My Blog

January 22, 2008

The stock market continues to crash.  After yesterdays’ unhappy 5.14% drop the Shanghai Composite was down 7.21% as of close to day, although late in the day it did bounce off its bottom – it had been down nearly 8.3%.  The Shanghai B-share market (in which I am invested – ugh) did even worse.  It closed down 9.27%.  By the way it has been damned difficult to keep the Shanghai Stock Exchange page open on my PC, and often it crashes for ten or fifteen minutes at a time.  I suppose an awful lot of frantic investors have been logging on and watching in horror, and the site is simply unable to keep up with the volume – or maybe, once again, some disgruntled PC-expert investors have decided to hack away to show their displeasure.  In an editorial in today’s Financial Times, Minxin Pei and Wayne Chen, from the Carnegie Endowment for International Peace, make the case that the performance of the stock market is so inextricably linked in the minds of many Chinese investors with government policy that, for political reasons, a stock market crash may have much greater repercussion than most economists expect.  My student assistant Oliver tells me that on the Peking University internet bulletin boards dedicated to the stock markets there is an awful lot of comment – mostly very angry – about the government’s role.  I am sure Peking University is not the only place where the anger is showing.

Among the hardest hit stocks today and yesterday were the banks, partly because of fears that mortgage-related losses were likely to be much larger than the reserves they took and partly because there are concerns that a US slowdown will have a sharp impact on underlying economic growth in China.  Bank of China was probably the hardest hit, largely for the former reason.  Last year it reported that it had $7.95 billion in subprime exposure, and it set aside $473 million for possible losses.  While a lot of people were impressed by how moderate the losses would be and congratulated the banks on their prudence and good sense, the more cynical among us wondered how long these relatively good numbers would be good for, and kept our fingers crossed that we wouldn’t get significant revisions.  In my August 23 comment on the disclosure of the value of mortgage securities held by Chinese banks I wrote: “I hope this report turns out to be the last.  In China there is a bad habit of hiding bad numbers, subsequently causing them to be revised upwards.”

Maybe we will get those upward revisions.  Yesterday BNP Paribas estimated that the actual loss for Bank of China was RMB 35 billion, or about $4.8 billion.  On the same day Bank of China issued a statement denying awareness of any reasons for sharp declines in its stock price.  Nonetheless its shares were suspended from trading in Shanghai pending the release of a statement on an “important issue”.

Whatever their reasons and whether or not they are justified, the recent sharp fluctuation in bank share prices reinforces, I think, two of the concerns I have often written about in this blog and in various publications.  The first concern is the composition of value in bank share prices and what it really implies about the quality of Chinese banks. 

Chinese banks, much to the surprise of many, are among the most valuable in the world in terms of shareholder market value, even if the their assets or annual earnings are far lower those of other large international banks.  Partly this reflects their bubble-like Shanghai-market valuations, but even abroad they are highly valued.  A lot of very misinformed comment explains the value as somehow reflecting the market’s opinion that Chinese banks have cleaned up their portfolios, improved their management, and are now on a substantially sound footing.  The high market values, they say, reflect the market’s evaluation of Chinese banks as solid, healthy, and rapidly growing (although few go so far as to say prudent).  I was told this just last week during an investor dinner, when one investor hotly disputed my claim that Chinese banks still had serious problems with non-performing loans by pointing to their extremely high valuations.  “Are you saying that the market is wrong, and if so why don’t you short their shares?”

Tempting as it is to say the market is indeed wrong, and often is, I actually think the market is making a realistic assessment of value, but we need to be careful about what exactly what that assessment is.  As I have argued in earlier posts and in a number of publications (for example see October 3: “Should Chinese banks acquire banks abroad?”), markets value shares both as a function of intrinsic value and time value, and whereas the intrinsic value reflects assessment of the quality of a company and its management, the value of its assets, and the expected growth in earnings, time value is valuable almost exclusively as a reflection of underlying economic volatility, of which Chinese banks have a lot. 

Chinese bank shares have extremely high time value and very little intrinsic value.  They are expensive, in other words, not because the market gives high intrinsic value to the banks but rather because a rapidly reforming, rapidly growing economy is extremely volatile, and purchasing shares in low-capitalized banks are typically the best ways to purchase options on this volatility.  In fact nearly every country going through substantial political and economic reforms during the past two decades has seen extremely high valuations placed on their bank stocks, even when, as is usually the case, the banks are bankrupt or near bankrupt. 

Time value is extremely sensitive to change.  As a consequence any shift in perception of asset quality or growth expectations will have a disproportionate impact on the stock prices of banks that have high time value.  This makes them extremely volatile, and the recent subprime-related gyrations shows just how volatile.  I remember when Mexican banks (also nearly bankrupt and also benefiting from an economy undergoing massive political and economic reform) went from having the highest valuations in the world in 1993 to some of the lowest in 1995.  Chinese banks are not going to be noticeably different.

This leads to the second concern, which is about the investment strategy of the CIC.  It seems to me that one of the most valuable roles the CIC can play is as an extension and even reinforcement of a traditional central bank role, and that is to act as a sort of stabilizer to the economy.  Its assets should be made available for supporting domestic economic activity whenever there is a danger that an economic slowdown is causing excess hardship.  From that point of view, the CIC can be seen as a rainy-day fund that can be used to help China when the economy most needs it. 

If that is one of its roles, clearly it needs to invest in ways that protect the value of the fund when conditions turn bad.  Its assets should be as much as possible inversely correlated with the underlying economy.  For this reason I have argued (see, for example, August 27 “CIC may buy state-owned firms” and October 15 “CIC should not invest in Chinese banks”) that the CIC should not invest in financial institutions and especially not in Chinese financial institutions.  The value of their shares is likely to soar just when global and Chinese conditions are at their peak and collapse just when things get ugly.  The sudden concern about bank asset quality and the impact of a global slowdown on Chinese growth has seen bank share prices plunge.  This will happen every time, so are financial institution stocks really the best place into which the CIC should put its money?  Not if they have any hopes of acting to stabilize underlying conditions.

I realize there are lots of other issues the CIC must deal with, many of them political, and these often conflicting issues affect the investment decision, but I am hoping that someone very senior at the CIC is tearing out his hair in worry as he contemplates the plunging value of the portfolio, and swears “Never again”.

Comments (11) for "Chinese bank stocks are vola...

the loss on Subprime or CDO is peanuts, the key question to ask of China banks is : " two year down the cycle, how much of the Rmb15 trillion new loans extended from 2002-2007 will become NPL" For CIC and the hot issue of how China deploy its 11% excessive savings globally, it have to be balanced vs. the inevitable need for NPL write off and bank recapitalization ( YEAH, AGAIN barely five year after last round) Comparing to SWF of gulf nations and Russia, I always wonder China's massive cumulation of Foreign asset is cyclical or structural ?? By isaac - 1/21/2008 5:56 PM

I believe that the high valuation of Chinese banks is driven by markets' confidence on Chinese government. First, those banks are owned by government and fully backed by government. When banks made mistake, their CEOs will be pubnished but the banks themselves will be supported by central government ultimtely. You do not need to worry about a citi style beg for capital. Of course government has its limits. Given the amount of wealth controlled by Chinese government, it has a much deeper pocket than before now. Second, these banks highly depend on Chinese economic development. You cannot always make the correct prediction about an emergent economy. However, since Chinese government generally made right economic decisions in the last 2 decades, it is only naturally to assume that they can make right decisons in the future. By fatbrick - 1/22/2008 12:12 AM

By "You cannot always make the correct prediction about an emerging economy. " I mean you cannot always make the right prejection based on its past performance. By fatbrick - 1/22/2008 12:17 AM

fatbrick: First, those banks are owned by government and fully backed by government. When banks made mistake, their CEOs will be pubnished but the banks themselves will be supported by central government ultimtely. The trouble is that if the everyone believes that then the banks will get into trouble. The Chinese government has been trying to get people to believe that the late-1990's bailout was a one time thing, and it is difficult going. I don't think that the stock market crash is such a bad thing. People need to be reminded from time to time that yes, you can lose money in the stock market, and it's better that it happen now when you have a reasonably benign global environment than in the middle of a big, big crisis. Yes people will be annoyed at the government, but if the bubble is popping then it is popping at a very early stage, and once you have reasonable valuations for companies, we might actually get people to think of stock as something other than lottery tickets. By Twofish - 1/22/2008 4:22 AM

I think Minxin Pei is basically looking for yet another reason why the Chinese government is going to collapse next year, like he has every year since 1989. The stock market is still a relatively small part of the economy so that you aren't going to have Japan-style knock on effects. Also while people do get very angry about stock market losses, it's not the type of thing that will get you a lot of public sympathy. It's not as if overthrowing the government is going to help the stock market. You can argue that the market is crooked and the government is manipulating stock prices, but if that's the case, why were you playing it in the first place. By Twofish - 1/22/2008 4:29 AM

Prof. Pettis, can you please explain how "purchasing shares in low-capitalized banks are typically the best ways to purchase options on this volatility". In what way does investing in Chinese banks function as an option? By jekhe - 1/22/2008 9:45 AM

Jekhe, the argument starts from the observation that equity in a company has many of the same characteristics as a call option on the underlying assets of the company. In fact in corporate finance we now think of equity as a long call and debt as a short put on those assets. Bank growth, especially for very large banks with nationwide branches, is highly correlated with underlying economic growth of an economy, so it acts as a proxy the economy. Since the value of volatility is captured in the time value component of an option, a bank whose shares have little intrinsic value and a great deal of time vaue is a very close substitute for underlying volatility. I explain this is some depth in my Far Eastern Economic Review piece last January. You can find a copy of it here: http://www.iea.usp.br/iea/english/articles/pettischinasvolatility.pdf By Michael Pettis - 1/22/2008 2:19 PM

Fatbrick, I would disagree for two reasons. First, if it were confidence in the guarantor that was the primary cause of market valuations of Chinese banks, stock prices would be much lower. If the US government suddenly guaranteed the obligations of JP MOrgan (and some may argue that they are already effectively guaranteed), its stock price would rise but it would still not trade at the multiples of the Chinese banks. It would trade a little higher than the market value of its assets minus the market value of its liabilities discounted at the risk-free rate. The fact that the banks has so much intrinsic value would limit the upside gains. Secondly, there is an unfortunate tendency among analysts and economists in most countries to see local developments as somehow being sui generis, but in fact the same things occur in many countries for many of the same reasons, and this is as true of China as it is of most countries. Throughout the developing world, there have been many, many cases of bankrupt or near-bankrupt banks -- some owned and some not owned by the government -- trading at extremly high multiples. The common factor has been underlying economic volatility, and it has been in countries undergoing rapid reform that valuations were at their highest. If it happens in Mexico and Brazil, where banks are not government-owned, why would we assume that when it happens in China it must happen because of government ownership? By the way, Minsheng Bank, which is not government owned, also trades at extremely high multiples. By Michael Pettis - 1/22/2008 6:03 PM

If the non-government backed banks in Mexico and Brazil could rally high before their bankruptcy. You would expect that the banks in China passed them since they are virtually shielded from that risk. As for Minsheng Bank, given its political background you could almost treat it as a non-bankruptable bank. The vulnerable ones are those regional and small banks, which are not large enough to get protection. Since there are only about 6-8 players in China banking industry enjoying the guarantee, this is an essential oligopoly market which banks have huge control over regulators. Thus, I see the high valuation of those banks is sustainable, as far as the government can keep the stability. By fatbrick - 1/23/2008 2:16 AM

Twofish, In 1990s, the bad loan problem of banking is largely irrelevant to the real economy. It is more close to be the junks left by the collapse of the planning economic system. Right now, if the economy goes south, I expect the bad loan problems will soar again. However, if every exporters are closed and every big state owned firms see their profits falling, it is unfair to balme banks for that. By fatbrick - 1/23/2008 2:24 AM

fatbrick: In 1990s, the bad loan problem of banking is largely irrelevant to the real economy. It is more close to be the junks left by the collapse of the planning economic system. Correct, and that is why it wasn't such a bad thing that the government bailed out the banks for this one time only situation since the government was just repaying the bad loans it forced the banks to make. fatbrick: Right now, if the economy goes south, I expect the bad loan problems will soar again. However, if every exporters are closed and every big state owned firms see their profits falling, it is unfair to balme banks for that. Yes it is. The fact that the economy would eventually go south, that exports would dry up, and that big state owned firms would see their profits falling is something that people could have reasonably foreseen, and the banks should have adjusted their lending practices to make sure that they would withstand a economic downturn. If a bank does go under, then the government needs to change the management and make sure that depositors (especially small ones) get protected. The shareholders of the stock should get nothing. By Twofish - 1/23/2008 7:17 AM