Chinese banks and Circular logic

Chinese banks are undergoing an odd kind of bail-out



THE banks of China did their duty by supporting the government’s stimulus efforts last year. Lending soared by a frenetic 32% in 2009; growth has slowed this year, but remains a robust 18%. Now the government is standing by the banks.

A flurry of reports in the local Chinese press predicts that on August 24th Huijin, a branch of China Investment Corporation (CIC), the country’s sovereign-wealth fund and the holder of big stakes in all of its main banks, will issue the first of a series of bonds. Up to 187.5 billion yuan ($28 billion) should be raised in short order, with much of the demand coming from China’s state-controlled companies. These funds are expected to be used to support rights offerings by the big Chinese banks later in the year, as they seek to maintain capital ratios and protect against an expected wave of dud loans.

Stripped to their essence, the transactions begin with one branch of the Chinese government issuing debt. A second branch puts up the money. A third gets to use it, relabelled as “equity”. That equity, in turn, allows the banks to provide additional dollops of credit to companies, thus fuelling China’s economy. Some have wondered whether the banks themselves will buy Huijin’s debt, a move that would make the process perfectly circular.

The plan has emerged as an alternative to a more straightforward blueprint—raising $20 billion-30 billion in fresh money through a series of rights issues in Hong Kong and Shanghai. That plan is looking unfeasible under current market conditions. True, Agricultural Bank achieved the world’s largest initial public offering just last month, and on August 18th China Everbright Bank, another lender, enjoyed a strong debut in Shanghai. But the markets are unstable and, bankers believe, increasingly tapped out. What is more, it is becoming ever clearer that the big banks face a wave of write-offs on their loans.

In July the government asked banks to conduct stress tests assuming a 60% decline in housing values. A steady trickle of leaks has emerged in the Chinese press about potential losses from loans guaranteed by municipal governments. The most recent reports put the amount of these loans at 7.7 trillion yuan, or about 17% of overall lending. Of these, about a quarter are thought to be tied up in projects where there is abundant cashflow to fund repayment and another half in projects where there may be enough income. That leaves a quarter where the prospects of repayment are poor. Pressure is apparently being put on some municipalities to cover losses. Banks are building reserves. Loans are quietly being restructured.

China has been through this process before. A decade ago bad loans amounting to 10% of bank assets were purchased by the government at face value and put into special fund-management companies, where they continue to sit. Back then, however, the banks were explicitly state-owned. Now they all have outside investors and conventional reporting requirements.

The possibility that China’s banks are more troubled than they seem is not lost on investors. By market capitalisation they are among the largest in the world but their shares trade at low multiples, under two times book value and below ten times earnings. Both multiples are far lower than those of smaller lenders in India and Indonesia that are perceived to have better growth prospects or less suspect accounts.

These modest valuations, and the apparent determination of the Chinese government to offer support come what may, means that the banks will probably still be able to raise some capital from outside. Simon Ho, an analyst with Citigroup, reckons that $6 billion-7 billion of equity will come from non-Chinese investors as part of the rights offerings.

If things do proceed in this manner, the odd effect of recapitalisation will be to increase leverage in the system. What appears to be equity on the balance-sheet of one set of government-controlled entities is really just debt on another. That makes everything more lucrative if things go well—and much worse if they don’t. The Economist