October 9, 2006 –
While I still like certain individual Chinese stocks, I don’t particularly like the banking industry in China. This week, there has been enormous hype surrounding the largest IPO in history planned on October 27th by the Industrial and Commercial Bank of China, which plans to raise USD $22 billion. To gain some perspective on the size of this IPO, Mastercard’s May 25th IPO, which raised USD $2.58 billion, was the largest IPO in the U.S. stock markets in two years. The mania surrounding Chinese IPO’s is evident. Though both the shares of China Construction Bank and China Commercial Bank skyrocketed by 45% and 25% respectively after their IPOs within the past year, this isn’t enough to attract me into these waters. Why?
Two words. Pacific Ethanol (PEIX). There was similar mania surrounding ethanol stocks earlier in this year that masked serious deficiencies in these companies. On the strength of the announcement of a Bill Gates investment, PEIX rapidly ascended from about $18 a share to a peak of $44.50. The mania surrounding ethanol stocks masked the fact that Pacific Ethanol had not even produced or sold a single liter of ethanol nor had demonstrated a single dollar of earnings. Since then, in the last six months, PEIX lost about 70% of its value. PEIX may still be a solid investment sometime down the road, but it certainly wasn’t anywhere close to being one back then despite the mania. I see this exact same feeding frenzy surrounding Chinese bank stocks today.
The mania that surrounds all Chinese stocks and the frenzy of almost every major bank wanting a piece of ownership in Chinese banks currently masks a lot of problems with the Chinese banking system. The list of foreign banks & financial institutions buying ownership in Chinese banks is extensive – Citigroup, Bank of America, BNP Paribas SA, ING, General Electric, Temasek Holdings, and Deutsche Bank just to name a few.
I believe HSBC (Hong Kong Shanghai Bank Corporation) is demonstrating one of the wisest strategies in the Chinese bank acquisition frenzy. Since its $1.75 billion acquisition of 20% of the Bank of Communications in China in 2004, HSBC has been content for the most part to remain on the sidelines in the recent feeding frenzy, instead opting to acquire more moderate stakes in smaller banks such as their $62.6 million purchase of a stake in the Bank of Shanghai. They have opted, unlike other foreign banks, to stay out of considerable investments in the big-four state-owned Chinese banks. Perhaps part of HSBC’s divergent strategy is based upon their superior understanding of the Chinese banking industry that is predicated by their presence in Asia for more than 140 years.
First of all, many large well-established foreign banks that have sought out joint-ventures with Chinese banks have stressed the need to overhaul and strengthen many of the poor internal regulatory procedures of Chinese banks that led to decades of high percentages of non-performing loans (NPLs). This past January, the China Banking Regulatory Commission (CBRC) reported that the percentage of NPLs among the four largest Chinese banks, Bank Of China, China Construction Bank, Industrial and Commercial Bank of China and Agricultural Bank of China, and a dozen additional national shareholding banks shrank from over 13% in 2004 to 8.9% in 2005.
To give you an idea of how high this percentage still is, the best international banks maintain NPL ratios of about 1% to 2%. I remember many years ago, when I was a private banker at one of the largest banks in America, fighting epic battles with senior management for the approval of multi-million dollar loans for my clients. I guarantee you that at many Chinese banks, no such battles are being fought.
Furthermore, I remain skeptical of any statistic reported by a state-run agency, especially given the fact that no doubt such improvement adds fuel to the fire of the foreign frenzy to buy Chinese banks and benefits Chinese banks greatly in the short term by granting them access to significant infusions of cash. Secondly, I don’t believe that decades of non-existent credit standards and poor lending practices can be solved in a few years despite the assistance of the expertise of foreign bankers. You just can’t change a widespread industry culture overnight. Even if the reported numbers by the CBRC are fairly accurate, the huge growth that is being spurred by great amounts of foreign cash being thrown around in the Chinese banking industry and the obscene amounts of cash that are currently being raised through IPOs, in my opinion, can only exacerbate the risk management problem of Chinese banks.
What we are now seeing, is tremendous growth in many Chinese banks before the problems of risk management have been addressed. I would not be surprised if in the future, we see a setback in the improvement of NPL percentages in Chinese banks as risk management systems struggle to keep pace with growth.
Finally, the Chinese yuan’s new managed float system introduces currency risk into an already inadequate risk management system. Mechanisms to manage currency risk are still highly inadequate in the Chinese banking infrastructure. Even in Thailand, many times when I advise friends and businessmen to utilize caps, collars and currency swaps to protect against a falling dollar, many inform me that their bankers have never once discussed such risk management mechanisms with them. So if you invest heavily into a banking system where currently mania is masking many problems that have been inadequately addressed, I say do so at your own risk.
Most high level martial artists develop a “sixth sense”, an ability to judge other people’s characters, even those of complete strangers, exceptionally well. Over time, one can learn to discern where inner turmoil dwells below peaceful exteriors or if a peaceful facade is truly indicative of a person’s disposition. However, one thing that you learn that is almost always true is that those persons in need of attention, those that always seem to draw attention to themselves are lacking peace in some capacity. That they suffer from inferiority complexes or are immature or arrogant and so on and so on. They need attention to substitute for some type of character deficiency. In investing, those opportunities that seem to attract enormous amounts of attention are also often times, a warning to stay away.
