Rating China's banks
WEDNESDAY, OCTOBER 25, 2006
Last week, the Industrial and Commercial Bank of China broke the record for an initial public offering by raising $19 billion from a sale of just 15 percent of its stock in the Hong Kong and Shanghai markets, valuing the bank at $126 billion.
There was much cause for rejoicing, particularly among the investment banks, which picked up 1.5 percent or so of the proceeds. This surpassed the 8-year IPO record of NTT/Docomo, which raised $18 billion in Tokyo in 1998. But be careful not to remind investors of what subsequently happened to the share price of that Japanese shooting star.
In the case of ICBC, three factors have come together to support not just a huge IPO, but a valuation of Chinese banks that places them well above their peers in the West, or elsewhere in Asia.
First is the general mania for all things Chinese; second, the continued surge in global liquidity linked to the current U.S. account deficit, which has fueled China's already high credit growth; and third, the actual or perceived huge improvement in the profitability of Chinese enterprises generally and of banks in particular.
A virtuous cycle has also been at work. When, about 18 months ago, foreign banks began buying stakes in the big Chinese banks there were worries about the wisdom of owning minority stakes in banks notorious for high non-performing loans and weak credit controls as well as for the pressure they are under to lend to other state enterprises. But new foreign capital, state-financed bad-debt write-offs and rising profits emboldened the banks and their sponsors. They started coming to the market and having done so found that their share prices soared.
So each successive IPO was greeted with applause and instant profits for investors. Now the Chinese state banks trade on earnings multiples up to double the 12-to- 15 times that is the norm elsewhere.
The bullish case is not entirely without foundation. The World Bank claims that there has been a huge increase in corporate profitability in China so that now two-thirds of China's huge investment in capital stock (nearly 50 percent of GDP) is being paid for out of retained earnings and new equity, not bank loans. More loans are for much safer home ownership and less for state enterprises. The banks' loan profiles have thus improved and the health of Chinese companies reduces the risk of a new surge of nonperforming loans.
Some analysts claim the World Bank analysis is supported by the microeconomic data - company results. But others dispute both the macro and micro data. They ask how profits can be growing so fast when output prices have been static while wages and raw materials have been rising. Although the rate of increase in credit has been slowing down, it remains very high. If China does have such a high rate of capital investment, the inference must also be that it is being used inefficiently. Japan, Korea and Taiwan all once had GDP growth similar to China but with much lower investment rates.
The Chinese corporate picture is probably very mixed. Some firms have been doing very well as a result both of demand growth and price trends. Others, however, have been suffering as productivity has been falling behind cost increases, and competition remains intense. The skeptics argue that the worst-off firms are most likely to be the slow-moving state enterprises. Political pressures then ensure that the state banks keep them afloat and fixed lending rates prevent proper pricing of risk.
Making sense of all this is even more difficult due to the unreliability both of China's macroeconomic statistics and the rose-tinted spectacles of the accountants and investment bankers who want the state banks' business. On balance, one might conclude that bank profitability is rising and credit quality improving. But given that at the peak of the last bad-debt cycle, nonperforming loans were over 20 percent, it would be asking a lot to assume they will rise from around 5 percent today to at least double digits following the lending spree of the past two years.
It is not hard to see an inverse correlation between China's GDP growth and state-bank profitability. History suggests Chinese banks deserve to be rated at a significant discount to those managed entirely on commercial principles rather than at a premium. Next time there is an nonperforming- loan surge at the state banks do not expect the state to bear all the burden of cleaning up their balance sheets. The foreigners are there for a purpose.