Bank failures and emergency rescues in the US and Europe have sent investors in the sector running for cover, but China’s banking stocks and bonds look altogether calmer. While they face a different set of challenges, from an investor’s standpoint there is an interesting diversification play available by looking instead to Chinese lenders.
Shares of China’s biggest banks have long traded far below book value, thanks in part to concerns over bad loans, ‘national service’ expectations from the country’s authorities, and potential dilution through stock sales.
Interesting, then, that China’s banks should appear to be broadly less affected by the storm that’s spreading through pockets of the global banking sector, from Silicon Valley to Switzerland. It may yet prove a storm in a teacup - if efforts by US authorities to contain the troubles among regional US lenders like Silicon Valley Bank (SVB) prove successful, and if a weekend deal brokered by Swiss authorities for UBS to take over its long-troubled rival Credit Suisse can put a floor under the problems there.
That’s a lot of ‘ifs’, but global investors looking to diversify risks across the sector might consider the case for Chinese banks in the current climate. To begin with, China is in a different place in the cycle. The US Federal Reserve’s rapid rate hikes to curtail inflation have contributed to the duration risks facing US banks, but China’s mild inflation has allowed its policymakers to maintain relatively loose monetary conditions. China’s central bank cut its reserve requirement ratio for lenders on March 17 2023, a move we believe was intended to boost liquidity preventatively and to fend off the risk of spillovers from the challenges playing out elsewhere. Not that we think the challenges facing US regional banks are likely to spread to China, where lenders have more diverse deposit books and lower exposure to held-to-maturity securities.
A tale of two banking systems
Part of the challenge for the US banking sector lies in how rising interest rates have exposed structural weakness in the balance sheets of regional banks. Lenders like SVB often have deposits tilted toward large corporate clients in a single sector. These banks tend to take more interest-rate risk, with relatively small loan books and large investments in securities like long-term Treasury bonds. Their capital adequacy ratios have been inflated because the value of such investment is not marked to market under relatively lenient regulation for smaller US banks.
However, banks in China and other major Asian economies are generally funded by a healthier mix of depositors, from households to large and small enterprises across different sectors. Typically, it’s loans rather than bond investments that account for the bulk of their assets. Their Treasury investments are typically marked to market or classified as ‘available for sale’ securities, and regardless of bank tier, gains or losses related to the AFS securities are factored in “other comprehensive income” and in the calculation of capital.
Japanese banks have higher US exposure than Chinese lenders do, but most of them have minimised the risk from US bond holdings through hedging. And they typically have a high proportion of household deposits which provide a cushion at times of corporate client outflows. Similarly, banks in India often have loans representing some 60 per cent of their asset mix and investments accounting for less than 30 per cent.
Zeroing-in on AT1s
Our analysis of additional tier one (AT1) bank securities across Asia-Pacific has found Chinese banks to be the most resilient in terms of valuation. While the AT1 spread widened by about 200 basis points last week in countries like Australia, India, South Korea, and Singapore, China’s AT1 spread expanded by fewer than 100 basis points.
The AT1 securities of many global lenders plunged on March 20, the first trading day after Swiss financial authorities ordered the value of around US$17 billion in AT1 bonds of Credit Suisse written down to zero as part of a restructuring in its takeover by larger rival UBS. Despite the broader turbulence affecting the asset category globally and regionally, the AT1 securities issued by China’s banks largely held firm.
Regional comparisons
When dealing with banking crises, regulators in countries like China, Japan, and South Korea have historically preferred pre-emptive measures such as equity injections. For instance, in South Korea, pre-emptive capital injections are explicitly written into laws. In 2020, China bailed out Bank of Jinzhou with all its AT1 bonds redeemed in full.
Even within the Asia-Pacific region, China’s mostly state-owned banks are differentiated both by their size (four of the 30 global systemically important banks, or G-SIBs, are from China) and their exposures and earnings drivers. That includes a unique risk profile, too. Moody’s has maintained a negative outlook on China’s banking sector since November, citing the risk of rising nonperforming loans. With the country now in an easing cycle, Chinese lenders also face the compression of net-interest margins, which is the opposite of what confronts Western banks. In addition, investors are concerned that Chinese banks may be required by the authorities to perform ‘national service’ by lending to companies in need or best aligned to official economic priorities - regardless of their credit quality.
Still, to borrow a phrase from Silicon Valley, the market tends to regard these as features not bugs of China’s banking sector, and as such these factors are largely priced into the valuations of China’s bank securities. We don’t think the risk-off sentiment in the global banking sector is likely to spread into this space in China, but should that happen, it could prove to be an option for global investors seeking to diversify their portfolios.
