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Country reportsOctober 1 2013

The two sides to China's banking story

Despite posting record profits and healthy loan books, China's banks continue to attract criticism from speculators, financial commentators and wary investors, who believe that the country's banking industry is a ticking time bomb.
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The two sides to China's banking story

When the global financial crisis erupted in late 2008 and China responded with a massive stimulus package, the first reaction of investors was one of great relief. It was clear within weeks that the state-led investment push would propel the Chinese economy forward, making it one of the world’s few reliable engines of growth.

But the second reaction was great nervousness at the manner in which China’s stimulus was deployed: it was pumped through the state-owned banking system. Banks issued Rmb9600bn ($1568.49bn) of new loans in 2009, 95% more than a year earlier. It seemed only a matter of time before the big jump in economic growth would boomerang onto the banks’ balance sheets as a big rise in bad loans.

“The Chinese banking system is built on quicksand,” was how Jim Chanos, founder of hedge fund Kynikos phrased it in 2011.

A storm brewing?

This has led to one of the major banking paradoxes of the past five years. Even as China has consistently outperformed every other big economy and its banks have turned in record profits, investors have steadily marked down the value of Chinese banks, bracing for the storm that they think is coming. The shares of ICBC, the country’s biggest lender by market value, are representative of this divergence – they are 20% lower now than they were at the end of 2009 even though ICBC’s profits have increased 80% during the same period.

For most of this time, Chinese bankers made little public comment about the slide in their share prices. But one month ago, enough was enough – one of the country’s top bankers finally spoke out.

“The market has had never-ending controversies about China’s banking sector, pushing the value of bank shares lower. There is a lack of fairness,” said Jiang Jianqing, chairman of ICBC. “We need to emphasise that Chinese banks have had excellent results for the past 10 years and have withstood tests, and we need to call on outside investors to clearly recognise the excellent investment value of our banks.”

Really robust?

The question of the true value of China’s banks is not just one of interest to their investors. It has become a critical concern for the banks themselves, hindering the ability of lenders to raise capital. And much more than that, it is an issue that will shape China’s economic development. The country went through a difficult recapitalisation of its banking sector just a decade ago and a similar exercise now would be far more costly and damaging for the economy.

So who is right? Mr Jiang or the more bearish investors? Looking at the banks’ numbers alone, it hard not to sympathise with Mr Jiang.

Consider Chinese banks' most recent results, for the second quarter of 2013. “Earnings came in higher than the market had expected for each of the individual banks, and this was after roughly 15% of upwards earnings revisions to the 2013 estimate figures over the 10 months leading up to the second-quarter earnings season,” says Mike Werner, an analyst with Bernstein Research, a US-based sell-side research firm.

Beyond their earnings, the banks showed impressive strength in other areas, too. The non-performing loan (NPL) ratio for the Chinese banking sector as a whole is 0.96%, just 0.02% higher than a year ago – hardly an indication of the long-anticipated deterioration in their asset quality.

The banks’ capital buffers are also robust. The country’s five biggest lenders, classified within China as systemically important financial institutions, will be required to have 11.5% capital adequacy ratios under the Basel III rules. At the end of the second quarter, despite some declines because of seasonal dividends, all five of China’s big banks exceeded that threshold. They ranged from 11.8% for Agricultural Bank of China to 13.3% for China Construction Bank.

Changing conditions

Yet many investors remain unconvinced. Their fundamental criticism is that banks have prevented bad loan ratios from rising not because of solid management but rather because of extremely rapid credit growth – the denominator of overall loans has grown even more quickly than the numerator of defaults. With the Chinese economy now entering an era of slightly slower growth after three decades in which it averaged double-digit expansion, banks will find themselves in a tougher operating environment.

“An increase of the NPL ratio seems inevitable,” analysts with CEBM, a Chinese research firm, wrote in a recent report. “In a pessimistic scenario, we estimate that China’s NPLs could exceed Rmb4000bn in the medium term. This means that NPLs will increase by sevenfold from the current level of Rmb500bn. The potential bad loans could wipe out 50% of the banking sectors’ total Rmb8000bn of capital.”

With such gloomy predictions, investors have been wary of wading too heavily into Chinese banks. The forward price-to-book (P/B) ratio of Chinese banking shares is about 0.8 for 2014 expected earnings, according to Barclays.

That is impinging on the ability of Chinese banks to raise new capital. Along with increasing the cost of equity for listed banks, it is preventing unlisted banks from going public. Chinese regulations on capital raising prevent mainland banks from issuing equity if it would value them at a P/B ratio below one, which would indicate that investors do not believe the stated worth of the bank’s assets. There is a long queue of Chinese commercial banks waiting for initial public offerings – Bank of Shanghai, Guangfa Bank and Everbright Bank are just a few of the bigger ones – but all have been stopped in their tracks by the P/B rule.

Earning power

Amid all the pessimism, a few investors are beginning to side with the banks, betting that their robust results will continue and that they are sorely under-valued. Joe Zhang, chairman of Guangzhou Wansui Micro Credit Company and a former UBS banker, has been the most strident in making this case, arguing that banks need not even worry about issuing new capital.

“In a few years, the Chinese banks will have enough retained earnings to replenish their equity base. In the meantime, neither the government nor the equity investors have to do anything but just sit back and relax,” he wrote in a recent commentary piece.

Mr Zhang is clearly overstating the case. China Merchants Bank, one of the country’s leading mid-tier banks, just announced an Rmb35bn equity rights issue to boost its capital ratio. Moreover, the regulator is mulling new rules that would allow banks to issue non-tradable preferred shares – shares that would likely be acquired by state-backed investors, giving banks an outlet for raising equity that would allow them to avoid a collision with bearish investors. Agricultural Bank of China, the weakest of the major state-owned banks, is expected to be one of the first to issue preferred shares.

Nevertheless, it is true that for most of China’s biggest banks, retained earnings have generated sufficient capital in recent years and, barring a major downturn, will do so for a while to come. In late 2011, Wu Xiaoling, a former central bank vice-governor, predicted that China’s five biggest banks would face a capital gap of Rmb400bn to Rmb500bn over the next half decade as they comply with Basel III. But two years on, these banks are mostly on course to hit their targets without any major equity issuance.

Mr Werner of Bernstein believes banks by and large will continue to be able to rely on their own earning power. “The organic capital formation rate at most of the banks was positive in the second quarter. This should allow the banks to report stronger capital ratios in the coming quarters,” he says.

In the shadows

Many of the most interesting – and riskiest – developments in the Chinese banking sector are occurring off the banks’ balance sheets. Financing in China used to be routed almost exclusively through the country’s banks. Just a decade ago, 95% of all financing took the form of conventional bank loans. But last year that figure declined to 58%.

About three-quarters of the surge in non-bank financing has taken the form of what, in China, is broadly defined as shadow banking: trust companies, company-to-company loans and banker acceptance notes. Although technically not on the banks’ balance sheets, the shadow credit impacts them in two important ways.

First, banks sell what are known as 'wealth management products' (WMP) to their clients. These are deposit-like instruments offered for fixed terms. They have been extremely popular because they offer higher interest rates than conventional bank accounts. The banks invest the WMP proceeds in a range of markets, with about one-third of the funds ending up in the shadow banking sector. In other words, the banks are channelling their clients’ funds into shadow banks. WMPs have grown explosively, from virtually zero five years ago to Rmb9000bn at the end of June 2013, or nearly 10% of total deposits in the banking system.

Many believe this has made the banks more vulnerable to financial trouble. The International Monetary Fund warned in its assessment of the Chinese economy in July: “The proliferation in alternative wealth management products, managed by banks and securities companies, raises concerns as the composition of underlying asset pools is often opaque, maturity mismatches create liquidity risk, and investors perceive that most WMPs are implicitly guaranteed.”

Turning sour?

The second way in which shadow finance has affected traditional banks is by helping to backstop their credit quality. Shadow banks have extended many of their loans to clients that regulators have blocked from borrowing from traditional banks because they are seen as too risky; such clients include property developers and steel traders. Had these companies been completely cut off from financing, there is a substantial risk that the loans that banks had previously made to them would have turned sour.

This proposition may soon be put to the test. Alarmed at the rapid increase in non-bank credit, regulators have implemented a series of rules that are slowing its growth; for example, they now only allow banks to invest 4% of their assets into 'non-standard credit assets'. They are already close to that ceiling, at roughly 3%.

“We believe that in the long run, the deleveraging of shadow banking may be the theme, thus non-bank financing growth will slow down,” says an analyst with a major US bank, who requested anonymity because of the critical tone of his comments. “This may increase financial pressure on some corporates, and could have spillover impacts on banks’ asset quality.”

The increasing complexity of China’s financial system was savagely illustrated in late June 2013, when the central bank withheld regular liquidity injections in its open-market operations. Several banks, especially mid-sized lenders, had become increasingly reliant on wholesale funding through the interbank market. When the central bank did not inject funds as expected, China was hit by a cash crunch. Interbank lending rates shot up to double digits. Rumours abounded of mid-sized banks defaulting on loan repayments to other banks. The stock market was pummelled, losing more than 15% in one week at its nadir.

The central bank initially took a hard line, declaring that liquidity was at a “reasonable level” and telling lenders the onus was on them to manage their own balance sheets. But when the cash crunch worsened, the central bank reversed course, promising to support any bank with funding problems.

That was the right medicine, quickly ending the market turmoil and reassuring investors. Chinese bank shares have rallied more than 20% since then, recovering the ground they lost during the cash crunch. Yet that just brought the banks back to the same old story of the past five years, with their top-notch results set against the deep, abiding suspicion of investors.

Out of state hands

Is there anything that might break this impasse? Perhaps there is one thing: the arrival of a new kind of private bank. Much of the scepticism about China’s banks centres around the fact that they are controlled by the state, with their lending decisions directed in part by the government, and their earnings reports read with a big pinch of salt.

But, in recent weeks, regulators have indicated that they are willing to open the door to private companies to form banks. Already, two of China’s biggest internet groups – Alibaba and Tencent – and a major electronics retailer, Suning, have applied for banking licences.

Competition from fleet-of-foot private banks is likely to eat into the earnings of China’s state-owned goliaths. But, it will also spur more innovation and create a breed of banks with numbers that investors are more likely to trust, whether for good or for bad.

“Giving Alibaba a banking licence will show traditional banks what a bank can be in the internet era,” Wu Xiaoling, the former central bank vice-governor, said at a forum in September 2013.

She might have added: it will also show investors the true worth of a Chinese bank.

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