II China report: banking. Nowhere else looks like this

Institutional Investor, September 2009

China report: Banking sector

Take a look at China’s banking sector and you could be forgiven for thinking the global financial crisis never happened.

In 2008, as US and European banks floundered in the worst financial turmoil since the Great Depression, Industrial and Commercial Bank of China – now the largest bank by market capitalization in the world – logged a 35.2% increase in net profit to RMB111.2 billion. China Construction Bank, the second biggest, climbed 33.99% to RMB92.64 billion, and Bank of China 14.42% to RMB64.36 billion.

No other bank results around the world look remotely like these. And, far from just consolidating, in 2009’s uncertain environment these banks have continued to grow at an extraordinary pace, particularly in terms of lending. Loans in the first half of 2009, at RMB7.4 trillion, have already surpassed annual new loans in any previous year, according to Bank of America Merrill Lynch. This is already way ahead of a targeted Y5 trillion for 2009 suggested by China’s leaders at the start of the year.

But is this all a bust waiting to happen? In the last financial meltdown, the Asian financial crisis of 1997-98, China’s big four state-owned banks each ended up with billions of renminbi of bad debts [non-performing loans, or NPLs] which eventually had to be taken off them and disposed of by custom-made asset management companies. In effect, they were bailed out by the state. It is widely assumed that risk management practices have improved dramatically since then and that the quality of loan books has improved with them. But if that’s wrong – and possibly even if it’s right – then this vast extension of credit could lead to considerable problems for the banks a year or two down the line.

The positive view is that a rising tide lifts all boats and that there’s therefore nothing to worry about in an economy that looks on track to post 8% GDP growth this year. “We are positive on the Chinese banking sector, as our view of banking is very much related to China’s macro position,” says Ning Ma, equities analyst at Goldman Sachs Asia. “We see strong growth for China’s GDP in the next two years, and perhaps five years down the road.” The question is whether China can successfully accelerate GDP growth without making the system overheat. “So far we haven’t seen indications of overheating,” Ma says. “We hope loan growth will slow down gradually to a more sustainable level – that will be quite positive for China’s economic growth sustainability and for the banking sector. But the PBOC [People’s Bank of China] and CBRC [China Banking Regulatory Commission] are very vigilant on the macro overheating risks.”

Most analysts believe it is a question of when, rather than if, China starts reining policy in to cool things down. Dong Tao, research analyst at Credit Suisse, feels it’s already happening to an extent, with the PBOC issuing punitive notes to some aggressive smaller banks, but feels it will be a while before tightening starts in earnest. “The recovery of the Chinese economy is highly uneven, with the export sector still struggling and the job market deteriorating,” he says. “Until exports show a clear sign of recovery and the unemployment rate stabilizes, we do not think Beijing will tighten aggressively and think it would avoid high profile measures such as interest rate hikes due to concern over shocking public confidence.” Tao expects what he calls “a soft lid” on overall lending in the second half of the year, with “a more assertive PBOC” emerging at the end of this year or early next – a consensus view among China economists.

The timing of this assertion has a big impact on the knock-on effects for the banks. “Until recently there were no signs of a credit bubble which would normally imply an increase in NPLs,” says Paul Cavey at Macquarie Bank. But “the system today is that loan growth is at 30% while economic growth is more like 6%. That makes it more likely there will be a credit bubble in future.” To Cavey, it’s all a question of timing. “If it only goes on for one year it’s not so bad. If it’s two or three years, there’s no reason we wouldn’t see the rise in NPLs every economy sees after a credit splurge.”

That said, it’s important to take a close look at where the lending is going. While 30% growth in loans is alarming, it is partly explained by the RMB4 trillion stimulus package announced by the central government late last year, much of which has gone into infrastructure development, which is correspondingly where a lot of bank finance is ending up.

“The banking sector is playing a big role in terms of financing state infrastructure investments,” says Frank Gong, chief China economist at JP Morgan (and promoted to Vice Chairman of China Investment Banking since the interview). “It’s good credit lending because infrastructure borrowings for these projects are guaranteed by the State. It’s more exposure to sovereign risk than company risk.” Additionally, China tends to privatize its infrastructure quite quickly through local or Hong Kong listings, which creates a quick source of capital to repay creditors.

That said, not everything is going to infrastructure: Ma at Goldman estimates around 30% of new loans, with around 6% to real estate developers, about the same to mortgage consumer lending, and the bulk instead to corporate and agricultural lending. “Pretty much everyone is receiving lending,” he says. Tao at Credit Suisse argues that the bulk of new lending is being channeled towards real estate, with June data showing a 61% increase in household loans compared to May, to RMB303.6 billion in June alone. “Lending to public infrastructure projects should have moderated, as most of them received funding early,” he says.

Nevertheless, mortgage lending is historically quite safe in China, says Yifan Hu, chief economist at Citic Securities. “It’s a very safe asset in China,” she says. “People save more [than elsewhere in the world] and normally put 30 to 40% as a down payment, so generally they are high quality loans. I don’t have too much worry about these.” Instead, she thinks local government infrastructure borrowing may be the bigger potential problem for the future, although she believes the sector should be able to handle any increase in NPLs.

Either way, there’s no problem so far – the latest data from the CBRC shows that non-performing loans in China dropped in the first half of 2009, both in terms of volume (RMB518.1 billion at the end of the second quarter, down from RMB 549.5 billion three months earlier) and ratio (1.77%, down from 2.04%). Coverage, too, has improved, from 123.9% to 134.3%.

China’s regulators, however, are preparing for more difficult conditions. In July, Liu Mingkang, the CBRC chairman, warned in July about rising loan risks and urged banks to strengthen their risk controls. The CBRC has asked banks to lift their provision coverage ratio over 150% in 2009, and has sent out circulars requiring that borrowers clearly state the purpose of their loan applications, in order to ensure that the money is ending up in fixed asset investment rather than the stock markets.

Naturally, the future of Chinese banks is not just about lending. All the major banks have sought to develop strength in wealth management, leveraging off the increasing wealth of Chinese consumers and the limited channels for them to invest and diversify their assets. “There is very strong fee income in this area,” says Ma. “But fee income is still a low base: it’s less than 15% of revenues for most Chinese banks. The near term earnings drivers are actually the net interest margin, balance sheet growth and asset quality.” The first of those, the net interest margin, is widely felt to have bottomed in the first or second quarter of this year, which is one reason many analysts are now seeing upside to Chinese bank share prices.

There is so much working in favor of Chinese banks – economic growth, state stimulus, a vast and largely untapped population, growth wealth and sophistication – that the only thing investors are really likely to worry about is whether risk management standards have improved sufficiently to fend off the dangers of over-extended credit. “I think they have,” says Samantha Ho, investment director at Invesco with responsibility for several Greater China portfolios. “Of course the concerns are understandable when there is such loan growth, about what happens if there is a slowdown. But I don’t think it would be too serious. We are watching closely.”

BOX: BROKERS

In China, securities houses are separated from banks and insurers by law. For the most part, brokerage and investment banking has been left to local houses like CICC, Citic Securities, Guotai Jenan Securities and Galaxy Securities, although a handful of international names have been able to get a foothold.

The growth of this industry reflects the sophistication of China’s markets and the institutions that invest in them. “Overall, the quality of research on A-share companies has increased expontentially over the last few years,” says Chris Keogh, senior advisor to the chairman at Gao Hua Securities in Beijing, a group that is partnered with Goldman Sachs. “There is much more rigorous and sophisticated modeling.” He has also seen a move by local brokers to build out coverage of mid cap and small cap companies. “As domestic mutual funds become more sophisticated in their investment strategies, there’s going to be larger and larger demand for high quality research in the mid to small cap space.”

Alongside this, the institutional marketplace itself is growing in sophistication too: institutions are receiving higher quality research and sales, getting greater corporate access, and listed companies themselves have improved their disclosure of information to the marketplace. “With the markets becoming more sophisticated, institutional clients definitely show increased demand,” says Yifan Hu, chief economist at Citic Securities. Citic’s brokerage not only covers almost 400 A-shares, it also has a global economic research team, partly because Chinese clients increasingly want an understanding of global influences on the domestic market. “They [domestic clients] have a much higher demand for macro research than overseas clients in my experience,” she says. “I used to work for Merrill Lynch, and there when we talked about China macro economy we might see the client twice a year. In China they’re very curious and I will see them four times a year.”

Where next? “Where I think the market has to evolve to – and I see our biggest institutional clients looking for help here – is in further development around execution services,” says Keogh. For example, it is difficult for institutions to complete large block orders. Keogh thinks the market is reading for algorithmic and program trading, systems that exists in bigger western markets to facilitate larger and more complex orders. This which would also help fund managers execute passive strategies and would help to address the long-standing overhang of state-owned shares that have become tradable during a program of share reform over the last four years, but have yet to reach the market.

For securities houses, the bulk of the institutional equities customer base is made up of domestic mutual funds, local corporate clients, international QFII [Qualified Foreign Institutional Investor – international groups given a quota to invest in China’s restricted A-share markets] clients and increasingly pension funds. On the debt side, it’s commercial banks, credit unions and funds. Securities houses are also trying to launch private wealth management businesses, as are the mainstream banks. “The holy grail for domestic brokers is understanding how to help out with the excess renminbi liquidity that now exists in mainland China,” says Keogh. Goldman/Gao Hua is trying to address that with private wealth management and asset management businesses.

The access of foreigners to the market has been gradual. The brokerage CLSA has had a longstanding joint venture in China, called China Euro Securities, but the two most closely watched have been those involving Goldman Sachs and UBS. The Goldman Sachs structure includes two ventures: one, Goldman Sachs Gao Hua, in which the US house owns a 33% stake, contains investment banking businesses such as underwriting and advisory; another, Gao Hua Securities, holds the research and brokerage side of the business. UBS took over a securities company created from a struggling local brokerage, Beijing Securities, in 2006; it holds a 20% stake in the business but effectively controls its management.

These businesses stand out because in addition to underwriting, they have been permitted to get into research, trading and private wealth management. They were seen very much as test cases, and have recently been followed by two new ventures, involving Credit Suisse and Deutsche Bank. These, however, are so far more limited, and for the moment are only permitted to handle M&A advisory and underwriting of debt and equity issues in the domestic market – not secondary market trading or research.