Central Huijin Buying Chinese Banks Doesn’t Mean Shares Prices Will Not Drop More11 October, 2011, 23:26. Posted by Zarathustra
Tags: Chinese Banks, Financials
I can’t believe that I am picking a fight with Tom Orlik for a second day in a row. Yesterday, he said it is too early to bet on the collapse of China, while I think it is too late as bearish bets are becoming rather more expensive. Today, he says “A bet on China’s banks is a bet on Beijing’s political decisions” regarding the decision for Huijin to buy Chinese banks’ shares.
So what is he suggesting?
Remember, in late 1990s, the big state-owned Chinese banks are in a major banking crisis. The four large state-owned banks were insolvent, and 20% of loans by 2002 were non-performing. But nothing seemed to have happened. These banks did not close, and they are still around, because the state backstopped the banking system. Or because Chinese banks were not banks in the Western sense.
And then the banks were restructured, recapitalised, reformed, and were subsequently taken public in Shanghai and Hong Kong. It was meant to be a step towards the Western kind of banking, in which banks make loans not because of policy reasons, but for commercial reasons (i.e. profit maximising). Unfortunately, as the Western banking system almost collapsed in 2008, China no longer sees the Western model as something good to follow. As Carl Walter and Victor Shih said, now it’s just like old time.
Or is it? Those banks weren’t listed on the stock market, so probably no one in the public should have given a damn on whether these banks were solvent or not, because it had nothing to do with them. As long as the state stood behind the banks, deposits were safe, and banks were still making loans, all was well.
Now these banks are listed, so shareholders should care about the asset quality and others. Again, even though Chinese banks are much less leveraged than its Western counterparts, the lending spree in the past few years would probably mean a very high non-performing loans ratio in the years to come, eating up banks’ capital. Equity capital of the bank can be thought of as a call option on bank’s asset, with the exercise price equals to the bank’s liabilities (which includes deposits and other debts). In an economic slowdown, as asset quality deteriorates, the value of bank’s asset will drop closer to the value of liabilities, which is relatively unchanged. Bank’s share, in turn, would behave increasingly like an out-of-the-money call option on bank’s assets as the bank becomes insolvent.
In that situation, the implications are, first of all, that bank’s cost of equity capital will become very high as beta of the share rises (i.e. volatility will rise). Second, stock price will become depressed because the equity capital is getting closer to be wiped out. Third, as cost of equity rose, it is harder to get the private sector to recapitalise the banks. In that case, the state would have to stand behind the banks.
Yes, I know the Chinese government will stand behind the banks; I know the Chinese government will not allow these banks to disappear; I know the Chinese government will not allow depositors to have their money disappearing mysteriously; I know the Chinese government will recapitalise the banks if private sector shareholders don’t. But please, that will not stop the banks’ shares from collapsing.
If you don’t believe that, just look at those Western banks which were probably insolvent but are still around after the financial crisis because of governments’ help. Look at the Irish banks, which are still here, but the equities have been wiped out. Look at RBS and Citi, which is still here, but the equity has been wiped out. This is what I meant when I suggested that we could see a RBS kind of outcome when it comes to Chinese banks: your deposits in RBS were very safe, but your investment in RBS’s shares was uber-risky.
“A bet on China’s banks is a bet on Beijing’s political decisions”? What are you really trying to tell investors? To buy Chinese banks shares or what?