China’s banks enjoy valuations most Western rivals would kill for. But compared with the earnings they are throwing off, their share prices look miserly. The country’s seven biggest banks trade at an average of 1.2 times their most recently reported book value, according to Reuters Eikon, despite aggregate returns on equity above 20 percent. Five years ago, lesser returns allowed them to command multiples above 4.5 times book. Though the derating is harsh, it’s justified.
There are three reasons to be cautious. First, healthy reported third-quarter numbers don’t show deteriorating credit conditions. China’s lenders in aggregate boast non-performing loans of less than one percent of their loan books. Agricultural Bank of China added its lowest level of quarterly provisions since listing in mid-2010. Bank of China’s non-performing loan ratio hit an all-time low, according to Bernstein Research.
Given that China’s banking sector doubled its loans over the past three years, such low bad debts are unsustainable. For an inkling of what is coming, look at the big banks’ accumulated provisions. AgBank holds reserves equal to three times its total reported bad debts – double the ratio demanded by the regulator. Reform of the banking system could unleash further problems. Many large borrowers benefit from suppressed interest rates. Were banks to price risk properly, good loans might turn bad with alarming speed.
Liquidity is the second concern. Banks have in aggregate lent the equivalent of 68 percent of their deposits, and in AgBank’s case, just 58 percent, against a limit of 75 percent. Yet the interbank market shows signs of strain. Rates have been spiking as banks clamour for more deposits, and interbank rates spike during regular times of scarce liquidity. The difference between banks’ average balances and their balances at the end of each quarter also suggests that balance sheet window-dressing is commonplace.
Finally, there’s capital. China’s banks were until lately among the most highly capitalized, but no longer. AgBank’s core capital ratio of 9.8 percent is little more than the 9.5 percent minimum demanded by the regulator. Bank of China is faring better at 10.4 percent, but further capital raisings next year can’t be ruled out. With so many unknowns, lowly valuations don’t seem such a mystery after all.