Last year a shock devaluation of the Yuan, continued slowdown in Chinese economic growth and growing concern over China’s rising debt pile contributed to the Shanghai and Shenzhen Composite indices halving in value. The already reasonably priced big 4 Chinese banks did not escape the carnage and now trade on trailing PE multiples of around 5. This is far lower than Australian banks (10 to 15), US banks and European banks. While the lower multiple compensates for poorer debt quality in the opinion of financial markets, China’s rapid growth must be factored in when considering the sustainability of debt levels. As such, price to book values of 0.65 (China Construction Bank) are almost certainly indicative of a major share price boost in the future, other than in the event of a systemic solvency crisis that could result in bank collapses.
A recent report in Bloomberg asked investment professionals from CLSA group to mention their stock picks for the following decade. One of the main takeaways was captured perfectly in the headline – “No One Picked a Chinese Bank”. Nevertheless, given that few people are successful at picking the bottom of a cycle, investing in the sector while most other investors are shunning it may prove an effective strategy for attaining big returns in future years. This reality is mandated by the nature of markets: stocks will bottom out when prices are lowest, which occurs when supply (created by sellers) exceeds demand (created by buyers) for the stock. As a consequence, it is unlikely that you will ever gain a sense of reassurance from the confidence of mainstream analysts and the media towards the bottom of a cycle. Furthermore, given the level of state ownership and intervention within the financial sector, it is unlikely that the Chinese government would allow a major bank to collapse given such an event could trigger an economy wide depression.
Nevertheless, with China being the fastest growing major economy in the world, the banking sector is well positioned over the coming decade. This is because the financial industry as a whole is heavily tied to the health of the underlying economies that it serves – economic growth lowers liabilities arising from NPL’s whilst increasing the desire of businesses to borrow and invest. China is also the world’s largest saver, a trend which will secure a vast, cheap source of capital to the banking sector in years to come. While consumption will be the largest driver of growth going forward, this will provide new and more diverse revenues streams for banks such as credit card services. It is unlikely to come at the expense of growth in household savings – both are likely to rise as a result of China’s rapid economic growth. As such, the banking sector can look forward to strong growth in the years to come, albeit with volatility on the way up.
China’s debt has brought about much concern in the aftermath of the GFC, with George Soros saying that the nation looks very similar to the United States prior to the sub-prime crisis. This view is supported by a recent McKinsey report which reveals that China’s debt to GDP ratio, now over 200%, has grown substantially since the financial crisis. Nevertheless, this is also true of most western countries which have a far lower ability to grow their way out of a debt crisis. Furthermore, rapid deleveraging of many US firms following the GFC shows corporates to be far more able to deal with higher levels of debt than governments are. This is an important point which supports a bullish view of China, a country in which debt is concentrated in the hands of corporates and one of the few countries to run multiple budget surpluses in the post GFC period.
Unlike debt which fuelled irresponsible spending and government corruption in countries such as Greece, Chinese debt typically fuels investment projects which will yield large returns in years to come. Despite China’s stimulus program in the GFC being criticised in the west as “building highways to nowhere”, in almost all cases China has also constructed cities which the highways were built to serve. Europe by contrast has “invested” in providing the world’s largest welfare state, a decision which has done little but yield a chronically high unemployment rate and, in some cases, poor national work ethics. As such, China has a strong and rapidly growing economic base from which to service its debt obligations.
One policy which has concerned investors in recent times is the increasing unwillingness of the Chinese Government to continue bailing out troubled SOE’s. Such policy though is likely to be implemented gradually as part of an overall transition to an economy less dependent on the state for support, as opposed to a sudden event which could cause shockwaves across the entire Chinese economy, via the financial sector. As such, while the banking sector may have a tough time pulling through China’s corporate debt issues, the industry will emerge stronger and is likely to see similar gains to US banks post GFC (with effects magnified by the growth in China’s economy and thus the ability of Chinese to demand financial services). In summary, China’s debt is used productively, the economy has strong long term potential and the financial sector will continue to thrive over the long term due to supply side tailwinds.
The recent performance of the Shanghai composite suggests that the market may be bottoming out. Volatility is down, and the market has started to trend sideways, indicating that the market may start to look towards fundamentals to find a new direction. In the event of the perpetually predicted and yet to be realised “hard landing” in China, this direction would be to the downside. Betting on a downturn though may be unwise – if one had maintained a bearish position on the Shanghai Composite ever since George Soros had announced his bearish views on the country, he/ she would have lost money. If even the world’s most respected trader lost potential trading income by avoiding China, losing out on growth in the world’s fastest growing economy to predict one crash may be a poor long term investment decision. It is also worth considering that a “crisis” in China could be a sudden slowdown of GDP growth by 3 percentage points. While this would mean growth of well under -1% in the US and Europe, the 4% growth proposition for China (where companies are still growing their revenue and ability to service debt) is an entirely different one.
While China continues to struggle with an over leveraged corporate sector and local government debt, this is unlikely to cause a collapse in China’s major banks. The nation is on a path to solve the debt problems, with the government sending clear messages to SOE’s that they will have to manage their own debt burden. Furthermore, the extreme bearishness of financial markets mean that the sector’s downside risks have been more than fully factored into the share price of most Chinese banks. As such, a long term investor needs only to worry about entry timing before buying into the sector.