Everyone, except the underwriters, has agreed that the Agricultural Bank of China’s (ABC) loans and management are pretty awful, although better than the bad old days of the 1990s. The Chinese authorities have been largely silent in its defense.
This bank is far less credible as a serious commercial bank than the other major state-owned Chinese banks. But the IPO, has been decreed, so it will go ahead, and up to US$30 billion will be pulled out of the markets in Hong Kong and Shanghai in the process. To take US$30 billion out of existing investments to buy shares of ABC will dislocate both Hong Kong and Shanghai at a time when the Asian markets need stabilization, not additional volatility.
Ironically, the size of the IPO may be a factor that contributes to a lowering of its valuation and hence share price. IPOs are priced in comparison to how competitors are trading. In the case of ABC, investors holding shares in its competitors will to some extent have to liquidate those holdings to free up cash for the ABC IPO. So by driving the valuations of the other banks lower, the valuation may also come down for ABC.
But what should ordinary investors do with this opportunity? Leap on the wagon with the Communist Party of China as owner and the main Wall Street investment banks as underwriters, or watch the drama from the sidelines?
SinoSage’s view is that to invest in ABC would be closer to a religious leap of faith than a calm, collected investment decision. Apart from the old tactic of buying at the IPO to dump soon after, an investment would have to be based on a belief that the government has decided the ABC will list successfully and therefore it will do so. It would be based only partially on a rational assessment of the commercial prospects, profitability and competitive advantages of the bank.
It is true there is the argument that the leap of faith is justified: the government cannot allow ABC to fail; China’s banking system is improving; and as rural incomes and spending rise (from a low base), ABC should have a strong potential customer base. The bank can also count on strong support from Beijing, which allowed ABC to dispose of huge amounts of bad debt in 2008 and 2009. That plus significant tax breaks means its financial situation has improved significantly. Never underestimate the power and determination of the party to protect its core assets.
ABC’s business now depends heavily and increasingly on interest income, which means the bank is very sensitive to changes in macroeconomic conditions in mainland China. That is both an advantage (China’s interest rates – high for loans, low for deposits – are fixed in favor of banks) and a problem (lack of diversified income streams). Interest income accounted for 72% of the bank’s total income in 2006, 77% in 2007 and 91% in 2008, while the proportion of income derived from fee-based services was 7% in 2006, 9% in 2007 and 7% in 2008. That’s a significant gap. Interest income is also based on the borrowers paying loans back, which is not traditionally one of ABC’s strengths.
The bank has been trying to move away from rural finance in the last three years. In 2006, loans related to rural finance amounted to US$248 billion, 55% of total loans; this proportion dropped to 34.75% in 2007 and 30.15% in 2008.
This is understandable. Rural finance involves higher risk and much higher costs than lending to urban individuals and enterprises. ABC’s massive network of outlets in little towns throughout the country – which must be a nightmare to manage effectively – means it has the highest management costs of all the four main state-owned banks.
The problem with lending money to small businesses far away from Beijing is that the loan becomes an extension of social policy, instead of a profit making venture. In these situations, foreclosure – often a problem for Chinese banks – becomes even more difficult. SinoSage has nothing against a social policy that gives people money, but not when it’s dressed up as commercial lending.
How far the government will allow ABC to divorce itself from its rural roots is not clear. In the meantime, the bank has shifted the balance of its business in the direction of the more developed Yangtze River Delta region around Shanghai, which puts it into direct and fierce competition with more sophisticated lenders. So ABC has the choice of making poor-quality loans in its own territory, or competing by lending money at lower rates in other territories. Neither is particularly appetizing.
The bottom line is that the listing is a political decision. After the IPO, SinoSage’s estimation is that the share price will be marginally supported for about six months, after which market forces will be allowed to play an increasingly significant role. That will almost certainly mean downward pressure on the share price, particularly for ABC shares listed in Hong Kong. There may be arbitrage opportunities between Shanghai and Hong Kong, but any way you look at it, it’s a fixed and murky play.
Remember that the underwriting banks care about the fee, not how the stock trades, which means they are incentivized to put “lipstick on the pig”, in the famous Wall Street phrase. They are thinking only about the fees and the fame that comes from being in on the biggest deal in history.
It looks like the price-to-book (P/B) ratio of the ABC deal will be somewhere around 1.8 in Shanghai and a little bit lower in Hong Kong, perhaps slightly over 1.7. In contrast the P/B ratio of Bank of China (BoC; 3988.HK), for instance, is 1.82, given its closing price of RMB3.9 on May 19.
SinoSage’s recommendation is for investors to stay away from it until the price/book ratio is equal to or lower than BoC’s. Under no circumstance should investors pay a premium to BoC for ABC.