Half time scores

Cognitive dissonance is a psychological phenomenon in which a person feels discomfort from holding two contradictory beliefs simultaneously. The sense of unease is intensified by an inability to explain the apparent conflict of view.

Psychologists looking to study the topic might well take a look at investors in the Chinese banks.

On the one hand, there is the belief that the banks are highly profitable institutions, enjoying a prolonged period of growth.

But on the other, there is the widespread belief that the stimulus package launched in 2008 has led most banks to lend in a profligate manner, funding unprofitable projects across the country, and supporting a mountain of local government debt worth Rmb10.7 trillion ($1.6 trillion).

Many think it is only a matter of time before these loans start to fail on a large scale.

The release of interim reports by the leading banks last week was an attempt to address both interpretations. Record-breaking profits were announced (as has become the norm). But in addition, there was more of an effort to reassure the naysayers, with greater disclosure on local government lending commitments, and even discussion of contingency planning in event that these loans go bad.

In terms of profitability, it is hard to fault the Chinese banking system. In the first half of 2011, all the banks benefited from higher interest rates and improvements in fee income.

Of the ‘big four’, the best performer was Agricultural Bank of China (ABC), which posted a 45% increase in profits in the first half.

Even the laggard in the elite group, Bank of China, still managed a 28% profit increase. As the bank with the largest portfolio of overseas assets, it is currently at a disadvantage to its domestic peers, since foreign assets have been producing lower returns than renminbi business at home.

Industrial and Commercial Bank of China and China Construction Bank reported profit increases of 29% and 31% respectively.

Outside the big four, the star performer was China Minsheng, which enjoyed a 57% increase in profits. “We believe that this should be the fastest growing H-share bank [mainland companies traded in Hong Kong] for 1H11 and FY11,” was the forecast in an HSBC research note.

Showcasing the industry’s current profitability was the easy part. Next up was conveying the idea that the sector’s outlook also remains promising, despite the perceived exposure to riskier debt.

That message was perhaps best summed up by Yang Kaisheng, president of ICBC. “I have been asked about local government financial vehicle loans so many times I have already memorised an answer,” he told attendees at a news conference. “I will say that the risk is manageable, the loans are properly spread out, we have enough provisions, and the assets are of good quality.”

The headline figure in testing the health of the loan book is the ratio of non-performing loans. And all of the big four posted a reduction in NPLs in the first half. At ICBC for example, NPLs accounted for less than 1% of total loans.

The other focus for bank bosses was to demonstrate that they have enough capital to withstand a situation where loans turn sour in a major way. CCB, for example, announced a capital adequacy ratio of 12.5%, in excess of the regulatory minimum. It also emphasised that 84% of its loans to local governments were covered by cash flow. Bank of China did something similar, announcing that provisions were in place for 217% of potential bad loans.

These claims were accompanied with assurances that there would be no need to sell equity to strengthen bank balance sheets for some time to come. “We’ll be able to maintain a good level of capital for the next few years. This won’t be a problem,” said Guo Shuqing, chairman of CCB, in the Financial Times.

So far, so good. The banks seemed to have painted themselves into a picture that showcased their strength, foresight and caution.

But there was also enough material in their reports to sketch out a more doubtful landscape, with a little less of the ebullient colour that the reporting season was seeking to convey.

Overdue loans are a case in point. These are NPLs in embryonic form (a defaulted loan that is less than 90 days old is simply overdue; after that, it becomes an NPL).

Analysts look at overdue loans to predict the future health of a bank’s loan book and the reports did not bode well. The 12 banks that announced results last week admitted a total of Rmb327 billion in overdue loans, a 3.4% increase on the beginning of the year, reports the People’s Daily. And as a proportion of total loans, overdue loans are growing quickly – at an average rate of more than 10% at most banks. China Minsheng was the worst affected, with overdue loans up by 24.7% in the first half.

This suggests a surge in default activity, but one that the banks think they can manage before delayed payments become NPLs. If this trend continues at a similar pace, though, growth in NPLs would seem unavoidable too.

The Ministry of Railways – a government agency now creaking under Rmb2 trillion of debt – is also a cause for concern. The ministry has borrowed so much to fund the expansion of the high-speed railway network that all of the big four banks are now close to the maximum loan concentration (15%) permitted for a single client, reports 21CN Business Herald.

Fitch, a rating agency, thinks banks could come a cropper thanks to the real estate market, reports the Wall Street Journal. A headline in the FT seemed to sum up the general mood: “Doubts plague China’s banks.”

The cynics say another issue worth a second look is capital-raising. Banking heads might have denied any plans to sell equity. But the larger institutions considered systemically important – in other words, too big to fail – will need to raise Rmb500 billion over the next five years to comply with Basel III, said Wu Xiaoling, a former deputy chief at the cental bank, at a forum last month. This is in addition to the Rmb594 billion raised since July 2010.

The immediate source of money will be the offshore renminbi market, or so-called dim sum bonds. CCB is looking to raise Rmb80 billion of subordinated debt in Hong Kong in this way. ABC also has approval to issue debt abroad.

Faced with countervailing opinion, investors now have to make up their own mind on the banking outlook. The optimists are buying into the positives of the story presented by the interim reports, as witnessed by the sharp rebound in the Hong Kong shares of China banks this week.

But pessimists note that some bluechip investors are cashing out. Bank of America sold $8.3 billion of its stake in CCB on Monday. Although the US bank is retaining a 5% holding, the question is whether the sale was forced more by its financial troubles at home or a seeping loss of confidence in the Chinese financial sector. It is worth noting that this week’s sell-off came just two months after Singaporean sovereign investor Temasek offloaded $2.4 billion worth of shares in Bank of China and $1.2 billion in CCB.

So buy into the rebound or take the time to retrench? Only time will tell which is the better option…

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