai and implemented the Retail Banking Incentive Framework that removes the formulaic link between product sales and remuneration.

In Hong Kong, we grew our average mortgage balances in RBWM by 2%, though activity levels in the property market were subdued, with average LTV ratios of 47% on new mortgage drawdowns and an estimated 32% on the portfolio as a whole. We saw continued adoption of our mobile banking applications, extended the contact-less payments system to Android phones and were awarded 'International Retail Bank of the Year' by Asian Banking and Finance and 'Best Regional Retail Bank' by The Asian Banker.

The collaboration between CMB and GB&M continued to benefit our clients, raising significant finance in Asia from debt capital markets. Our ongoing collaboration efforts were a key factor in being named as the 'Best Bank in Asia' by The Euromoney Awards for Excellence 2014. In addition,

Analysis of mainland China

we were awarded 'Best Trade Finance Bank in Hong Kong' by both The Asian Banker and The Corporate Treasurer.

In GB&M, we maintained our market leadership in Hong Kong dollar bond issuance and also led the market in Asia ex-Japan G3 currency bonds and Asian local currency bonds, demonstrating the strength of our network and capabilities. We were involved in three of the five largest equity capital markets transactions in Hong Kong during the period.

We continued to lead the market in offshore renminbi ('RMB') bond issuance in Hong Kong and were one of the first foreign banks to announce RMB cross-border pooling capability in the Shanghai Free Trade Zone. We completed Japan's first RMB-denominated import transaction, were the first foreign custodian bank in mainland China to service a Singaporean renminbi qualified foreign institutional investor and won 'Best Overall Offshore RMB Products and Services' in the AsiaMoney Offshore RMB Poll 2014.

In mainland China, we continued to expand our branch network with 167 HSBC outlets, 24 HSBC rural bank outlets and 50 Hang Seng Bank outlets at the end of June. We streamlined the mortgage application process in mainland China and were awarded 'Best Foreign Retail Bank' by The Asian Banker for the sixth consecutive year. In Payments and Cash Management, we launched the Global Payments System which supports all cross-border payments in and out of mainland China in all currencies, including RMB. In M&A, we were adviser to a number of state owned enterprises on significant overseas investments and acquisitions.

In India, we were adviser on two of the largest mergers and acquisitions transactions in the first half of 2014, assisting UK corporations investing in India, and in Wealth Management we launched Managed Solutions, a multi-asset fund series.

In Australia, we were a mandated lead arranger for the largest mining project financing deal and we were awarded 'Best Project Finance House in Asia' by The Asset AAA Award 2013.

Review of performance

The following commentary is on a constant currency basis and comparisons are with the first half of 2013, unless stated otherwise.

Net interest income rose by US$675m, primarily in Hong Kong and mainland China from growth in Balance Sheet Management income, increased term lending and growth in customer deposits.

The rise in Balance Sheet Management income reflected portfolio growth and higher reinvestment rates. Average term lending balances increased in Asia, driven by strong loan growth to GB&M clients in Hong Kong and mainland China, and in CMB from property-related, commercial and industrial lending. The benefit of this growth was partly offset by lending spread compression compared with the first half of 2013, although spreads in CMB were broadly unchanged from the end of 2013. 

Deposit balances increased in Payments and Cash Management in GB&M and CMB, notably in Hong Kong, as well as in Taiwan, mainland China and Singapore. Deposit balances in RBWM also increased, mainly in Hong Kong, in part from new Premier customers, while net interest income growth in mainland China reflected a widening of deposit spreads as market interest rates rose in the first half of 2014.

Additionally, in RBWM, higher net interest income reflected growth in the debt securities portfolio of our insurance operation in Hong Kong, reflecting a rise in premium income, while increased mortgage lending across the region was offset by asset spread compression.

Net fee income decreased by US$74m, mainly in GB&M, due to a reduction in fees received from other regions reflecting lower activity in Markets. In addition, fees from debt under-writing and corporate finance activity decreased due to reduced issuance volumes and the non-recurrence of significant transaction fees in the first half of 2013. These factors were partly offset by higher equity underwriting fees in Hong Kong.

Net trading income was US$454m higher due to the non-recurrence of adverse fair value movements on the Ping An contingent forward sale contract of US$682m, partly offset by an adverse DVA compared with a favourable DVA in the first half of 2013. Excluding these items, net trading income fell, mainly on structured deposits in mainland China from both revaluation losses as yield curves fell and increased interest expense from volume growth where the related income is included in 'Net interest income'.

Net income from financial instruments designated at fair value was US$386m compared with a net loss of US$260m a year earlier, primarily due to higher investment returns on assets held by the insurance business in Hong Kong reflecting improved equity market performance. To the extent that these investment returns were attributed to policyholders holding unit-linked insurance policies and insurance contracts with DPF, there was a corresponding movement in Net insurance claims incurred and movement in liabilities to policyholders.

Gains less losses from financial investments were US$440m compared with US$1.2bn, primarily reflecting the gain on disposal of our investment in Bank of Shanghai of US$428m in the first half of 2014, and the gain on the sale of our investment in Ping An of US$1.2bn in the first half of 2013.

Net earned insurance premiums grew by 7%, mainly in Hong Kong, due to increased new business from deferred annuity, universal life and endowmentcontracts, coupled with higher renewals. This was partly offset by lower new business from unit-linked contracts. The growth in premiums resulted in a corresponding increase in Net insurance claims incurred and movement in liabilities to policyholders.

Other operating income decreased by US$1.2bn, as the comparable period in 2013 included an accounting gain of US$1.1bn on the reclassification of Industrial Bank as a financial investment and a gain on the disposal of our investment in Bao Viet Holdings of US$104m. Excluding these items, other operating income was lower by US$47m, mainly reflecting lower revaluation and disposal gains on investment properties, and a loss on the reclassification of our banking associate in Vietnam of US$32m, partly offset by an increase in PVIF assets due to favourable market conditions and a rise in the value of new business.

LICs increased by US$30m, primarily in CMB in Hong Kong due to a rise in individually assessed impairment charges and the non-recurrence of collective impairment releases. This was partly offset by lower collective impairment charges in RBWM in Malaysia reflecting reduced delinquencies, and the non-recurrence of individually assessed impairments on a few corporate exposures in Australia.

Operating expenses rose by US$299m, reflecting investment in the region, notably in risk and compliance initiatives such as Global Standards. Staff costs rose from inflationary pressures and additional headcount, in Hong Kong to support business growth, and in mainland China and India from increased usage of our Global Service Centres. Higher costs also reflected a litigation provision release in the first half of 2013, higher property costs in Hong Kong from rent inflation and refurbishments, and ongoing branch expansion in mainland China. These factors were partly offset by the non-recurrence of a US$72m write down of Hana HSBC Life Insurance in the first half of 2013. In addition, we achieved over US$100m of sustainable cost savings in the period.

Share of profit from associates and joint ventures rose, primarily from BoCom, reflecting higher fees and trade revenues, along with increased net interest income from balance sheet growth, partly offset by higher operating expenses and increased LICs.

Profit before tax and balance sheet data - Asia

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