Thursday, 22 January 2009

Chinese banks may not be as solid as they look

As a fresh attack of the jitters shakes the world’s financial system, the stocks of mainland banks listed in Hong Kong have held up relatively well. Unfortunately, their apparent stability could prove an illusion.

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Guanyu said...

Chinese banks may not be as solid as they look

Tom Holland
19 January 2009

As a fresh attack of the jitters shakes the world’s financial system, the stocks of mainland banks listed in Hong Kong have held up relatively well. Unfortunately, their apparent stability could prove an illusion.

At first, the recent performance of mainland bank stocks hardly looks impressive. Shares in the three big state banks listed in Hong Kong have all fallen since the beginning of the year, with Industrial and Commercial Bank of China’s stock price slumping 20 per cent.

But compared with Britain’s Barclays Bank, which is down 36 percent, or US financial services giant Citigroup, which has shed almost half its value, even that woeful performance looks respectable.

And the comparative resilience of mainland bank stocks is even more remarkable when you consider that prices have come under heavy pressure in recent weeks as international cornerstone investors - principally western banks - have sold down their holdings.

At the end of December, Swiss bank UBS cashed in a 1.3 per cent stake in Bank of China. Next, Bank of America Corp sold a 2.5 per cent slice of China Construction Bank Corp. Then last week, Royal Bank of Scotland Group unloaded its entire 4.3 per cent stake in Bank of China.

Yet other investors have largely remained sanguine, reasoning that the western banks are selling out because they are desperate to raise cash, not because they are bearish on Chinese bank stocks. Indeed, there appears to have been no shortage of buyers. Many investors note that mainland banks look cheap at current prices, and draw comfort from their low exposure to international credit markets, recent risk management improvements and generous provisioning against potential defaults on their domestic loan books.

With debt levels among Chinese corporations generally low and the government ramping up fiscal spending to support growth, many investors believe asset quality at mainland banks will remain sound and that non-performing loan ratios will stay modest.

This view may turn out to be overly optimistic. Although non-performing loan levels could well decline in the near term, any fall is likely to be misleading.

That’s because mainland banks have massively stepped up lending over the last two months in response to orders from Beijing to support the economy. Last month, the banking system extended new domestic currency loans worth 772 billion yuan (HK$877 billion) - a 14-fold increase over December 2007 - after granting 477 billion yuan of new loans in November. As a result, non-performing loans are likely to fall as a proportion of total loans simply because the total value of loans outstanding is increasing so quickly.

According to analysts at Fitch Ratings, the waters are further muddied by doubts surrounding the classification of non-performing loans at mainland banks. For example, loans are typically rolled over to prevent the appearance of default, while collateralised loans are allowed to fall up to a year overdue before they are deemed non-performing, even though historical recovery rates are low.

To make matters worse, mainland banks’ credit risk models are based on relatively short data histories for default and loss levels built up during the economic boom years. As a result, although current provisioning levels appear adequate, they may turn out to be insufficient as the economy slows.

That could eat into the banks’ capital bases. According to Fitch’s estimates, factoring in potential losses on so-called “special mention” loans and on loans formally classed as non-performing, would push tier 1 capital ratios at the big three listed mainland banks below the 8 per cent level “generally considered the new international norm for well capitalised banks”.

If that happens, the investors forced to sell down their stakes in mainland banks recently may turn out to have had a lucky escape.