China’s banks are “misunderstood”

According to Gustav Rhenman, a portfolio manager at East Capital, China’s banks are much stronger than people think and are backed by political levers that will ensure good performance, despite the threat to profitability from the recent interest rate cut.
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China's banks: not as shaky as you think (AFP)
<div style="text-align: left;"> China's banks: not as shaky as you think (AFP) </div>

Worries about China’s slowing economy and property overhang leads many to think that China’s banks are due for the same kind of problems that banks in the West are currently facing.

But at least one investor disagrees. Gustav Rhenman, portfolio manager of East Capital, a Swedish private and public equity manager that invests in China and Eastern Europe, said that China’s banks are “misunderstood”, especially by Western investors.

This is especially the case in terms of the quality of their loan books. According to Rhenman, China Construction Bank’s loans to local government financing vehicles (the politically sensitive LGFV asset class that worries most other observers) only amount to 6.6% of the total loan book and 85% of those are fully covered by project cashflows. Similar figures can be found within the books of the other big banks — ICBC, Agricultural Bank of China and Bank of China.

Moreover, the loan books as a whole typically have coverage ratios well above 200%. “They have been very conservative in their provisioning and as a result have huge buffers in place,” says Rhenman. The relatively small portion of the loan books that may be of lower quality is not substantial — probably less than 15% of less than 10%, or less than 1.5% of the total. And substantial provisions are already made to cover these losses should they arise.

The very high historic earnings growth among China’s big banks will gradually slow but should still remain quite attractive for several years to come. And Rhenman said this holds true despite the recent changes to the interest rate regime. This is likely to be slightly negative since banks are now able to compete more aggressively and price their loans up to 20% below the official lending rate and offer deposits up to 10% above the official deposit rate.

In practice, the actual deposit rates that the banks would have to pay to attract depositors could come down because they have been sidestepping deposit rate limits through short-term wealth management products that are, in effect, higher-paying deposits. New regulations will do away with this practice, which should increase bank margins.

Even so, the share prices of China’s banks have already fallen by 2% to 4% on this news, so the marginal negative effect is now at least partially priced in.

Profit growth for the banks is largely determined by loan growth, net interest margins and credit costs. The government decides on the credit growth allowed by the banks through quotas, now growing at an annual rate of around 14%. This is more or less in line with China’s nominal economic growth, and Rehman does not predict this to change dramatically during the next few years.

If this improvement in the quality of their loan books does start to weaken, Chinese officials have two tools at their disposal that many other bank regulators do not.

First, they can change the quotas of credit growth. At the moment it is 14% a year, but they could let that grow. There is an obvious danger that this could make the problem worse as those loans turn into more bad assets, but China has a solid track record in managing its way out of banking crises. During the aftermath of the Asian financial crisis and Sars, Chinese asset management companies became repositories for bad debts that have since been successfully turned around.

Second, the government determines the net interest margin, in effect, that banks can charge. According to Rhenman, “the government can give the banks whatever profits they want”. And there is no doubt about what the government wants. “The top people in government do want the banks to be high growth and high profit,” he said. “The banks are opening up around the world to grow profits for themselves, but also to finance China Inc as it goes global.” Since the state, through various agencies, still owns 70% to 80% of those banks, it is in their naked economic interest to make them successful.

At heart, it is a question of trust. Rhenman admitted that it is hard to trust the numbers produced by China’s banks. “You don’t have access to all the details you want,” he said. And judging the Chinese banking system through the same lens as other banking systems makes it difficult to arrive at any other conclusion. “Foreign investors have seen so many other banks blow up that they feel China’s banks have to blow up too.”

But Rhenman does not buy it, arguing instead that China is not like other countries due to the high level of government control.

¬ Haymarket Media Limited. All rights reserved.
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