Trigger finger

On the surface, Chinese banks seem healthier than ever. Profits of the biggest lenders have notched up like clockwork, rising 30% year-on-year in recent quarters. In the third quarter, bad debt accounted for just 1.84% of total loans and the ratio of loans to deposits was only 65.3% – making Chinese banks vastly more liquid and less leveraged than their peers in Western markets.

Yet, despite this apparent strength, investors have been unloading shares with gusto. Between April and October, the Hong Kong-listed shares of Industrial and Commercial Bank of China (ICBC), China Construction Bank (CCB) and Bank of China (BoC) lost roughly one-third of their value. Then, in November, Bank of America and Goldman Sachs sold off multi-billion dollar stakes of CCB and ICBC, respectively, sparking rumors that even institutional investors were spooked.

Shares have since rebounded, partly because Central Huijin, the domestic arm of China’s sovereign wealth fund, has stepped in to buy bank shares and restore confidence to the market. Yet investors remain deeply skittish about Chinese banks. And with good reason: Bad debt must come due at some point, and banks are the fulcrum of the Chinese economy.

Chinese banks are more closely intertwined in the political sphere than any Western equivalent, making them far too important to fail. If and when bad debts grow unsustainable, Beijing would undoubtedly recapitalize them. The only question is how much investors would lose in the process.

Free-flow

Beijing has battled with a pernicious addiction to policy- and relationship-based banking over the past few decades. The most recent surge of policy-driven lending began in late 2008 as the US$586 billion stimulus package was funneled through the banking system. Banks were effectively required to extend loans to projects that garnered approval from China’s economic planner, the National Development and Reform Commission, regardless of their credit worthiness.

Once the money was flowing freely, the tap proved difficult to turn off. By the end of 2010, Chinese banks had lent out about US$3.8 trillion to offset the effects of the downturn, more than doubling their balance sheets since 2008, according to the IMF (Beijing’s National Audit Office puts the figure at a more modest US$1.7 trillion.) As is often the case with policy lending, some of these loans will not be repaid – either because the funds were invested in poorly planned projects that will not generate a profit, or because the money was embezzled away into property and Louis Vuitton handbags.

To absorb that eventual shock, regulators are steadily raising the amount of capital that banks are required to set aside. At some point, distressed banks may need to issue new equity to meet these higher targets, diluting the value of existing shares in the process. That possibility worries investors.

Investors would also lose out if China’s big banks cut their generous dividends, which have historically equaled about 40% of earnings. Several bank bigwigs have muttered in recent months that they cannot be expected to raise capital while also doling out dividends.

The threat of dilution and dividend cuts explains why investors are closely watching bank fundamentals, even though the banks are clearly too big to fail outright. Most of the worry has focused on banks’ significant exposure to property, as price growth stagnates and begins to reverse in many cities. Yi Zhang, a vice president at Moody’s, estimates that property has been used as collateral for around 40% of all bank loans.

Anxieties about the property market also bleed into worries about local government debt, much of which is tied up in infrastructure projects. Local governments derive much of their revenues from property-related taxes on land sales to developers – more than official fiscal budgets – according to a 2011 study by the US-based think tank Lincoln Institute. That means a fall in the demand for property could quickly deplete local government coffers and, in turn, jeopardize their bank loans.

Whacking moles

As a result, regulators have moved to limit bank exposure to property and other potentially wasteful projects. However, they have instead become entrapped in a cat-and-mouse game of finding and closing credit loopholes, with the tighter restrictions causing shadow banking and off-balance sheet lending to balloon.

Due to lending caps and negative real interest rates, banks have turned to peddling wealth management products that offer yields of 8-10% on investments in property, small businesses and infrastructure projects. These products are technically managed by trust companies and off-balance sheet vehicles, but they are programmed to appear on the books when deposit-to-loan ratios are calculated at the end of each month. In other words, banks actually lend out more than they are allowed – raising serious doubts as to the accuracy of balance sheets.

This opacity pushed regulators to conduct “stress tests” in April that evaluated banks on how they would perform if property prices dropped by 50% and transaction volume by 30%. The results, announced in July, were that bad debt would rise only slightly, and that banks were fundamentally safe.

But those assumptions already appear unrealistic: While property prices in many Chinese cities are roughly flat, transactions have dropped off sharply, in some areas by more than 30%. Homeowners can wait out the storm, but property developers have been forced to sell homes at steep discounts to keep liquidity flowing. If they are forced into bankruptcy, that might wreak havoc on the bank loans of whole swathes of developers.

Moreover, a similar IMF stress test released in November showed that while banks probably could weather a downturn in a single area – such as a property crash or a rise in local government loans – they were far less prepared if a crash in one sector sent shock waves across the economy, as it almost certainly would.

Finding the trigger

The threat of contagion explains why investor attention has jerked from property to local governments to credit-starved private companies to European woes. Observers believe risk is highly correlated across industries, and the market is searching for the trigger that might set off a broad crash, argued Zhang of Moody’s. “What this is really all about is the confidence in the market, and confidence issues that may cause liquidity problems,” she said. “Once we get to a certain point, it becomes a chain reaction.”

With so many variables at play, there is little consensus on the future of Chinese banks. Fitch Ratings warned in March of a 60% chance of a banking collapse by mid-2013; by December it was forecasting that inevitable credit rollovers and efforts to mitigate defaults would lead to frequent liquidity squeezes, rather than non-performing loans. Credit Suisse predicted in October that bad debt could rise to 8-12% of all lending and eat up 65-100% of bank equity.

Many analysts are more sanguine. Yi of Moody’s said that in the near term, banks are likely to sustain profit growth and have enough capital to cushion any small shocks. Tom Quarmby, a director at Barclay’s Capital, agrees that banks will probably be fine for the next year.

The ultimate risk, he argues, is Beijing. Most of the pressures on Chinese banks loans originate with the government. In theory, regulators could simply lift property restrictions and ease lending conditions and monetary policy to reduce pressures on the banks.

The problem is that such a rescue is already being factored into bank stocks. “The key risk is that we don’t see the policy support that’s being priced into the market,” Quarmby said. Those who do invest in Chinese banks, therefore, would do well to keep one eye on Beijing and their broker on speed dial.