In this three part series, we discuss macro risk posed to the markets by the enormous Chinese banking sector. In Part #2, we take the perspective of the ‘bulls’, providing reasons why the macro risk posed by the Chinese banking sector is overstated. In Part #1, we provided the perspective of the ‘bears’, discussing why the sector could be the epicentre of a further global sell-off and/or additional macro uncertainty (see previous post). In Part #3, we review the financial results of the Chinese banks.
Part #1: For BEARS, Four Reasons Why Chinese Banks’ Distress Could Amplify the Global Sell-Off
Part #2: For BULLS, Four Reasons Why Macro Risk from Chinese Banks is Overstated
Part #3: Are Chinese Banks Solvent? Q&A on the Sector
Please see “Notes to Reader” at the bottom of this Insight for additional information
FOR BULLS, Four Reasons Why Macro Risk from Chinese Banks is Overstated
As mentioned in Part #1 of this Chinese bank series, concerns that the Chinese economy – the second largest in the world – will suffer a “hard landing”, and possibly stress its banks, triggered a ~14% correction in the global financials beginning in August. Although much of this decline was recovered in the fall, sharp declines to start 2016 demonstrate that the risk remains at the top of investors’ minds. In Part 1, we addressed what we believe the bears consider to be the most important reasons that the sector poses a significant threat to the global markets.
In this, Part #2, we offer the bulls’ strongest arguments for why the sector does not pose a significant risk to the global economy from a systemic perspective. Implicit in the first two parts of this series is that the data provided by the Chinese government is not reliable, or has material flaws (we evaluate the sector based on actual reported data in Part #3 of this series).
As we wrote in Part #1, the bear arguments that the sector poses a serious threat to the global markets are simpler to understand, and therefore, easier to make. However, in this note, we provide four reasons why the bulls would consider macro risk posed by the Chinese banking sector to be overstated.
Reason #1: Government Mandated Recapitalization Could Prevent Contagion/Deflation
In the event of sector distress (or concerns thereof), the Chinese government could engineer a recapitalization of the banking system, either in the form of mandatory equity raises (through the global markets), and/or through a direct injection from the government. It would seem highly likely the Chinese banks could raise substantial capital in the global markets or from its citizenry. If global investors internalized one lesson from the credit crisis and the European debt crisis, it is that buying bank stocks at distressed prices can be very rewarding (with the caveat being the level of capital raise has to eliminate insolvency risk).
If required, a mandated system recapitalization would be – by far – the most effective tool to restore health in the system and forestall a macro driven global market sell-off, since it would reduce the risk of financial contagion. In our view, this is the single most powerful argument for the bulls in arguing against the Chinese banks creating financial contagion across the globe (i.e., Chinese bank losses transmit losses into other banking systems through counterparty risk).
Recapitalization can also forestall deflationary pressures, if the health of the sector requires some remediation. Insolvent banks allowed to operate introduce a powerful deflationary force into the economy, as they focus internally on rebuilding reserves and capital at the expense of lending (credit creation), a key driver of economic activity. Since 2008, the United States and Europe both forcefully – and successfully – worked to restore solvency/confidence to the system, while Japan in the 1990’s did not.
Reason #2: Regulatory Forbearance is a Very Powerful Tool to Cope with Systemic Distress
The application of regulatory forbearance is also a potential mitigant to the risk of a global sell-off. In its purest form, regulatory forbearance is a policy where bank regulators allow the system to operate below required capital/reserve levels, either deliberately or because loss levels cannot be estimated (and hence recognition is delayed).
For all investors know, regulatory forbearance is already being practiced by Chinese authorities. It is possible regulators are allowing the banks time to gradually recognize non-performing loans (“NPLs”) through ongoing earnings/internal capital generation. This policy approach can be extremely successful (see the Canadian banks during the less-developed country debt crisis – LDC crisis – of the ‘80s), or it can have a disastrous effect (e.g., Japanese banks in the ‘90s). Success or failure depends on whether or not the sector uses its reprieve to restore the system’s health by building reserves and/or capital in advance of problem loan recognition (as Canadian banks did from 1983 to 1987). The faster this balance sheet repair takes place, the faster economic growth can return, and the lower the risk that deflationary pressures become entrenched (Japan being the biggest example of the latter).
Reason #3: Government Could Engineer Internal Adjustments to Economy to Benefit Banks’ Asset Quality
We believe regulatory forbearance could take a different form from the traditional forms of (i) delayed NPL recognition, and/or (ii) permission to operate below required capital levels (either tacit, or explicit). The Chinese government could seek to ensure priority payments to its banks from loans owed by state-owned-enterprises (“SOEs”) and/or other large corporates, knowing that the health of its banks is of paramount importance to sustaining its GDP growth, avoiding a recession and/or preserving market confidence.
For example, the Chinese government could require other areas of the economy incur painful internal adjustments to protect bank asset quality (perhaps by reducing SOE labour costs to create cash flows to service loan payments). This is not a form of forbearance that has been observed in prior cycles, primarily because this is the first cycle in modern times (that we are aware of), where a central command economy was systemically important from a global economic perspective (versus geopolitical). In fact, the Chinese banks’ substantial exposure to SOE loans means that much of their credit risk has been de facto nationalized.
It is also worth noting that a primary reason for China’s ratio of “bank assets to GDP” being among the highest of the major global economies (as discussed in Part #1) is the high proportion of Chinese bank loans that are essentially to the government, including local governments. In developed economies, this debt (i.e., state, municipal, provincial, city bonds) is generally in the fixed income markets versus the banking system.
Bulls might speculate that this fact gives the Chinese government the option to make at least some required internal adjustments within the economy in a way that favours the systemically important banks to ensure global stability.
Reason #4: Even if Questionable, Reported Data Implies Substantial Cushion Against Financial Distress
Notably, a review of the reported data supports the conclusion the Chinese banks are not only solvent, but retain formidable financial strength to absorb potential financial distress (asset quality, balance sheet metrics, and quarterly earnings – discussed in more detail in Part #3 of this series). Even in a severe downturn – and assuming the sector’s reported financial data is reliable – the Chinese banks’ reported data implies the sector retains formidable cushions against a credit shock, including (annualized) pre-tax, pre-provision earnings of over US$400 bln per year, US$250 bln in reserves (or a respectable 2.8% of loans) and relatively low leverage ratios as a starting point.
Conclusion: Will China Learn from the U.S., Europe, Japan? Bulls Think Yes
It is clear that the United States (credit crisis) and Europe (sovereign debt crisis) learned a very important lesson from the Japanese banking crisis in the 1990’s; during times of distress, aggressive measures to recapitalize the banking system help restore investor confidence (through stress tests which aim to add transparency), and promote a faster economic recovery.
In many ways, Japan in the late 1990’s became a case study in what not to do. After Japan’s enormous property bubble burst and was followed by a huge correction in the equity markets, Japanese banks did not aggressively seek to restore their health, essentially operating as functionally insolvent for many years (“zombie banks”). This was an important factor underpinning the debilitating deflationary spiral that ultimately became entrenched.
We surmise the successful recapitalizations of the European and American banks enforced by regulators has not been lost on the Chinese authorities, and that they would seek to emulate this approach should the potential for severe credit stress emerge. This is one of the most powerful arguments for bulls, who argue that macro risk related to Chinese banks is overstated.
In the final note of this series, we evaluate the financial condition of the sector using reported financial data.
NOTES TO READER:
(1) Sources for this three part series are SNL Financial LC and Hamilton Capital. The universe of companies consists of 20 major publicly traded Chinese banks, or ~70% of total bank assets in China, all of which the government holds a controlling interest (total assets of ~$17.5 trillion at YE). Our universe does not include the three wholly government owned “policy banks” (i.e. Agriculture Development Bank of China, China Development Bank, and the Export-Import Bank of China) which account for a further ~10% of the total Chinese banking system assets (i.e. an additional ~US$2.5 trillion at YE).
(2) With respect to China, foreign investors can generally invest in only the ‘H’ shares (13 of the 20 public banks in our universe), while domestic investors can also invest in the ‘A’ shares (7 additional banks).
(3) There is not sufficient and/or reliable information to review the implications of Chinese “shadow banking” system (including Chinese wealth management products), to the extent it exists.
 In fact, this is arguably happening with the debt swap between the government and the banks for local government financing vehicles (or LGFVs), which Bank of America Merrill Lynch estimates represents ~14% of H-share bank loan books. In October 2014, the state council/Ministry of Finance issued No 43 Article to address asset quality concerns of the bank asset quality. MOF plans to cover 100% of government’s direct debts and 15-20% of their contingent liabilities. BofAML estimates that RMB12 trillion in total, which would represent ~RMB3 trillion being swapped per annum.
 As of Q2 2015, the leverage ratio – i.e. tangible assets divided by tangible common equity – for the Chinese banks was ~16x, which compares favourably to the U.S. and European banks as they entered their downturns. Leverage for European banks and certain U.S. broker-dealers was close to 50x when they entered the credit crisis.