Marc Rubinstein has over 25 years experience as an analyst and investor in the financials sector which he distills into a weekly newsletter, Net Interest, which I think is a really great read! Between 2006 and 2016 he was senior analyst and portfolio manager on the Lansdowne Global Financials Fund, a fundamental long/short equity fund focused exclusively on the global financials sector. Prior to that, Marc was an Institutional Investor ranked analyst on the sell-side, most recently at Credit Suisse, where he was a managing director overseeing its European banks team. As well as writing Net Interest, Marc is an active angel investor in fintech. He can be contacted via his newsletter or on Twitter (@MarcRuby).
As with all of our guest contributors, Marc’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.
Fifteen years ago – almost to the day – I sat in a meeting room at my London-based hedge fund, across the table from the management team behind the world’s biggest IPO. They’d come halfway across the world on a global roadshow to educate investors about their company. There was nothing fancy about this company, no cutting edge tech or innovative business model. It was a bank – the largest in China. After years of Communist party ownership, it was opening itself up to private capital.
The meeting itself was a formality. We wanted stock and they knew we wanted stock. An interpreter sat alongside the most senior executive and questions and answers were routed via her. They told us about their operational reforms, about their financial restructuring and about their strategy to grow fee income. But the investment case was simple: this was the biggest bank in China, home to almost a fifth of the deposits in the country, and an investment in it would grant exposure to the rapid growth of the country’s economy.
The IPO was 30 times oversubscribed; the domestic retail tranche even more so. It came at a price that valued the bank at 2.2 times its book value (the accounting value of its assets). On the first day of trading, the stock went up 12% and over the next year it doubled.
But that was then. The Industrial & Commercial Bank of China’s stock has spent most of its time lower than that first year high. Right now, it languishes at 0.45 times its book value. Questions about profligate loan growth and impending bad debts have swirled around the bank for the past few years. But with property developer Evergrande – which we discussed here back in July – struggling to make debt repayments, these questions are becoming more pertinent. Evergrande has disclosed that ICBC is one of its principal bankers, although relative to its overall size the exposure is small. The bigger risk is that ICBC and other Chinese banks suffer contagion via a deteriorating real estate market. With $300 billion of assets, Evergrande is big, but if you want big, take a look at the balance sheets of Chinese banks…
No Time To Die
When ICBC came to the market in 2006 it had only been in existence for around 20 years. It was formed as part of a sweeping reform of the Chinese banking sector that began in 1978. Prior to that, there was only one bank in China – the People’s Bank of China. The People’s Bank gathered deposits from households and a separate entity, under the direction of the Ministry of Finance, disbursed funds to state-owned companies to finance investment projects.
The reforms carved four new banks out of this set-up, each with a slightly different mandate. ICBC – the Industrial & Commercial Bank of China – was the last to be formed, to oversee the commercial banking functions previously done by the People’s Bank. The four banks bolstered their presence by building out branch networks and growing their balance sheets.
While the reforms put the banks on a slightly more commercial footing, their operations were still very much driven by government mandate. That loosened up in 1994 with the establishment of a group of formal ‘policy banks’ tasked with relieving the state-owned commercial banks of state-directed lending practices. A commercial banking law was passed the following year which shifted responsibility for business operations, risk management and financial performance onto the banks themselves.
Sadly, the new law was too late to protect the banks from the state-directed lending they had done in the past. In the late 1990s, the government turned its attention to the corporate sector and closed down thousands of state-owned enterprises. Many were unable to repay their debts, leaving the banks saddled with enormous non-performing loan portfolios. The government injected additional capital into the banks and set up four ‘bad banks’, one for each of them, to take on their worst performing loans.
ICBC transferred RMB 408 billion of assets over to its bad bank, Huarong Asset Management, equivalent to about 17% of its total loan book. However, even that wasn’t enough; loans continued to sour. At the end of 2003, around a quarter of ICBC’s loan book was designated non-performing. So just prior to its IPO, in 2005, the bank transferred out another RMB 705 billion of non-performing assets.
By the time ICBC management came to see me, they had managed down their non-performing loans to just 4.1% of their loan book. They were circumspect. “We cannot assure you that the quality of our existing or future loans and advances to customers will not deteriorate,” they wrote in their offering prospectus. But the bank looked fairly clean, and more importantly, they had an interesting story to tell.
When ICBC came to the market, it had the tailwind of Chinese growth behind it. In the five years prior to its listing, Chinese GDP had grown at 13.6% per year. The interest rates banks charged for loans, though, were a lot lower than that, so loan demand was very high. What’s not to like about borrowing at 6.5% to invest in an economy growing at 13.6%?
Banks set interest rates on loans and deposits with reference to government benchmark rates. In the past, banks had been allowed to set rates only within a very narrow corridor around the benchmark rate. In 2004, the government removed the ceiling on this corridor but, even then, banks’ lending rates continued to cluster around the benchmark. In order to stop loan growth (and hence inflation) spinning out of control, the government used a quota system, handing down loan disbursement targets to the banks under their purview. Rather than relying on price to manage credit conditions in the economy, the government retained a direct hand in controlling volume.
The mechanism was favourable for banks because deposit costs were also kept low. At the time, the benchmark rate for demand deposits was 0.72% and the rate for a three-year time deposit was 3.69%. This gave banks a guaranteed source of profits. They could lend out for three years at 6.5% and fund those loans via deposits to lock in a spread of at least 2.8%. Depositors couldn’t really do much about it because there was nowhere else for them to put their money – equity and bond markets were not yet sufficiently developed (although real estate was starting to look attractive; hence the growth of Evergrande). Through this process, borrowers got cheap loans and banks locked in a profit, all at the expense of Chinese households. In their book, Trade Wars are Class Wars, Matthew Klein and Michael Pettis estimate that the transfer was worth 5% of Chinese GDP each year between 2000 and the start of interest rate liberalisation around 2013.
ICBC’s loan book grew by 12% per year in the two years after its IPO but GDP kept pace. For the system overall, loans didn’t really swell as a percentage of GDP over the entire period.
But then the global financial crisis happened.
Faced with slowing economic growth, the Chinese government doubled down on the tool it knew best: its loan quota system. The government instructed banks to ramp up lending in 2009 to stimulate the economy. ICBC grew its loan book by 25% that year and 19% the next.
By the time the government put the brakes on in 2010, borrowers had a newfound thirst for credit and banks had a newfound thirst for size. Credit allocation was devolved to local government and they were not done, needing to draw down additional credit to complete projects. An audit in 2013 concluded that local government debt had ballooned to RMB 18 trillion.
To fund local government projects and other borrowings, yet constrained by a reduced loan quota, banks and non-bank financial institutions devised innovative ways to get credit out into the economy. In some cases, this involved creating investment products which could be sold to households and corporations. These were a win/win solution: banks originated loans with an implicit government guarantee (this was local government debt after all) and investors finally got access to higher investment rates than they could get from deposits. By disguising credit advances as investment products, banks were also able to minimise associated capital requirements and escape another regulatory constraint that limited their total lending to 75% of deposits.
The only problem was that much of the credit went to oversupplied industries and real estate. Nor did it do much good. Over this period, it took two dollars of incremental debt financing to drive one dollar of incremental GDP growth. Debt to GDP ratios in China began to rise.
But shadow banking had been introduced into China and, once released, it was difficult to contain. According to Moody’s, shadow banking assets grew by 170% between 2012 and 2016 to RMB 65 trillion. Banks devised increasingly complex ways to extend credit without breaching specific guidelines. In 2014 and 2015, for example, the market discovered peer-to-peer lending. Peer-to-peer lending platforms offered both of the generic advantages of shadow banking: access to credit for anyone that wanted it and higher yields for investors who financed it. By 2015, over 3,500 peer-to-peer lending companies had popped up across China.
Live and Let Die
In 2016, authorities began to take a hold of the problem. Two years prior, they had revised an old Budget Law that had prevented local governments from tapping into bond markets directly. They followed that up with a massive swap programme under which local governments could convert their shadow bank loans into bonds. Separately, they conducted quarterly assessments of banks, paying special attention to their off-balance sheet exposures, and they set targets to unwind complex wealth management products.
The deleveraging hasn’t been painless. Some state-owned enterprises have defaulted. Huarong Asset Management – the saviour of ICBC before its listing – collapsed in a corruption scandal. And now there’s Evergrande, whose downfall was triggered by “three red lines” that authorities drew to contain its leverage.
So far, the blowback to banks has been limited. Three banks had to be rescued in the summer of 2019 (Baoshang Bank, Bank of Jinzhou and Hengfeng Bank) and smaller, rural banks have seen pronounced increases in non-performing loans. But in ICBC’s case, only 1.6% of its loans are deemed non-performing and for the system overall, the ratio is 1.9%.
What happens next seems key. A recent paper by a team of researchers reckons that non-performing loans in the system are being understated and that total non-performing loans are 2-4 times the reported amount, at RMB 4-9 trillion. Underneath that there is increased risk in the real estate sector highlighted by Evergrande. Developer loans and mortgage loans account for over a third of commercial banks’ aggregate loan books, so if the real estate market stumbles, the banks do.
The Chinese state has always had its hand on the banks. First, it simply ran them; then it guided them, sometimes overtly, sometimes covertly. In October 2006, private investors such as myself were invited along for the ride. Initially, our interests aligned when banks were used as a conduit to transfer value from households to state enterprises. Even after that, when the state backstopped credit quality through implicit guarantees, there was an alignment of sorts. Now, the state is signalling that it may not stand behind overstretched borrowers. For private investors that marks a fundamental divergence.
 Huarong Asset Management did a pretty good job managing ICBC’s portfolio of non-performing assets. By the end of 2006, it had disposed of 80% of the initial tranche of bad loans. Indeed, so successful was Huarong that it tried to make a business out of it. It began to acquire distressed assets on a commercial basis and branched out into other areas of financial services. Nine years later, Huarong followed ICBC to the market itself, listing on the Hong Kong exchange. In 2018, the business ran into trouble and its chairman, Lai Xiaomin, was accused of bribery (and bigamy). He was sentenced to death and executed earlier this year.