BUY OR SELL-Small Hong Kong banks: M&A hype or reality?

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* Small HK bank shares beat the blue-chip index .HSI in Q2

* Bullish view sees banks in potential M&As

* Bearish call is based on uncertain US financial mkts

By Alison Leung and Parvathy Ullatil

HONG KONG, July 6 (Reuters) - Small Hong Kong banks have become investor favourites over the past quarter, rising on hopes they will be acquired by Chinese banks eager to gain a foothold in the territory as they gear up to expand abroad.

The enthusiasm for them hasn't waned even after China's ICBC (1398.HK) (601398.SS) late last month denied rumours it was in talks to buy Wing Hang Bank (0302.HK) [ID:nHKG316414]. Wing Hang and other banks such as Dah Sing Banking Group (2356.HK) and Chong Hing Bank (1111.HK) are still viewed as potential targets.

But with some predicting a broad market pullback after the blue-chip index saw its best quarterly gain of 35 percent in more than 15 years, can M&A hopes keep the small banks' rally going?

EYED BY CHINA, TAIWAN

Definitely, says Ivan Li, an analyst at Kim Eng Securities. Not only are China banks and insurers potential buyers but also Taiwan banks, who are eyeing a springboard into China, as all three potential target banks have units on the mainland, Li said.

"The story is still there, we always believed that local banks are attractive M&A targets," Li said, adding their valuations were not rich despite the recent run-up.

Wing Hang, the fifth-largest Hong Kong lender, jumped 83 percent in the second quarter and had a price-to-book valuation of 1.8 while Dah Sing and Chong Hing, which both trade below 1 price-to-book, soared 79 percent and 52 percent, respectively. That compared with bigger rival Hang Seng Bank's (0011.HK) 40 percent gain.

JP Morgan upgraded Wing Hang to 'overweight' from 'neutral' and lifted its 12-month price target 50 percent to HK$90 last month.

"From a purely economic point of view, Chinese banks, which are at higher valuations, could look at buying these Hong Kong banks, which are comparatively cheaper, as that would ultimately be valuation-accretive for the Chinese lender," said Andrew Gillan, investment director at Aberdeen Asset Management, which owns 6.99 percent of Wing Hang and 2.69 percent of Dah Sing.

NOT ISOLATED

Some disagree.

Despite their potential as takeover targets, the trio of Hong Kong banks are still part of the global banking sector and thus are prone to its ups and downs, said Peter So, head of research with CCB International, a unit of China's second-largest lender.

"Speculation may drive the shares up for a few weeks, but in the longer term these Hong Kong banks are still vulnerable to the situation in U.S. financial markets which remains quite uncertain," So said. CCB rates Hong Kong banks as its "least preferred" stocks.

Some even doubt the M&A story will materialise.

Hong Kong banks may be less willing to sell as they are not under financial stress, and Chinese buyers have become more restrained after China Merchants Bank (3968.HK) (600036.SS) said earlier this year it would make a hefty provision on its purchase of another bank in the territory, Wing Lung Bank, analysts said.

"M&As probably won't happen in the near future as mainland banks are more cautious now and China's economy is still a bit uncertain," said Andrew To, sales director and head of research of Tai Fook Securities. (Editing by Muralikumar Anantharaman)