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Australia's dependence on its mining sector, and the mining sector's anticipated slowdown, will adversely impact the country's banking system. Banks that have considerable exposure to the country's natural resource rich regions, particularly its mining sector, will take a hit. We have identified three such banks: Westpac Banking Corp. (WBK), Australia and New Zealand Banking (OTCPK:ANZBY), and Commonwealth Bank of Australia (OTCPK:CMWAY). These banks are trading in proximity to their 52-week highs and are trading at premium book value multiples. Global mining stocks are already down significantly; therefore, the best way to play the Australian mining slowdown is to short these three banks.

Recent Developments in Australian Mining Sector

Australia and its economy have remained alarmingly dependent on the country's mining sector. Today is no exception, with the total mining sector representing 19% of the GDP. Mining in Australia has been experiencing a boom for some time now, with tremendous growth witnessed in export volumes. The Bureau of Resources and Energy Economics, in its forecasts, said that Australian exports earned the country $200 billion in 2011-2012, which is expected to surge by another $60 billion over the next five years. Much of this anticipated growth is attributed to the growth in iron ore, coal and liquefied natural gas. However, the Bureau of Resources and Energy Economics, in its same report, notes that sluggish growth in China and the concerns stemming from debt-stricken Europe have the potential to slow export earnings growth to 4.6% in 2012-2013 from the current 11.2%. China alone accounts for about one quarter of the overall Australian exports. Iron ore stands to be the single largest commodity, constituting over half of Australian exports to China. This is why concerns about the Chinese economic growth have accelerated the fall in iron ore prices. Iron ore prices reached a record high of $191.9 per ton in February last year and $90 per ton this week. BHP Billiton's recent decision to mothball the Olympic Dam extension project worth $20 billion may serve as a signal that the Australian mining sector is slowing down.

Australian Banking Sector's Exposure to Australian Mining Sector

Australian banks will be adversely affected if the situations in China and Europe don't improve, and as a result, the country's mining slows down. Since the financial meltdown in the U.S., corporations in Australia have lowered their gearing ratio to record lows of 50% (debt-to-asset basis). However, in Australian regions abundant with natural resources, corporations have increased their gearing since the financial meltdown. Most of these companies are mining companies, who increased debt in their capital structure to finance new mining projects. Banks that have exposed themselves to these natural resource rich regions, and particularly mining companies, will experience a cut in their profits. According to a survey conducted by East & Partners and Macquarie, these natural resource rich regions account for around 40% of the banks' net interest income, which is more than double the 2008 percentage. This reflects the increase in exposure of the banks towards the country's mining sector.

At the end of the first quarter of the current year, Australian banks' credit outstanding to the country's mining sector was A$15.3 billion against the total A$689.5 billion. Despite the fact that it is not a significant portion, we believe that Westpac Banking Corp., Australia and New Zealand Banking, and Commonwealth Bank of Australia will face the biggest risk, as they have the most exposure to the resource rich regions of Australia.

Westpac Banking Corp. has a Tier 1 capital ratio of 9.81%, whereas Commonwealth Bank of Australia has a Tier 1 capital ratio of 10.01%. All three banks being considered have significant exposure to the Australian mining sector. A further slowdown in the country's mining sector will lead to deterioration in the quality of assets for these banks, and the banks will see an increase in their provisions in the coming quarters.

Valuations

All three banks are overvalued with regards to their book values. The stock for Westpac trades at a significant 77% premium to its book value, whereas CMWAY and ANZBY trade at premiums of 116% and 72%, respectively.

Source: 3 Banks To Sell On Australian Mining Bubble Burst