Preamble
With the exception of a puff in 2014~15, mostly and quickly reversed, China’s stock markets have been dull places since the GFC. For a full-throated roaring bull market to ever reestablish itself investors, both domestic and foreign, are going to have to buy bank stocks as these dominate major indices.
Without such a move pockets of enthusiasm will bubble up from time to time. However, a self-sustaining rising valuation merry-go-round, the hallmark of equity bull markets, cannot reoccur without a rethink of financial stocks. As this group are held in particularly low regard I wondered how investors might be persuaded to look more favorably, in time, on the sector?
Summary Conclusion
It’s hard to imagine a situation where investors could put aside long held deep suspicions; but a complete reversal of opinion may not be necessary for the sector to attract more attention. It may be enough that characteristics are reconsidered at the margin.
If some of the negatives are rethought as being a little less scary and some of the positives given a greater weight such a sentimental shift could tip fund flows significantly.
As I write I see no sign of the above in progress; but markets are not static. By giving thought now to how things might change we may be better prepared in the event.
Why Are Chinese Banks So Mistrusted?
In order to keep an eye on changing attitudes it will help if we consider why investors feel, today, the way they do.
Apprehension seems to concentrate around three main issues:
1) The Fractional Reserve Model. Before Einstein Newtonian physics explained the world well enough to underpin technological development through the Industrial Revolution and beyond. A better understanding of the universe though allowed Mr. Steve Jobs to stand on Mr. Isambard Kingdom Brunel’s shoulders.
My point? We know the system in use today to run banks is a dangerous one prone to regular and spectacular failure; but until a better one comes along we’re stuck with it. It works well enough. We have no choice but to allow banks to operate as the product of two enormous numbers that they don’t often seem to have a good grasp of; and if the creators of the numbers haven’t got a good grip don’t expect regulators to have a better one.
Given the reputation (justly or unjustly) Chinese financial companies have for being creative in terms of mandatory reporting it’s natural investors would regard an already dangerous business model as being especially so in a Chinese context.
2) The Agent/Principal Problem. The GFC had many causes but undoubtedly one of the major ones was Agents i.e. bank’s management teams failing to act in the Principal’s, shareholders, best interests. In China the line between Agents and Principles is a very blurred one. Minority shareholders may reasonably wonder where their place is in the hierarchy?
The issue gets knottier when we consider who the majority shareholders are in all the major financial institutions. Even if the Agents set about trying to work in the best interests of their majority shareholders what are those best interests? In China it’s not going to be a question of maintaining a solid balance sheet while delivering reliable dividends. There’s a raft of broader societal and political considerations at stake.
With the above contradiction manifest and Agents with recent experience of having been bailed out from a period of uneconomic asset creation why would a minority investor think attitudes had changed sufficiently to make sure his or her interests were being anything other than peripherally considered?
3) The Lies. Let’s not beat about the bush. In a recent ‘Sunday Paper’ I highlighted work that slam-dunk proves certain reported aggregates from Chinese Banks must be, to some extent, fictionalized [https://www.chinadream.asia/the-sunday-paper-hidden-risk-detecting-fraud-in-chinese-banks-non-performing-loan-data/].
We’re fairly sure data for bad loans is the main problem; but how are we to know? There’s never just one cockroach in the kitchen. What if data affecting key ratios is also wobbly? If investors can’t get comfortable with data for poorly performing loans how can they be expected to focus on other numbers like cost/income or ROE? And what of the most important number of all, book value? If we’re not sure what the assets and/or liabilities really sum to how can we be confident of the residual?
Banks elsewhere in the world have been caught lying to shareholders and regulators. The unique problem in China’s case is the hand-in-glove relationship banks have with these two constituencies. Wary investors are right to be concerned about data reliability.
What’s Unappreciated?
Above I’ve tried to condense the principal reasons for investor caution with regards to the sector; but there are a couple of net positives presently being given a very low weighting. Viz?
1) Shareholding Structure. Chinese banks differ from banks in other major economies in that they’re majority owned by the state. China’s economy differs from other major economies in that, still to a large extent, it’s controlled by the same state. You can guess where I’m going with this?
How risky is a financial institution operating in an environment which is steered by its largest shareholder? What risk is there to profitability when the majority shareholder controls the price of its assets and its liabilities? How likely are regulators to be looking the wrong way when they too are controlled, de facto, by the majority shareholder?
2) Full Faith and Credit. You can’t have this is writing but even the crustiest China basher would probably agree that an investment in a Chinese bank is an investment in China Inc. The point of departure with cynics is probably whether that’s a good place to find oneself, or not?
What’s not up for discussion is how unusual this proposition is. A minority holding in stocks of Goldman Sachs, Barclays or NAB does not put you directly on the same page as the governments of the United States, the United Kingdom or Australia.
Consider also this; how confident are we in ten-years’ time banks named above will still be trading with the same handles? Whither ABN Amro, Lehman Brothers, Merrill Lynch, Bradford and Bingley, Wachovia and Anglo Irish (to name just a few)? In ten years’ time I’m confident I know what code number I’ll find The Bank of China trading under, because it’ll be the same as today (and, BTW, it’ll still be called The Bank of China).
Mr. Graham’s Voting Machine
Markets are rate-of-change barometers; and, because many companies are works of near-perpetual progress, the ‘voting machine’ is the key to determining stock prices over the medium term. Banks are the best example of this.
Unless you believe the Chinese financial system is heading for a catastrophic collapse (it isn’t) it makes more sense to consider how business will progress rather than vexing on a theoretical and unlikely end game. Returning to my Bank of China example if you accept it’s likely to be around in 10-years’ time what an investor wants to know is will it be in better or worse shape at that time than today?
Alternative Scenarios
I laid out five issues above that explain most of the sentimental assessment investors are making about the industry. Let’s look at each and imagine what might change?
1) The Fractional Reserve Model. Very dangerous as discussed because tiny changes to big numbers can quickly pin a bank to the mat. This cuts both ways though. Tiny changes, if they’re positive, can equally produce significant sentiment uplift.
What could cause this? Improved corporate cash flow, an overall de-gearing of the economy or less rapid credit expansion perhaps? An improvement in any of these would necessitate an adjustment to attitude.
2) The Agent/Principal Problem. A tangle of cross connected wants, needs and desires won’t, in any of our life-times, unravel into clearly observable threads. Complete clarity isn’t necessarily required to precipitate sentimental change. All that’s required is less confusion.
How might this happen? The government have been signaling a desire for less lending to no-hopers for a while and the old dash-for-growth development model is being retired. Both policy shifts should make banker’s lives easier; and there’s probably more good sense where these initiatives came from.
3) The Lies. Two recent books that touch on this are worthy of recommendation. ‘Myth-Busting China’s Numbers: Understanding and Using China’s Statistics’ by Matthew Crabb and ‘China’s Economy: What Everyone Needs to Know’ by Arthur R. Kroeber both give good guidance on the reliability of official data.
Both books conclude the quality of official data in China has improved significantly. It’s reasonable to speculate this trend persists. As the bad loan problem slowly resolves itself (which it will) it’s likely banks will report numbers in future closer to the truth than those we’re getting today.
4) Shareholding Structure. There’s a dimension to this benefit I’ve rarely seen discussed that has implications for both capital raising and overall profitability. Chinese banks are capital hungry as they’re growing. Elsewhere in the world this would be a harbinger of dilution via equity capital raising.
In China though the majority shareholder has little interest in contributing fresh capital; but, as already observed, it has a lot of say about profitability. Solve for y? Capital increases are most likely to be provided by ongoing profitability i.e. by customers not owners, a significant unappreciated benefit for minorities.
5) Full Faith and Credit. This is hardly new information; but that so little weight is given to it in discussions about the sector seems a curios oversight? Investors in banks must always consider the what-if of who stands behind the outfit in times of maximum stress?
If you believe in investing based on hoping for the best but planning for the worst where else in the world are we offered such a robust safety net should calamity happen along? This is a valuable option whose price (presently around zero?) can only go in one direction.
In Conclusion
My main point is a sea-change of sentiment will not be required to temp investors into Chines banks. With so much passive money now in markets and so many still benchmark sensitive an allocation driven change in fund flow could force many investors’ hands.
What I’ve tried to think through above is how they’ll justify such a move considering a long-held-by-many noisy antipathy to these assets*? The answer, I believe, will be via ‘modification’ of views. It’d be impossible for most to reverse negative views and nobody with a position in a bank should ever sleep soundly.
However, a complete reversal of views won’t be required to prompt fresh investment. In the event, given how relatively small mainstream allocation may be presently, the impact on stock prices would be significant.
As noted, I see no sign of this at present; but I’m looking out for a shift in tone to, what has been for some time, implacably negative chatter.
[* An excellent example; and I could have found many more. Fidelity’s Fidelity Emerging Market’s Fund manager Mr. Nick Price from last November; “We continue to be selective in the financial sector and do not own any Chinese financials as we believe that the non-performing loans within the banking sector will be realised in time and this will be painful.”]