Chinese banks are currently trading on c.0.7x our 2017 book value estimates. With dividend yields of greater than 5% and return on equity (ROE) in the mid-teens, these valuations reflect warranted concerns over the sustainability of credit growth and the ability of Chinese banks to digest non-performing loans (NPLs). With this in mind, the critical question an investor must then ask themselves, is do these valuations reflect the reality of China’s credit situation?
At KIS Capital we believe that it pays to develop one’s own opinion. Contrarian views can often provide some of the most tantalising discrepancies between price and intrinsic value. That being said, contrarianism in isolation is not a recipe for success and must be supported by a strong investment thesis. Whilst avoiding the dangerous lures of overconfidence, it is important to have an understanding of the range of possible macro outcomes, paying particular focus to those the market has perhaps under or over-weighted. As such it is essential that an investor conducts their own work, attempting to focus attention on what they believe to be the most salient factors. In the words of Einstein:
“Everything should be made as simple as possible, but no simpler.”
When attempting to analyse the sustainability of Chinese credit growth, it is first important to ascertain its source. Over the last few years, credit flows into the inefficient and overcapacity industrial sector, a sector that has typified Chinese growth, have all but stagnated. Credit growth in more recent years has instead been sourced from infrastructure, government and household sectors. Infrastructure alone accounted for c.32% of new system credit in 1H16. To further illustrate this point, credit flows to manufacturing, mining and trade finance have slowed from a staggering c.29% per year from 2008 to 2012 to only c.6.5% from 2012 to 1H16. In the same 2012 to 1H16 period, infrastructure credits grew at a compound rate of c.19%. From these numbers it is clear that the Chinese credit mix has undergone a drastic change in composition over the last few years – somewhat relieving fears of credit expansion further exacerbating industrial overcapacity. So how sustainable is this infrastructure growth?
Many headlines have exhausted attention professing that the end is nigh for China, touting the nations c.250% debt to GDP ratio as an insurmountable problem. However, given the asset-rich composition of the Chinese government’s balance sheet, the more important measure of credit growth sustainability is the country’s net interest burden. China’s net interest burden currently sits at c.1.4% of GDP, less than both that of the US and Japan. This will undoubtedly expand over the coming years as borrowings increase, although at a rate tempered by a lower-interest credit mix. Admittedly a somewhat ‘kicking the can down the road’ approach, the continuing local government funding vehicle (LGFV) debt swap, which revolves maturing debt into lower-rate, longer-maturity municipal bonds, will help alleviate the country’s net interest burden. Furthermore, despite the widespread belief that infrastructure has been overbuilt, estimates from Morgan Stanley suggest that as much as 50% of credit flows to infrastructure can be funded from project receipts. This is before incorporating any wider economic benefits to productivity likely to transpire. Regardless, the RMB25trn of deposits held by government agencies should provide support for mid-teen investment growth in infrastructure through to 2020.
This changing credit mix has several important implications for the outlook of the Chinese banking sector. For one, the altered credit mix will likely reduce the formation rate of non-performing loans (NPLs), lowering credit cost pressures and reducing credit risk. In terms of legacy NPLs, the proactive recognition and digestion of NPLs demonstrated by banks should help assuage fears of a need to raise capital for further digestion. Reports suggest that over 50% of the NPLs in trade finance and 30% in manufacturing have already been digested. Noting this, NPLs surprising on the downside would likely provide a catalyst for Chinese banks as investors cover their short and underweight positions. With a slowdown in fixed asset investment in real estate, affordability levels at below historical highs, and reports of improving cash flows to developers, the NPL ratio for property-related loans is expected to remain low in the near term. Moving to net interest margins, sustainable credit demand from infrastructure spending would provide a reasonable buffer for margins to be maintained at current levels. Whilst the continuing LGFV debt swaps offer lower-yielding assets, their lower risk weightings as well as their exemption from value-added tax should allow the banks to maintain their current ROE.
Reading the above analysis may leave readers with the impression that there is a level of certainty in such analysis. This is not the case. At KIS Capital we don’t believe we can consistently forecast macro events. However, we do believe that an understanding of the range of possible macro outcomes, especially a consideration of those outcomes the market has undervalued, is essential in estimating the risk profile of an investment. In essence, we attempt to invest in situations with limited downside and an appropriate payoff. These opportunities are often most prevalent where risk is most obvious, and thus priced into the security. As described by Howard Marks, “it’s the investor’s job to intelligently bear risk for profit”. Whether our analysis of the current environment facing Chinese banks is accurate, only time will tell. What we do know, is that Chinese banks at these levels offer compelling value based on our estimation of likely outcomes.