The Unnatural Effervescence of Chinese Bank Stocks
The listing is an odds-on favorite to make fools of large investment institutions around the world and impoverish the hundreds of thousands of petty punters in Hong Kong who have been queuing up to buy this sure thing, allowing it to be oversubscribed by at least 10 times.
The ICBC issue is likely to be the biggest IPO ever but like other big Chinese banks that listed earlier, it remains state-owned and run, decentralized, and more responsive to the loan demands of state enterprises than to market forces. It is a recipe for a potential disaster.
The only long-term winners from all this will probably be the investment banks handling the issue. It’s the usual group of salesmen, in this case headed by Merrill Lynch, who will collect 1.5 percent of the subscriptions – likely to amount to not less than US$15.5 billion for the Hong Kong shares, most of which will go to institutions and the clutch of patriotic tycoons ensuring a frenzied rush by small investors for their allotment. The Shanghai A share tranche will raise around US$5.5 bn. As only 15 percent of enlarged capital will be in public hands, the issue price puts a value of upwards of US$125 billion on the whole bank.
But is it big. The combined raisings of H shares in Hong Kong and A shares in Shanghai are likely to exceed even the $18.4bn Tokyo flotation of NTT/Docomo in 1998. The subsequent career of the NTT share price, now a fraction of its peak, ought to be a warning sign. Instead, the media focus on ICBC’s “biggest ever” status has added to excitement at a time when China fever is still raging worldwide. The mania to buy Chinese banks has become a self-fulfilling prophecy.
The eagerness of western banks (and Singapore) to get a foothold in the big names of Chinese banking was the first stage. At the time that seemed to many observers to be a highly risky proposition given the poor credit controls and high nonperforming loans of mainland banks. But the foreign capital, bad-debt write-offs and expanding balance sheets helped bring the apparent NPL ratios tumbling down. This prepared the way for listings by Bank of China, China Construction Bank, Bank of Communications and China Merchants Bank. These not only got off the ground but made earlier foreign bank buyers look as though they got a great deal. China fever and glowing reports of falling NPLs and steeply rising profits drove up prices of the new listings, delivering hefty returns to the IPO subscribers.
The punters now think the ICBC float is money for old rope and the price will surge further after its listing at a level likely to be at the upper end of a HK$2.56-3.07 range (and yuan equivalents for the much smaller A share portion). They may be right in the very short term. Financial-sector manias are by definition driven by the dynamics of crowd greed and stockbroker hype.
But few seem to have noticed that despite their abysmal records, mainland bank share prices are already in the stratosphere compared with their peers elsewhere in the world. The four existing listings in Hong Kong enjoy a price to earnings ratio ranging from 16 to 32. That compares with averages for Hong Kong’s own banks of less than 15 – around the norm for those in the west.
Of course the China banks promise big lifts in profits, heftier even than their increases in assets. So if one believes that they now have credit controls and management systems to match those of large foreign and Hong Kong banks they might be worth the premium price. But there is very little to suggest that the lending habits of these institutions have radically changed since their last round of write-offs. Given their state-controlled nature, they still have almost no room to make loans according to their perception of risk.
In short they remain accidents waiting to happen when the economy slows or loans made during the binge of the past two years need to be serviced other than with new loans. Although the recent slowdown in new lending has given some comfort to the market, the fall-out from the excesses of the recent past is as yet in the future.
Over-rapid credit growth has not been entirely the fault of the banks themselves. It is the direct result of the interaction of 15 percent-plus global liquidity growth caused mainly by the US current account deficit – now heading for the US$1 trillion a year level – with China’s own increases in forex reserves (which are about to hit $1 trillion). Add in almost-fixed exchange rates and a pegged interest rate, and money and credit growth are hard to stop, even if the banks did practice self-discipline (which they seldom do anywhere).
NPLs won’t be so bad in this cycle, claim the China boosters. They may well be right. More lending is for relatively safe things like home loans, less for state companies. And, according to the World Bank, most of the huge increase in investment spending, which has pushed the investment-to-GDP ratio close to 50 percent, is being financed by profit, and only about a third by new bank lending.
In the World Bank’s view, profits of (still mostly state) enterprises have boomed in the past three years and now amount to 20 percent of GDP compared with less than 10 percent a few years ago. If true this would suggest that companies are far less reliant on loans, and in a much better position to service the ones they have. Hence, banks must be in better shape with much reduced corporate NPLs and more opportunity to lend to households. The assumption of very profitable corporations has even led the government to consider forcing them to pay out more in dividends, which would reduce their fixed asset investment and provide the government with more money to spend on social demands and development of poor inland regions.
However, this macroeconomists’ view of the Chinese banking world has been ridiculed by many closer to the real world of Chinese business. A notable critic has been Weijian Shan of TPG Newbridge. Shan, a former Wharton professor who has several years on the front lines of mainland business, believes the World Bank numbers are in no way reflected in actual corporate performance and are inherently implausible.
National income statistics are seldom a good measure of overall corporate profitability, least of all in China, where all macro statistics are questionable. There was also an inherent contradiction between the efficient use of capital implied by the 20 percent to GDP return and the fact that investment as a percentage of GDP had been running at well over 40 percent for some years – implying a very inefficient use of capital. (During its high-growth years, Japan’s never exceeded 28 percent).
Morgan Stanley economist Stephen Roach, long bullish about most aspects of the Chinese economy, is also skeptical of the World Bank’s use of China’s flow-of-funds data. He is “astonished that the World Bank is leaning so hard on a literal interpretation of what could well be the least reliable piece of Chinese macro data, ” he said in a recent report.
Of course it is likely that at a time of global boom, very low real interest rates, easy money and gradual corporate reform, Chinese companies have become more profitable. That is likely to be particularly the case with large ones in energy, telecoms and some other sectors where competition is limited by central controls. However, the sheer scale of fixed-asset investment, the fierce competition in many manufacturing industries, the slow increases in output prices compared with inputs of raw materials, energy and labor all point to some nasty NPL jolts to come – and that is without adding in the property investment boom.
And if Shan and Roach are right, much of the macro justification for even according mainland banks a double digit PE ratio, let alone ones of 25 or more, is highly suspect.
The next bad debt cycle may not be as bad as the last one. But a rise in NPLs from, in the case of ICBC, the current 5 percent to 13 percent would be huge blow to the bottom line – and that would still be less than half the NPL level before the last capital restructuring.
Naturally, as the government will continue to own most of ICBC, like other banking giants, it is not going to fail. It is even possible that the next time its NPLs rise to unsupportable levels, the government will find a way of taking the bad debts off the books without injecting new capital, which would dilute the outside shareholders, or insisting that they join any recapitalization packages at a less-than-favorable price.
The bottom line is that being a big state owned bank in China ensures rapid asset growth. But there is almost an inverse correlation between GDP and loan growth in China and bank profitability. Caveat emptor.