China Banks Shunned as Investors Eye 2003 Low in Credit Bust
Sept. 27 (Bloomberg) -- The cheapest Chinese bank stocks since 2004 may drop further as the three-year credit boom that created the world's most profitable lenders shows signs of turning into a bust.
The MSCI China Financials Index sank 24 percent this month, falling more than benchmark bank gauges for Europe, the U.S., Japan and emerging markets. Valuations in China dropped below levels reached during the global financial crisis for the first time last week, even after Industrial & Commercial Bank of China Ltd. and Bank of China Ltd. said first-half profits hit a record and analysts raised forecasts for next year.
While banks in the MSCI index reported $104 billion of earnings in the past 12 months, bad loans to local governments, a fading real estate boom and slower economic growth are making some of the most successful investors bearish. Jim Chanos, the short seller who predicted Enron Corp.'s collapse, says Chinese banks will fall below the value of their net assets for the first time since December 2003, from an average premium of about 20 percent. Fund managers at Vontobel Asset Management Inc. and International Value Advisers LLC who beat 99 percent of peers this year are avoiding the stocks.
Five Times Faster
"China's economy is very distorted, and the banks, as ever, are at the epicenter of the distortions," Edward Chancellor, who helps oversee about $106 billion as a strategist at Grantham Mayo Van Otterloo & Co. in Boston and warned of a "sucker's rally" in Chinese stocks three days before the benchmark index peaked in August 2009, said in an interview. "If China runs into problems with the banking system, which I think it will, I cannot see a situation in which foreign investors are the main priority of Beijing."
The tumble in Chinese bank shares has surprised equity analysts, who have more positive recommendations on the Asian country's financial stocks than in any of the world's other 10 biggest markets. It contrasts with a Chinese economy that's expanding more than five times as fast as Europe and the U.S.
Bad debts may cut China's growth rate to near zero from 9.5 percent, hurting a global economy that's already weighed down by Europe's sovereign debt crisis and a stagnant U.S. job market, according to Chanos, founder of New York-based hedge fund Kynikos Associates LP.
'Not Touching' Banks
China has led the recovery from the worst recession since the 1940s, contributing more than 30 percent to global growth last year, after the central government ordered state-owned banks to increase lending and encouraged local governments to boost spending on infrastructure and housing. New loans in China since September 2008 totaled $3.8 trillion, while fixed-asset investment surged at an average pace of 28 percent during the period. Property prices have climbed about 60 percent since the end of 2006, according to the International Monetary Fund.
"The main concern we have, and the reason we're not touching the banks, is we're not sure that the Chinese economy is sustainable as it is," said Charles de Lardemelle, whose $2.3 billion IVA International Fund slipped 5 percent this year through Sept. 23, compared with an 18 percent average drop for peers, according to data compiled by Bloomberg. Similar surges in credit and investment in Japan, Thailand and South Korea all ended with a collapse in economic growth, he said in a phone interview from New York.
Severe Outlook
Evidence is building that Chinese property developers and local government financing vehicles, used to get around laws prohibiting direct borrowing, are struggling to repay their obligations as the economy slows. About 85 percent of the government financing vehicles in China's Liaoning province, on the border with North Korea, had insufficient income last year to cover debt-servicing payments, according to a July speech by the provincial auditor.
Chinese developers face an "increasingly severe" credit outlook, which may force them to cut prices and turn to costlier funding sources as sales weaken, Standard & Poor's said in a report today after conducting stress tests of the nation's real estate companies.
Developers are paying as much as 25 percent interest to borrow from private trust companies as banks withdraw credit, said an official at Beijing-based National Trust in May who asked not to be identified because he isn't authorized to speak to the media.
Bonds of Guangzhou-based Evergrande Real Estate Group Ltd., China's second-biggest developer by sales, fell to 76 cents on the dollar last week from 109 cents at the start of the year, sending yields to a record 24 percent, according to Bloomberg data.
'Worst Isn't Over'
A 30 percent decline in sales may leave many developers facing a liquidity squeeze, S&P said. Most developers would be able to "absorb" a 10 percent sales drop next year, the credit rating company said.
"The worst isn't over for China's real estate developers," S&P analysts led by Frank Lu wrote in the report. "Developers are bracing themselves for slower sales and lower property prices ahead."
A gauge of Chinese manufacturing compiled last week by HSBC Holdings Plc and Markit Economics showed the industry may shrink for a third month in September, the longest contraction since 2009. China's nonperforming loans may rise as high as 30 percent of total debt, Fitch Ratings said in April.
Falling Valuations
Tumbling valuations for Chinese bank stocks signal increasing concern that bad debt will erode earnings. ICBC, the world's most-profitable lender and the biggest bank by market value, dropped 17 percent in Hong Kong trading last week to 6 times reported profits, the lowest level on record. The stock trades for 1.3 times book value, or assets minus liabilities, an all-time low, according to Bloomberg data.
Agricultural Bank of China Ltd., the nation's third-biggest lender by market value, and Bank of China, the fourth-largest, have record low price-to-earnings ratios, the data show. China Construction Bank Corp., the No. 2 lender by market value, and China Merchants Bank Co., the sixth-biggest, trade at the lowest valuations since the global financial crisis. All five banks are state-controlled.
Regulators have taken steps to curb risks from the nation's record lending boom, and a repeat of the bad debts that led to a $650 billion bailout last decade is "impossible," China Merchants Bank President Ma Weihua said in a Sept. 14 interview. Press officers for ICBC, China Construction Bank, Agricultural Bank of China and Bank of China declined to comment, as did an official from the China Banking Regulatory Commission.
Price-to-Book
The MSCI China Financials Index, which has a 63 percent weighting in bank shares and includes insurers and property companies, dropped to 1.2 times book value last week, the lowest since January 2004, according to Bloomberg data. The index is trading at a discount to the MSCI Emerging Markets Financials Index for the first time since January 2006.
The China gauge's price-to-book ratio has fallen 47 percent this year, more than the 36 percent decline for Europe's Stoxx 600 Banks Index, which trades at 0.6 times book value. European banks may face a 400 billion-euro ($540 billion) capital shortfall because of losses tied to indebted governments including Greece, according to Nomura International Plc.
The Stoxx banks index and the Standard & Poor's 500 Financials Index both dropped 11 percent this month, while the MSCI Japan Financials Index lost 6.3 percent and the MSCI Emerging Markets Financials Index declined 20 percent.
'Lot of Headwinds'
Shares of Chinese banks "can still go a lot lower," said Chanos, who bet on a decline in Enron shares before the company filed for bankruptcy in 2001. Kynikos is selling short "virtually all of the large banks in China," he said, without naming specific companies. In a short sale, an investor borrows a security and sells it, expecting to profit from a decline by repurchasing it later at a lower price.
For Chinese banks, "we don't think valuations are clear- cut, even though they trade on cheap price-to-earnings and price-to-book ratios," said Amit Mehta, a London-based senior vice president on the emerging-markets equities team at Pacific Investment Management Co., which is "underweight" Chinese bank stocks and oversees about $1.3 trillion worldwide. "There are a lot of headwinds for the earnings outlook," he said.
The MSCI China financials index jumped 6.5 percent today amid a rally in global equities as European policy makers increased efforts to contain the region's sovereign-debt crisis.
Buying Chinese bank shares near current valuations proved profitable in 2008 after Premier Wen Jiabao's government unveiled a stimulus package and increased lending to spur economic growth. The MSCI China Financials Index jumped 96 percent in the 12 months after the plan was announced on Nov. 9 of that year, with shares of Bank of China climbing more than 120 percent.
Nonperforming Loans
China's stimulus in any world economic slump is unlikely to be more than half the nation's estimated 9.3 trillion yuan ($1.5 trillion) fiscal and monetary expansion from November 2008 through 2010, according to Ma Jun, a Hong Kong-based economist at Deutsche Bank AG. China has $3.2 trillion of foreign-exchange holdings, the world's biggest hoard, according to data compiled by Bloomberg.
A growing Chinese economy will help limit the rise in nonperforming loans to between 3 percent and 4 percent of total debt by the end of 2013, up from the current level of 1 percent, said Mike Werner, a bank analyst at Sanford C. Bernstein & Co. in Hong Kong who has "outperform" ratings on ICBC and China Construction Bank. Profits in the MSCI China Financials Index will probably climb 12 percent in the next 12 months, according to analysts' estimates compiled by Bloomberg.
'Soft-Landing Scenario'
China maintained economic growth of at least 7.6 percent in the late 1990s, even after nonperforming loans jumped to more than 40 percent of the total, according to Bloomberg data and "Red Capitalism" authors Carl E. Walter and Fraser J.T. Howie.
"The chance of having a banking crisis in China is rather low," Stanley Li, an analyst at Mirae Asset Securities (HK) Ltd. in Hong Kong, said in an interview. "If nonperforming loans shoot up, profit will fall, but we are likely to see a soft-landing scenario. The government will step in and won't let the system collapse."
Some Chinese lenders still have bad loans on their balance sheets from previous banking crises, and the debt the central government is "implicitly" backing through state-owned companies and local government entities has climbed to about 200 percent of China's gross domestic product, on a par with some European nations, Chanos said in an interview.
The surge in Chinese debt exceeded credit expansions in the U.S. before its financial crisis, in Japan before its stock and property bubbles collapsed in 1990 and in South Korea before the Asian financial crisis of the late 1990s, according to Fitch.
Loans to Developers
Chinese lenders are exposed to a potential drop in real estate prices after the government cracked down on speculative purchases and restricted new credit to developers, according to Rajiv Jain, who oversees about $15 billion at New York-based Vontobel Asset Management Inc.
The CBRC told lenders in July not to extend the maturity of loans to developers and not to grant new credit to help developers repay maturing debt. The regulator is also looking into financing of developers through trust companies as part of a broader evaluation of real estate lending, a person familiar with the matter said last week.
China's home prices were "basically unchanged" in August from a month earlier, according to SouFun Holdings Ltd., the nation's biggest property website.
"There's already a very frothy asset market with real estate," Jain, whose $1.9 billion Virtus Emerging Markets Opportunities Fund outperformed the MSCI Emerging Markets Index by 15 percentage points this year, said in an interview. "They don't have a lot of maneuvering room on the policy side."
More Capital
Chinese banks may have to raise more capital to support their expansion of lending and increase their cushion against bad loans, according to Nicholas Yeo, the Hong Kong-based head of China and Hong Kong equities at Aberdeen Asset Management Plc, which oversees about $298 billion. That will add to the supply of shares and may weigh on prices, he said.
ICBC's Tier 1 capital ratio, a measure of financial strength, was 9.82 percent as of June, down from 10.8 percent in 2008, according to data compiled by Bloomberg. Bank of China's ratio fell to 10 percent from 10.8 percent.
Banks' funding costs are rising in the short-term lending markets, with China's seven-day repurchase rate climbing to 3.8 percent yesterday from about 2 percent a year ago. The rate surged to 9 percent in June, the highest level since October 2007, according to Bloomberg data.
"We'd rather stay away from the big four banks," said Yeo. "There's still a lot of overhang in the market."
--With assistance from Stephen Engle, Daryl Loo, Dingmin Zhang and Paul Panckhurst in Beijing, Bonnie Cao in Shanghai, Allen Wan, Leon Lazaroff and Fabiola Moura in New York and Weiyi Lim in Singapore. Editors: Robert Friedman, Stephen Kirkland
