Chinese banks hog the dance floor
In the past week, China's big five banks have defied dire predictions of soaring problem loans to report strong profit increases ranging between 19 and 30 per cent for 2011. But the reaction from investors has been far from enthusiastic, and Chinese bank shares have tumbled.
One reason, of course, is that investors are not convinced that Chinese banks have yet to fully recognise the extent of their problem loans they built up during their massive lending spree following the global financial crisis when they were urged to boost lending to stimulate the economy. And the Chinese government's move to encourage banks to extend the maturities of some of their troubled loans has only served to fan these fears.
As a result, investors were somewhat surprised to see that most of China's big banks reported a fall in their problem loans in their latest results. For instance, the Agricultural Bank of China (AgBank), which is often regarded as the riskiest major Chinese bank because of its heavy exposure to the rural sector, reported that its non-performing loans fell from 2.03 per cent of total assets in 2010 to 1.55 per cent last year. Industrial and Commercial Bank of China, the country's largest lender, reported a fall in non-performing loan ratio dropped from 1.08 per cent to a mere 0.94 per cent.
But even more worrying for investors were the banks' aggressive plans for boosting their capital levels by slashing dividends. For instance, China Construction Bank cut its dividend payout ratio to 35 per cent from 39 per cent in 2010; Bank of China to 35 per cent from 37 per cent; ICBC to 34 per cent from 43 per cent; while AgBank cut its payout ratio to 35 per cent from 52 per cent. Bank of Communications, China's fifth largest lender, cut its payout ratio to a mere 12 per cent, from 17 per cent last year, after announcing a $US8.9 billion private placement plan earlier this month.
An excellent research note by GaveKal analysts Arthur Kroeber and Joyce Poon argues there are several reasons why China's financial institutions are continuously hungry for capital.
In the first place, they point out that China's banking regulator, the China Banking Regulatory Commission, does not believe that the banks have fully recognized their non-performing loans from the past two years, and so it is putting pressure on banks to bulk up on capital. The CBRC wants the 'systemically important' banks to have a capital adequacy ratio of 11.5 per cent (including tier one capital of 9.5 per cent) by 2013, which is well above the Basel III capital rules.
Even more interestingly, Kroeber and Poon point out that China's four biggest lenders all share the same major shareholder – Central Huijin. As they point out, Central Huijin (which used to be owned by China's sovereign wealth fund, CIC, but is essentially an arm of the Chinese Ministry of Finance) was the vehicle used to recapitalise the four top banks between 2004 and 2010.
The Ministry of Finance has put pressure on the big banks to pay high dividends not only so that it can meet the interest and principal repayments on the bonds that were issued to raise money to recapitalise the banks, but also so that Central Huijin is able to buy shares in each new bank capital raising, so that the Chinese government's stake in the banks is not diluted.
As the GaveKal analysts point out: "in other words, China's banks dilute minorities by raising capital to finance dividend payments to the state, which the state uses to pay for past bank bailouts and protect itself from dilution. It's hard to see how this is a good deal for minorities.” GaveKal notes that in 2010, China's big five lenders paid out more than 144 billion yuan ($US22.8 billion) in dividends, and raised more than 199 billion yuan on capital markets. "Now, dividend payments are being cut, but capital raising continues. Minorities beware.”
The GaveKal analysts point out that banks will also need extra capital if they are to meet ambitious lending targets. In order to meet Beijing's target for GDP growth, bank lending will have to increase at least 10 per cent a year, but Fitch Ratings estimates that even if the banks are able to maintain their strong profit growth, they will not have enough capital to finance the expansion in their balance sheets that the government's economic growth target implies.
As the GaveKal analysts note, it's difficult to know how much capital the Chinese banks will eventually need. A lot will depend on how big their problem loans eventually turn out to be, and for how long they can continue to put off recognising losses by rolling over their problem loans.
Several years ago, many investors piled into Chinese bank shares in the belief that Beijing would pick up the tab for the losses that banks made as a result of the 2009-10 state-directed lending spree.
But, as the GaveKal team points out, it's now clear that this Beijing put does not exist. Instead, "latent bank losses will be paid through lower dividends, more capital raised from the market, and ultimately lower bank profits. Despite their apparently lively step, Chinese banks will make poor dance partners for the next few years.”