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China’s Bank Plans Make Markets Nervous

June 19, 2010

This Thursday (June 17), Motley Fool published a special guest column I wrote on Chinese banks’ big capital-raising plans this summer, and why some investors are wary.  The original post can be found here.

The World’s Largest IPO, and What It Means for China
by Patrick Chovanec

Chinese bank stocks took a tumble early last week, with nearly a dozen hitting 13-month lows on the domestic A-share market. They rallied back later in the week, on news of strong Chinese exports, but not before calling into serious question the viability of the planned listing of Agricultural Bank of China, still scheduled for mid-July. The size and importance of the AgBank offering — billed at $23 billion, which would set a new record as the world’s largest IPO — not to mention the long lineup of other Chinese banks hoping to raise additional capital in its wake, make it worth getting to the bottom of what’s really going on here.

Chinese jitters

To some extent, last week’s plunge in bank stocks is part of a broader case of jitters that have driven the Shanghai market down more than 20% this year, as investors worry the eurozone crisis and government measures to rein in lending and property speculation will dampen China’s fast-paced economic growth. But it’s also just beginning to dawn on investors just how many Chinese banks are going to be coming to market looking for capital this summer.

Chinese banks have already announced plans to raise at least 300 billion yuan ($44 billion) over the next few months by selling both stocks and bonds. In addition to ABC, the last of China’s “big four” state banks to list, the other three — Bank of China (BOC), Industrial and Commercial Bank of China (ICBC), and Construction Bank of China (CCB) — are set to raise tens of millions in secondary share offerings. The Bank of Communications (BoCom), China’s fifth largest bank, hopes to raise 33 billion yuan ($4.8 billion) in a rights issue later this month, after paring back its initial plans this week by 20%. At least a half dozen other midsize banks are also actively planning to raise capital following the ABC listing. Even if you’re bullish on China’s banking sector, you have to wonder whether the market has the appetite to buy all these stocks in one go.

Less-than-bullish appetite

Some investors aren’t feeling very bullish. They wonder why Chinese banks seem so eager to raise funds in such a lackluster market, and they suspect that the banks are desperate to shore up their balance sheets against a mountain of bad debt that has yet to be disclosed. Last year, at the government’s encouragement, state-owned Chinese banks engaged in an unprecedented lending boom to help stimulate the economy. By year’s end, they lent 10 trillion yuan ($1.5 trillion) — more than double the previous year — expanding the country’s entire loan portfolio by a third. Some analysts warned that, with so much money being lent out so quickly, many of the loans could eventually go bad. During previous bouts of state-directed lending by Chinese banks, non-performing loan (NPL) ratios topped 20%.

Ironically, at the same time Chinese banks were making all these new — and potentially risky — loans, they were reporting record low NPL ratios. This happened in part because the denominator, total loans outstanding, had exploded, and in part because of more lenient loss recognition guidelines from encouraging regulators. In any event, these figures gave a seriously flawed impression of banks’ future risks. Chinese banks bragged that their loan loss reserves totaled 150% or more of NPLs. But with recognized NPLs so low, those allowances covered only a paltry portion of new loans being made that year. ICBC, for instance, increased its bad debt reserve by 9.5 billion yuan, while its loan portfolio grew by 1.2 trillion yuan — a provision rate of just 0.8%, barely half the bank’s existing NPL ratio of 1.54%.

Troubled loans

This time last year, Chinese regulators actively pooh-poohed concerns that banks were not making adequate provisions for bad debt, arguing that since most of the loans were going to government-sponsored projects, they were virtually certain to be paid back. Now the very loans they once touted as “safe” have become regulators’ worst headache. Worried that provincial and local governments lack the wherewithal to stand behind the guarantees they issued, China’s Ministry of Finance has revoked those guarantees, leaving the loans they backed in limbo. Preliminary studies estimate that such troubled loans account for 40% of total lending by Chinese banks both last year and this year.

Faced with the prospect of big holes in their balance sheets, Chinese banks are now being encouraged by regulators to raise more capital — but to do it with smiles on their faces. Given China’s 10%-plus rate of GDP growth this year, officials are painting the moves as purely a “precautionary” measure.

Some bullish investors argue that China’s state-owned banks are a good buy, regardless of their true financial condition, because the government would bail them out if they ran into trouble. That reasoning ignores two critical points.

First, Chinese banks were originally sold to global investors not only on their limited downside, but an upside story as well: that they were being reformed into commercially viable, profit-driven enterprises. Their reversion, last year, into mere conduits for government stimulus spending calls that upside story into question. Today, Chinese banks earn hefty profits on the guaranteed spread in regulated interest rates. But as China moves toward a more convertible currency, those protections can’t last forever.

Second, when Chinese banks were last bailed out, the government was the only shareholder. A similar recapitalization in the future would almost certainly mean stock market investors would face dilution. China’s big state banks may be too big to fail, but their private shareholders may not be so invulnerable.

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4 Comments leave one →
  1. Hua Qiao permalink
    June 23, 2010 1:50 pm

    Patrick:

    Nice job. While the commercialized banks have improved in many areas, I don’t think there has been an appreciable amount of improvement in analytic discipline. Cash flow lending is still a foreign concept. As long as debt to cap ratio is less than 80 or 75%, project approved! Of course, debt to equity ratios don’t pay back loans and if the equity is based on inflated asset values or even worse, falsified asset values, well the lender’s only option is the game of extend and pretend (and hope they can service the interest).

    To change the risk culture of a bank, you need endorsement from the top of the house. You would have to centralize the risk and credit approval function in order to ensure consistency. You would have to stand up to the powerful regional fiefdoms (branches) who are run like their own little banks.

    But if everybody knows the CEO is a party placeholder for a few years, then he will be gone. So, nothing will change. Legacy policy banks are just like other SOEs, they are highly socialized organizations with millions of connections and relationships. Highly complex political dynamics impede real change. HR departments are the most powerful.

    Even if a CEO wanted to change the risk culture, he would find himself competing against a lot of dumb banks with gobs of liquidity. His desire for prudence, structure and diversification (smaller deal chunks) would curtail volume and leave his company behind in the league tables. His management team would be the laughing stock of the industry. Tough problem.

Trackbacks

  1. AgBank IPO and Jilin Trip Report « Patrick Chovanec
  2. Chinese Banks At Risk, Part 1 « Patrick Chovanec
  3. Our Year End Recap of Top Stories « China Lawyer

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