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A compelling—but unprovable—thesis about what is really going on inside Chinese banks

GMO, a global hedge fund that is presumably shorting Chinese stocks, has released a searing analysis of the nation’s credit problems. You can read it in full here.

A short section of the paper outlines a theory about Chinese banks’ lending practices that will turn investors’ hair white.

It says the banks are shunting dud loans they made a few years ago into savings products, which they then sell on to unsuspecting retail investors.

Back in 2009-2010, Chinese banks lent a record 17.5 trillion yuan, under orders to keep the economy motoring despite the global crisis.  Local governments began building huge and questionable projects, such as this planned replica of Manhattan, and racked up a lot of debt. Property developers built ghost towns. It is highly likely loans are now coming due that borrowers cannot repay.

Because China has not seen a wave of bankruptcies, Chinese banks might be ever-greening loans or moving them off balance sheet.

But where?

GMO (which also offers mutual funds and other financial products) may have found the answer.

Its paper notes Chinese banks are cutting their exposure to local governments. Yet corporate bond issuance is booming. As is issuance of so-called “wealth management products,” which are investment vehicles that Chinese banks manage on behalf of retail depositors. (Quartz has noted this already.)

So GMO thinks Chinese banks are encouraging their dud borrowers to refinance their un-repayable loans with bonds. After that, the hedge fund believes, the banks are stuffing those bonds into WMPs. This shifts all their exposure to unviable projects off their books and onto their unsuspecting customers’ balance sheets.

If the theory is correct, it is reminiscent of how US investment banks sold subprime mortgages that were never going to be repaid to hedge funds and pension funds. But what might be happening in China is much worse. The institutional investors who bought subprime mortgages had some —albeit misguided and badly priced—idea of what they were buying.

From the GMO paper:

“After China’s economy turned down in early 2012, there were calls for another economic stimulus. The banks, however,were reluctant to add to their [local government] exposure. So the local governments turned to the bond markets.”

It continues:

“In the past, China’s banks have purchased most new corporate bond issuance. This time, however, an increasing number of bonds have been bundled into wealth management products, which are sold on to the banks’ retail and corporate clients.”

So far so good. But where is the proof? That is where we get onto shakier ground.

GMO says:

“[Chinese newspaper] Caixin quotes a source at a major bank claiming that many bonds, which purported to finance new infrastructure projects, were actually being used to pay off old bank debts.”

So the theory comes from an article from a Chinese newspaper (admittedly the newspaper in question, Caixin, is one of China’s most reliable) which itself is quoting an anonymous source.

The argument does appear to stack up.

There is no visibility on what China’s WMPs contain. But Reuters notes here that while WMP prospectuses are usually scant on detail, Chinese banks have a history of shuffling bad loans into special purpose vehicles such as trust companies.

McKinsey says here that bad loans and the high volume of wealth management products are “areas of immediate concern” for Chinese banks. Apparently in agreement with GMO, McKinsey adds the WMPs “may come back to haunt Chinese banks in the same way structured products plagued Western ones in the early stages of the global financial crisis.”

But we may never know for sure if GMO is right, as we are unlikely to hear Chinese banks’ version of events.

These lenders, which have no real culture of Western-style corporate  disclosure, have generally said nothing so far in response to the stories about China’s credit binge that appear in global media daily.

For while independent ratings agency research has shown China has a huge local government debt problem, the country’s biggest banks are strongly giving the impression this is not affecting them.

In its last interim report (pdf p.56-7) ICBC, China’s biggest lender, said nothing about  local government and real estate loans other than that it was reducing exposure to these sectors. Bank of China, another of the nation’s largest banks, made remarkably similar and brief comments (pdf p.6) in its interim report.

The black box nature of China’s financial system is what attracts short sellers. While American companies they target will happily come out and accuse hedge funds of telling stories for personal gain, this does not happen in China.

China’s largest banks are state-owned enterprises, majority owned by the Communist Party and with Party officials in key management positions.

There is no culture of accountability to majority shareholders. So disclosure is poor and criticism tends to be shrugged off.

As the Wall Street Journal explains here about SOE’s in general:

“Unlike private companies, China’s state-owned enterprises serve two masters: the Communist Party and private shareholders. And the party holds the trump card, because it, not the board, appoints CEOs.”

This accountability deficit at Chinese banks is one reason to avoid owning the shares.

It allows short sellers to drive banks’ valuations down. They can release well-timed research to the media, which encourages fearful retail investors to dump stocks, without the targets defending themselves.

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