In an article for the January/February 2007 issue of the Far Eastern Economic Review (“Buying into China’s Volatility”) I used an option framework to explain and predict the behavior of investors in China’s bank IPOs.Chinese banks are, or are close to being, technically insolvent. Share prices of insolvent or nearly insolvent banks consist almost entirely of what option traders call “time value”, with little to no “intrinsic value” (which is the excess of asset value over liabilities).
Not all of my readers will agree that large Chinese banks are basically insolvent, but I am very skeptical that the published figures correctly state the extent of bad loans.They almost certainly understate the extent of expected bad loans associated with the surge in new lending over the past three years.
The option framework predicts that in such a case investor perceptions of the quality of management or of levels of non-performing loans will have little to no impact on the share price performance of Chinese banks.Instead share prices will primarily reflect investor perceptions of changes in China’s underlying economic volatility.China’s banks are expensive, in other words, not because they are in good shape, but rather because there is so much future uncertainty about the Chinese economy, and it is increases in that uncertainty, not improvements in the quality of the banks, that are most likely to drive prices up.
This has happened in many countries undergoing reform besides China.For example when Mexico’s 18 banks were privatized in 1991-92 as part of the massive economic and political reforms the country was undergoing (I was part of the team at credit Suisse First Boston that advised the government on the privatization), their purchase prices far exceeded even the most optimistic estimates provided by the advisors, the government, and the banking industry, which were largely based on discounting expected earnings.
In fact, what investors were buying in Mexico was not the average expected outcome, but the fact that there was so much potential variation about the final outcome (which is another way to define time value).After the privatization, prices continued soaring and I often heard wry comments from senior Mexican bankers about their valuations relative to the Citibanks of the world.Of course those valuations didn’t last, and within the decade Mexican bank prices had collapsed to the point where they were nearly all acquired by foreign banks.This is a fairly typical story during the 1990s.
Basically the thrust of my Far Eastern Economic Review article was to argue that China is like many other developing countries with weak banking sectors who are undergoing major economic reform.Its banks will necessarily have very high valuations – indeed much higher than those of much more profitable banks in the developing world.This is because countries undergoing significant economic reforms are likely to have highly uncertain outcomes.
If it were possible to buy a call option on the underlying economy of a country experiencing massive reform, this option would be very valuable in the same way that any call option on a very volatile asset would be valuable.Most of the value would consist of time value, which is mostly a reflection of uncertainty about the range of outcomes.
It turns out that a bankrupt or near-bankrupt bank is actually very similar to such an option.Because the profitability of the banking sector is highly correlated with underlying growth, buying shares in a bank with very low intrinsic value (i.e. whose asset value is less than or barely exceeds its liabilities) allows investors to “buy” the country’s underlying volatility.In my previous life as a Latin American bond trader, I can say that most of the region’s banks were in very poor shape during most of the 1990s, but nonetheless they had much higher valuations than their rich-country counterparts once it was clear that these countries were going to undergo major reform – and it is worth noting that while some cases of reform were very successful, others were not, which is the definition of a volatile range of outcomes.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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December, 2007
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