China Stocks and China Bank Bad Debt Both Soar

03/31/2015 8:24 pm EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

After a brief pause for profit taking, MoneyShow's Jim Jubak expects to see the Shanghai Composite head even higher after roaring ahead to a new seven-year high on Monday, but he also thinks the one thing that might derail that trend is the bad news on bad loans coming out of China's biggest banks.

The 1.02% overnight drop last night in China's Shanghai stock market is about what you'd expect from a market that roared ahead 2.6% on Monday to a new seven-year high.

After a brief pause for profit taking, I'd expect to see the Shanghai Composite head even higher.

The one thing that might derail that trend is the bad news on bad loans coming out of China's biggest banks as they report fourth quarter earnings.

The move to a new high in Shanghai has been based on a belief that the People's Bank has more stimulus moves in mind. China's central bank has already cut interest rates twice since November but traders are convinced another cut is not too far off.

The conviction got a considerable boost over the weekend when Zhou Xiaochuan, the governor of the People's Bank, issued a deflation warning. "Inflation in China is also declining. We need to have vigilance if this can go further to reach some sort of deflation or not," Zhou said. The pace of the drop in inflation, he continued, was a "little too quick."

To me-as to traders-that does indeed sound like the central bank is worried that growth has slowed too much and that stimulus to date hasn't been enough to support growth and to maintain a modest and steady rate of inflation. Inflation at the consumer level dropped to a year over year 0.8% in January, down from an already low 1.5% annual rate in December. The January reading was the lowest year over year inflation rate in five years.

At this point, I think another interest rate cut from the People's Bank is a question of When? and not If?

The danger, of course, is that this interest rate cut is already priced into Shanghai stocks at a seven-year high. The answer to that is whether traders in China expect that the next interest rate cut would be the last. Unless this rate reduction is a lot more effective at increasing growth and inflation than the last two, I'd expect traders to start dreaming of another cut almost as soon as this one is announced.

I don't think I'd chase Shanghai stocks here. A move above the seven-year high is likely but I don't think we're looking at a big rally from here. So the reward, while definitely present, is likely to be limited.

On the downside, recent earnings reports from China's big banks worry me.

For example, on March 25, Agricultural Bank of China, China's third largest bank, reported that net income fell in the fourth quarter of 2014 and bad loans soared. (It was the first year over year decline in net income at the bank in three years.) Non-performing loans rose by 21.5 billion renminbi ($3.5 billion) for the biggest quarterly increase in bad loans since the bank began disclosing quarterly numbers in 2010. The increase took the bank's non-performing loan ratio to 1.54% from 1.29% at the end of September.

That would still be an extraordinarily low non-performing loan ratio, except that no one outside China's big banks believes the number. The official non-performing loan ratio for China's entire banking system was just 1.29% the end of 2014. Which is amazing for a financial system awash in bad debt. Banks generate this low ratio by engaging in various shell games that move bad loans off their books.

What's important in this context then isn't the absolute level of non-performing loans but the direction of the trend. Another number, the gross non-performing loan formation ratio, which adjusts for disposals and write-offs, climbed to 1.64% in December at the bank from 0.68% at the end of September, China Merchants Securities Hong Kong estimates.

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