Maybe it's time to invest in Chinese banks

Critics say a crash is inevitable but china's banking system is based on solid ground

I have never doubted that stock ownership of one or two of the larger and better Chinese banks, through a purchase of shares listed in Hong Kong (or Shanghai) is a fundamentally solid investment strategy. Such an investment provides broad exposure to one of the big investment stories of the 21st century: the emergence of a large, prosperous Chinese middle class. For me, the question is not whether to invest, but when to invest.

In March 2011, I received a research note from an Asian stockbroker which signalled a "buy" for Hong Kong-listed shares in Chinese banks - Industrial and Commercial Bank of China, China Construction Bank and the others. The research analyst based her recommendation on her estimate that Chinese bank shares were then trading, on average, at 8.3 times forecast earnings.

Today, 27 months later, the profits of the big Chinese banks have grown by some 30 percent since the broker's recommendation, but their share prices on the Hong Kong stock exchange are much lower than they were in March 2011. ICBC's share price in Hong Kong was HK$6.2 ($0.8, 0.6 euro) at the time of the broker's note: today, it is HK$4.7. China Construction Bank's shares, at HK$5.25, are down 25 percent from their level in March 2011. If Chinese bank shares were cheap in 2011, today they are much cheaper.

When I read the research note, my first thought was that although Chinese bank shares seemed quite cheap against profitability and earnings growth, the shares could fall further because of adverse market sentiment against banks, and market fear of China's long-awaited economic slowdown. If I bought at what seemed then to be rock-bottom prices, I could have lost money. As it turned out, I was right.

But today, I am asking myself: how cheap can Chinese banks get? ICBC, the world's largest bank by assets, whose significant market share makes it a prime indicator of the Chinese economy, is trading at less than five times forecast earnings for 2013. In the recent past, ICBC has paid out about 30 percent of its net profits as dividends. If I buy ICBC shares today, I can get a return on my investment of nearly 6 percent before tax from dividends. ICBC's profits might continue growing by at least 15 percent annually, so my dividend income could increase at the same rate. With a performance like that, at some point the price of the shares will increase. Buying ICBC's shares today could be a very good financial decision.

But before I take the plunge and invest, I have to be confident that the share price is close to the bottom. Why are the shares so cheap? Could they go even lower? It seems that the immediate cause for the low price is the June cash crunch in China, which has created a lot of uncertainty in investors' minds. In late June, overnight borrowing rates in the interbank market began to fluctuate wildly, the Shanghai Interbank Offered Rate rising as high as 30 percent.

For years, the People's Bank of China has injected liquidity into the market when it became tight. On this occasion, it did not. The unexpected change in policy created a mini-panic among banks and households. This panic was reflected in the stock market. On June 24, the Shanghai Composite Index fell by 5.13 percent to its lowest level since August 2009. Would the PBOC go on supporting the financial system? Suddenly, banks started holding onto their money in case they found they could not get it back from other financial institutions which had non-transparent balance sheets. A day or two later, as the PBOC announced it would support creditworthy institutions and began to inject liquidity again, the panic subsided and rates fell.

My interpretation of these events is that in June, the government decided to reinforce its message of restructuring and moderation by hitting financial institutions where they could feel it. The PBOC, acting in concert with the highest levels of the government, deliberately gave the Chinese financial system a shock in order to change expectations, and make each financial player think carefully about the creditworthiness of its counterparties. If my interpretation is correct, then what happened in late June should be a positive for the Chinese financial system and in particular for the strongest members, the large Chinese banks. The long period of fiscal and monetary expansion since 2009 has created some bubbles in China which have to be deflated in a way that does not crash the economy. Maybe a short shock is the right approach.

But if economic restructuring is on the way, how much worse could things get before they get better? Are the Chinese banks in a strong enough situation to withstand more difficult financial circumstances?

I examined the latest audited financial accounts of the three largest Chinese banks published in 2012 - ICBC, China Construction Bank and Bank of China - and compared them with 2007 (the year before the financial crash), and with the 2012 accounts for HSBC. The Chinese banks are in a very strong position in terms of cash and immediate liquidity resources, because the PBOC has ordered them to hold nearly 20 percent of their assets as deposits at the central bank. At the end of 2012, ICBC held 23 percent, Construction Bank 22 percent and Bank of China 30 percent of customer deposits as cash and central bank deposits; the ratio for HSBC was 14 percent.

This ratio means that in case of serious liquidity problems, the main Chinese banks do have a large cash cushion. Although loans made by the three Chinese banks more than doubled between 2007 and 2012, their high profitability has enabled them to retain profits sufficiently to keep their equity at an adequate level relative to their assets. In 2012, in spite of the fast growth of their balance sheets, all three banks had equity as a proportion of total assets of between 6.4 percent and 6.8 percent; HSBC had 6.8 percent.

Some analysts have suggested that many of the loans made by the banks during the great stimulus in 2009 and 2010 will turn out to be bad. What if they are correct? Between 2007 and 2012, ICBC's loan book increased by 4.6 trillion yuan, to a total of 8.6 trillion, against its December 2012 equity base of 1.1 trillion yuan. That means that today, only 12 percent of ICBC's loan book needs to become non-recoverable for the bank to become insolvent.

How likely is this? According to Huang Haizhou, the chief strategist of the Chinese domestic investment bank China International Capital Corporation, "a financial crisis within three years is inevitable". All China can hope for is "a controlled, minor crisis". He may be referring to the collapse and closure of many of the unofficial financial institutions which mushroomed in China between 2009 and 2011. With the government unwilling to do anything which might threaten economic growth, the establishment of financial institutions outside the official system for the purpose of channelling credit to local governments and their corporations became increasingly common. The real threat to China's banks lies in these unregulated institutions, because the extent of the connection between the official and unofficial financial sectors remains unclear, even to the authorities.

There's no way of knowing just how bad the fallout will be if some of the larger shadow banks start to fail. Financial crashes which follow expansion driven by credit are not the exception, but the norm. The lesson that history teaches from many such episodes is that rapid recovery from a financial crisis depends on prompt recognition of the real damage to bank balance sheets, followed by repair, in the form of write-offs and recapitalization. The examples of Japan in the 1990s, and Europe today show what happens if the banking system is not forced to address the full extent of its problems. Years of stagnation follow, even economic collapse.

So an investment in a Chinese bank, even at the depressed share price levels of today, runs a significant risk. For an investor, the real question is whether the discount in today's share price is enough to compensate for the risk of a loan write-off which is large enough to force a recapitalization, led by the majority investor, the Chinese government.

Added to the balance sheet uncertainty is the prospect of a year or two ahead of increasing competition in the Chinese banking market. Chinese banks have reduced their dependence on net interest income (the difference between interest paid out on deposits and interest received on loans), but in 2012, ICBC still derived 79 percent of its operating income from net interest income. The corresponding figures for China Construction Bank, Bank of China and HSBC are 76 percent, 70 percent and 46 percent. In a competitive global banking market, net interest income makes up a much lower share of profit than it still does in China.

Furthermore, in China the margins on lending have steadily fallen. When the market is free to set lending and borrowing rates, there will be a period of ferocious price competition. As the Chinese banking market liberalizes, and lending margins are crushed, the dependence of Chinese banks on interest income could do real damage to their profitability.

Yet, from a strategic perspective, Chinese banks continue to have a strong attraction as investments. The big banks have huge branch networks and strong consumer brands in one of the most brand-conscious countries in the world. It will take many years for foreign banks to make any significant inroads into their market share. Their profitability has been driven by their excellent cost control. And competition would spur further improvements in management and operational efficiency.

Nothing ventured, nothing gained. Now could be the time to invest.

The author is a visiting professor at Guanghua School of Management, Peking University. The views do not necessarily reflect those of China Daily.