Interesting paper out last from the cross assets Asia team at SocGen. It looks at the Chinese banks and argues, not unpersuasively, that all the concerns are overdone. And what might those concerns be? The first chart below I think nicely sums up the worries. It shows the declining rate of nominal GDP growth alongside total credit growth and bank lending. Notice the fairly obvious synchronized descent for all three measures.
But this steady decline is just the start of a wider set of concerns. Investors are also worried about the omnipotent mountain of nonperforming loans hidden on bank balance sheets – eventually, this must all be written down in some form of restructuring. Next up investors are also concerned about the net profit margin in an era of lower interest rates – Chinese bank margins are higher than European peers but not that much higher. If interest rates fall during the next recession, surely the banks will struggle to make money as their rates decline and defaults pile up?
The SocGen team doesn’t dispute these concerns but they reckon its probably now in the price after a long period of derating of local bank shares. According to the SG analysts “For the past four years, they have mostly traded below book value despite their high profitability amid slowing growth, a changing regulatory framework and rising non-performing assets (NPA)”.
According to SG the banks currently trade at around 0.8x book value despite a 13% return on equity.
To be fair these low valuations might be deserved, if only because debt and bank asset growth is likely to cool from 15% to 8-10%. And those investor concerns about balance sheets are explicitly acknowledged. In particular…
- The risk of further deterioration in profitability – “The interest rate liberalization and an elevated NPA cycle have eroded net interest margins over the past four years. With the latest variant in the loan pricing mechanism, loan pricing is now linked to the Loan Prime Rate (LPR) rather than the benchmark lending rate, marking another step in interest rate reform. However, we believe the potential for margin contraction from the current level is limited, unless we see a significant drop in the deposit rates that constitute close to three-quarters of the banks’ financing cost”.
- The risk of equity capital dilution – “China banks are in the midst of a second NPA cycle. The first began with the SOE reform in the 1990s, which resulted in a total recapitalization in the early 2000s. The current NPA cycle is now stabilising after increased recognition of NPAs and the write-offs over the past two years. At current valuations of 0.8x P/B, our calculations suggest the market is pricing in a stress ratio of more than 8% (NPL + Special Mention Loans) on banks’ books compared to the current stress ratio of 5.1%. We do not see a high risk of equity dilution given the healthy capital adequacy ratios of the listed banks and the shift in capital-raising to debt instruments”.
So trouble ahead but, as I said, maybe its all in the price? The SG analysts suggest focusing on banks with “i) low NPL ratios, adequate loan-loss reserves and high ROEs, and ii) high and sustainable dividend yields”. My own suggestion is that if this trades takes your fancy, concentrate on the really big, systemically important banks i.e the banks the CCP won’t want to go bust and which need to stay on the stock market.