Banks are back in favor with investors
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Maverick Chen stared at his computer screen showing charts of stocks, assessed them against his portfolio and smiled.
"The banking shares have rallied after underperforming the market," the 33-year-old retail investor said.
Chen bought shares of three banks - the Industrial and Commercial Bank of China, the Bank of Communications and Shanghai Pudong Development Bank.
He said he made the most paper gains, totaling several thousand yuan, from the shares he bought in Pudong Development at the end of 2010. The shares have so far risen 17 percent this year, against a 7 percent gain for the benchmark Shanghai Composite Index.
Indeed, banking shares are back in favor after four of China's five biggest banks exceeded analysts' forecast with their 2010 annual results released at the end of March. Only China Construction Bank fell slightly below expectations.
Chinese bank profits have been rising since the global financial crisis as strong domestic growth and relatively easy monetary policy allowed banks to go on a lending spree. The banks extended an unprecedented 18 trillion yuan (US$2.7 trillion) of new loans in 2009 and 2010.
Last year alone, aggregate net income in the banking industry surged 35 percent to a record 899.1 billion yuan, according to the China Banking Regulatory Commission. Interest income accounted for two-thirds of profit.
The People's Bank of China raised interest rates on April 6 for the fourth time since October, and that provides impetus for the glowing forecasts for banking profits and shares.
"In most cases, banks can boost their earnings in interest rate increase cycles," said Zhang Qi, a Haitong Securities Co analyst. "Banking shares have strong support in the long run."
But like every silver lining, there are clouds.
The credit boom and accompanying bubble in the property market have caused concern about a rise in non-performing loans. China faces a 60 percent risk of a banking crisis by mid-2013 if the property bubble bursts, according to Fitch Ratings.
Moody's Investors Service said it's monitoring loans to real estate-related corporate borrowers and to local government financial vehicles that have been heavily involved in property speculation.
"We're especially concerned about loans that originated in 2009 and early 2010, when monetary policy was most accommodative, and banks' lending standards were apparently relatively loose amid a temporary lifting of loan quotas," Moody's analyst Yvonne Zhang said.
"Property prices have risen to a level that is not supported by fundamentals, and a sharp decline in the market would add to the banks' asset-quality pressures," she said.
China adopted an "accommodative" monetary policy in the wake of the global financial crisis to try to shield its economy from the downturn that swept through Western nations.
Unlike the United States or Britain, where interest rates were slashed in tandem with government stimulus programs, interest rates in China were untouched for most of 2009 and 2010.
The credit boom shored up China's economy, which grew at 10.3 percent in 2010, but also created headaches for policy makers by accelerating inflation and asset price bubbles. China then eased from being too "accommodative" and began raising rates in October for the first time since December 2007.
The banks may benefit from higher rates because of the wide spread with deposit rates. The bigger the bank, the bigger the benefit.
On April 6, when China's fourth rate increase took effect, the Shanghai Composite Index rose to a monthly high on the back of banking shares, which account for about a fifth of the market value.
Since March 25, when banks started to post rosy annual reports, the Industrial Bank has risen 9 percent, heavyweight ICBC and BOC added 2 percent, Citic Bank gained 5 percent, and BoCom up 6 percent. The Shanghai Composite Index rose 2 percent in the same period.
"Banks will benefit further from widening margins this year," said Qiu Zhicheng, a Guosen Securities Co analyst.
"Banking shares were already boosted by their strong earnings."
Zhang Lei, a China Jianyin Investment Securities Co analyst, expects the Big Five to show average profit growth of 27 percent for the first quarter, with joint-stock banks, the second string in China's banking industry, forecast to post average 41 percent gain.
Of course, risks remain, and Chinese regulators aren't blind to the possible threat the credit boom poses to loan quality.
The China Banking Regulatory Commission has sent armies of inspectors into banks to review loans to local government financing vehicles which are used to invest in property.
In China, local governments are barred by law from directly selling bonds or borrowing from lenders, so they set up indirect vehicles to allow them to do so. The dealings of some of the vehicles, especially in property speculation, have raised eyebrows.
Banks are also following regulatory calls to trim risks in that segment. Shanghai-based BoCom has already halted new loans to quasi-government vehicles, while ICBC said it will also trim such lending.
Banks are required to perform quarterly stress tests on their liquidity positions and increase their loss reserves to at least 150 percent of non-performing loans.
Besides, regulators have issued guidelines to ensure that bank loan proceeds are used for intended purposes.
Tighter capital requirements are also in place. The minimum capital requirement has increased to 11.5 percent for the Big Five and to 10 percent for smaller banks.
The Big Five raised a combined US$56 billion last year from sales of shares and convertible bonds to boost their liquidity. Purchases of other banks' subordinated debt have to be deducted from the purchasing bank's total capital.
The CBRC also has ordered banks to transfer some off-balance sheet assets back onto their books to tighten risk management.
Banks' off-balance sheet assets, which are deemed risk-weighted, stood at 5.32 trillion yuan at the end of December, accounting for 5.6 percent of total assets.
For the moment, problems seem to be under control. The industry-wide non-performing loans shrank by 170 billion yuan to 1.24 trillion yuan at the end of 2010 from the year's beginning. The bad-loan ratio dropped 0.89 percentage point to 2.4 percent.
"The credit boom did trigger concerns about bad loans," said Qu Hongbin, HSBC China chief economist. "But risks do seem to be under control."
Qu said loans advanced to local government's financing arms are mainly made for infrastructure projects, and any risk should be covered by the government itself.
Moody's Investors Service on March 28 maintained its "stable" outlook for the industry over the next 12 to 18 months.
"While we expect rising non-performing loans - which typically follow very strong loan growth, robust earnings, significant loan-loss reserves and additional funds raised from capital markets will help the banks to tackle asset-quality challenges, Moody's Zhang wrote in the report.
"Bank shares are set to rise in the long run," Haitong's Zhang Qi said. "Fund managers are underweight in the industry."
The banking industry accounted for about 40 percent of profit for all listed companies in Shanghai last year, but only accounted for 10 percent of fund managers' holdings, Zhang said.
Retail stock investors like Chen may feel more secure investing in bank shares.
"They are not dark horses whose shares can skyrocket," Chen said. "But they're a good choice for long-term investors like me."
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