The huge bank problem (bigger than Spain) that nobody is talking about

05/01/2012 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

What country does this describe?

The country’s banks are short of capital and will have to go to the financial markets to raise more in 2012—and 2013.

Bank balance sheets have ballooned as a result of lending to real estate developers.

Everyone believes that banks’ official accounts badly understate the number of bad loans on their books.

And, finally, it’s just about impossible in this country to separate bank and government finances.

Spain and Italy? Of course. And you can work your way around Europe adding other names to your list of guesses.

But the country I had in mind was China. China’s banking problem isn’t as far along as that in Europe. Notice that I’m calling it a “problem” rather than a “crisis.” But China’s banking sector is headed toward a crisis—and the government’s efforts to head off that escalation will be one of the major drivers in China’s economic and monetary policy in 2012 and 2013. Want to understand how much stimulus Beijing will pour on its economy—and therefore whether you should be putting money into Chinese stocks or taking it out (and when)?  Take a long look at China’s banks.

If you understand the nature of China’s banking problem, you’ll understand why I believe that China’s government will move sooner rather than later and more aggressively rather than more moderately to stimulate China’s economy. In the short run, China simply can’t afford to let a slowing economy make the problems in its banking sector worse. In the long run? Ahh, a very different question with a much more worrying answer.

Let’s start with the strangest manifestation of the problems in the sector, the need of China’ banks to raise a huge amount of capital. In the last 12 months, according to Citigroup (C), China’s seven biggest banks have raised $52 billion in capital. Citigroup estimates that the banks are looking to raise an additional $18 billion in capital in the next few months.

To put that in the context of the euro debt crisis, the $70 billion in capital raised or projected to be raised by China’s biggest banks compares to the $84 billion that the Irish government needed to recapitalize its banks and the projected $130 billion to $160 billion that Bank Paribas recently estimated might be need to recapitalize Spanish banks.

China isn’t yet in as deep water—especially when you remember that China’s economy is, at $11.3 trillion (at purchasing power parity not the official exchange rate), about 8 times bigger than the $1.4 trillion Spanish economy.

But $70 billion isn’t a trivial amount of capital to raise and the need by China’s banks to raise this much capital in so short an amount of time is startling. After all China’s Prime Minister Wen Jiabao has recently criticized China’s banks for making too much money. In 2011 China’s four biggest banks reported a combined profit of more than $90 billion, a 25% increase from 2010. Agricultural Bank of China (ACGBY in New York and 1288.HK in Hong Kong), the least profitable of the big four lenders, made $18.9 billion in 2011. That’s almost as much as JPMorgan Chase (JPM), the most profitable U.S. bank made in 2011.

So why do China’s banks need to raise so much capital—and how could they possibly be in trouble?

First of all, because these tremendously profitable banks can’t use all of the profits from their lending activity to build up capital against those loans. The banks don't retain all of the profits but instead pay out of high percentage in dividends. In 2010, for example, when profits at the big four banks equaled about 500 billion yuan, the banks paid out 144 billion yuan in dividends. Much of that went to the banks’ biggest shareholder, the Chinese government.

In the same year that the banks paid out 144 billion yuan in dividends, they also raised 199 billion yuan in capital on the financial markets.

In other words China’s banks currently operate as a huge cash circulation machine. China’s banks make profits lending at a very profitable interest rate spread—an average 2.7 percentage points currently—because the People’s Bank of China has set a floor under what banks can charge on loans and put a ceiling on what they can pay depositors. (The current 3.5% cap on interest on one-year deposits is running slightly below the most recent 3.6% rate of inflation.) Much of that profit is then recycled to Beijing, which then makes sure that the banks can raise capital in the financial markets by gently pressuring global institutions to buy into the bank offerings (with the understanding that doing business in China might be easier for institutions that participate) and by having state-owned companies step up to buy into the offering as well.

For the big banks, however, the system is starting to show some stress because the balance sheets of these banks have been growing so rapidly. In March China’s four biggest banks reported that total loans and other assets had climbed another 14% in the first quarter to $7.4 trillion. That’s roughly the size of the German, French and United Kingdom economies combined. Some of that balance sheet increase results from the banks’ role in financing China’s $588 billion stimulus to combat the effect of the global financial crisis. Some comes from the sector’s participation in the country’s real estate boom. And some of it is more recent as banks, in response to government worries about an economic slowdown, have again increased lending. New bank lending from the country’s big banks came to $160 billion in March, 21% higher than the consensus estimate of economists surveyed by Bloomberg.

And all those loans increasingly worry regulators. What if they start to go bad?

So far official estimates of the bad loans in the portfolios of these big banks say this isn’t a problem. In fact non-performing loans fell in 2011 to 1.15% of loans from 1.34% in 2010.

Nobody really believes that those figures accurately state the dimensions of the problem (just as financial markets and the Banco de Espana doubt that Spanish banks are accurately stating the amount of their bad real estate loans.) Rather than fighting to improve bank accounting in China—a long and very difficult battle—Chinese regulators are pushing banks to increase their capital reserves. Under new rules, for example, banks will be forced to increase their core Tier One capital levels to 9.5% of assets.

Think that might send the banks to the financial markets to raise capital?

Of course, but just as European regulators have discovered, when you push banks to increase their capital ratios some unexpected things can happen. First, banks can decide to stop lending in order to shrink the assets on their balance sheets. Fewer assets means less need to raise capital. So far, there’s no evidence that China’s banks are pulling back on overall lending, although they have clearly cut lending to smaller companies that don’t have government ownership. Second, banks can look for ways to push assets off their books. Off-balance sheet lending in China has just about doubled from 2009 to 2011.

What you can see in this part of China’s financial system is a very precarious balance. Banks need to continue to generate high levels of profit so they can pay out big dividends and so they can raise the new capital that will enable them to keep paying out high dividends and to make the new loans that China needs to keep economic growth from slowing too radically. And the banks need to remain spectacularly profitable if they’re to have any hope of raising the new capital that regulators are requiring. Of course, that extra capital is critical to keeping the confidence of the investors—especially the overseas investors—who the banks need in order to raise that capital.

The first quarter results from China’s big banks China's that started to come in at the end of last week weren’t reassuring news on preserving that balance. The big four banks, in fact, have reported weaker than expected first-quarter earnings because of a slowing economy and rising funding costs. On Friday, April 27, for example, the Industrial and Commercial Bank of China (IDCBY in New York and 1398.HK in Hong Kong), the biggest bank in the world by market capitalization, reported that profit growth had slowed to 14% year-to-year in the first quarter. On Thursday Bank of China (3988.HK in Hong Kong), the country's No. 3 bank, fell short of analyst consensus and so did the Agricultural Bank of China on Friday. When China Construction Bank (CICHY in New York and 939.HK in Hong Kong), the last of the big four to report, missed projections too, it made the sector zero for four. For the quarter, China’s banks as a whole will report profit growth of 13% to 14%, according to Bernstein Research. That would be 2 percentage points below the consensus estimate.

This decline in profit growth has got to be setting off loud alarms at the People’s Bank and throughout the Beijing offices of the government. Whatever their problems, China’s big banks are the healthiest part of China’s banking system. Just as in Spain, where the Banco de Espana isn’t worried about Banco Santander (STD) or Banco Bilbao Vizcaya (BBVA) foundering, but about the weaker regional banks going under or needing a big bailout, in China regulators and government officials know that the really dangerous problems are elsewhere in the system.

And they’re everywhere.

You can start with the halls of the Ministry of Railways where the rapid expansion of the country’s railway system—and the not so rapid expansion of revenue from tickets—has left the ministry to struggle with interest payments on $300 billion in debt.

You can then go out to the financial groups affiliated with local governments that financed everything from real estate to factories to the tune of $1.6 trillion—without the revenue to pay for interest payments on the debt.

And way down the end of the banking totem pole (or at least the end of the official banking system) there are the problems at China’s credit co-ops that make loans in rural areas. About a third of them, according to Zhou Xiaochuan, governor of the People’s Bank in a recent interview, have a risk-adjusted capital to asset ratio below 4%.

I’d guess that if bank regulators are worried about the big four banks enough to require capital to asset ratios of 9.5%, they must be terrified by what might happen to the rural cooperative lenders.

So what do you do if you’re sitting in Beijing and looking out at this problem?

First, you are absolutely convinced that you can’t let the economy slow much more than it has. A significant further drop in bank profitability at this point would make it harder—perhaps impossible—for the big banks to raise capital in the financial markets in offerings with a credible number of non-governmental investors.

Second, you know that to rev up the economy you’ve got to keep China’s big banks at the job of increasing their lending. That’s tough given the stretched balance sheets at these banks and their need to put on lipstick for their next round of capital raising, but one way out of this box is to cut back on the reserve ratio requirements that China raised repeatedly in its efforts to fight inflation. Right now China’s big banks have to keep 20.5% of their capital in reserve under the current formula. That’s money that can’t be lent. The financial market anticipates at least one reduction in the reserve ratio this quarter and one next quarter. I think that’s about right.

Third, you know you’ll have to be very, very careful about any reductions in the actual benchmark interest rate. Lowering this rate is Beijing’s big gun when it comes to giving the economy a boost to counter the drop in exports to Europe. Cutting the rate would provide big stimulus for China’s real estate and stock market sectors—and wouldn’t hurt the capital goods and durables sectors (autos, for example) either.

But with the big four banks already feeling the effects of higher funding costs—and smaller banks and rural cooperatives pushed even harder to find money at a reasonable cost—the People’s Bank is going to be very careful not to do too much to reduce the spread between the floor interest rate on loans and the ceiling interest rate on deposits. The central bank might be able to get away with one cut to the lending rate without a corresponding reduction in deposit rates—but I think even that is uncertain and a second reduction to the spread is extremely unlikely.

I think there’s enough wiggle room in the banking system and in China’s state finances to let the country and its banking system get through this round of problems. But the likely solutions just store up problems for the future. (Sound familiar? Europe? The United States? Japan?) If savers get an even worse deal from the official banks on their deposits, even more of them will take their money to unofficial financial institutions that offer higher rates and that then lend to cash-strapped smaller businesses and to anyone else unable to come up with the government connections to qualify for a loan from one of China’s big banks. That will also push money back into real estate and stock market speculation. When the pressures build up so that authorities are facing the danger of another bubble, they’ll find themselves with less control over the financial system because more money is now outside the official system.

It’s hard to see how China can stimulate its economy sufficiently to take local governments and smaller banks off the hook for all the bad loans they backed in this cycle without undoing the country’s progress on fighting inflation. And if China faces another bout of potentially run away inflation, it’s hard to see how Beijing will be able to slam on the brakes hard enough to reduce inflation without producing a financial crisis in these parts of its financial system.

As with so much else in the interplay between financial markets and macroeconomic finances, China—like Europe, like the United States—comes down to timing. If China can get its growth back to 8% in fairly short order—by increasing the flow of money into the economy—I think 2012 will turn out to be a pretty good year for Chinese consumers and for investors in China. My worries, if those moves succeed, would look out to 2013. That’s when the bill for any short-term fix would start to come due.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Banco Santander and Banco Bilbao Vizcaya as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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