The growth potential for China’s financial sector is undisputed, driven by strong growth and an under-penetrated, large population rapidly accumulating wealth (see here). In anticipation of this, investor valuation of Chinese banks put them into the top group of global banks by market capitalization. Critical to the development of its economy, China’s domestic financial sector has been nurtured cautiously, shielded from foreign competition and remains under significant regulatory oversight. For example, in banking, lending growth is targeted, lending rates must exceed a floor, deposit rates cannot exceed a ceiling, and all deposits and foreign currency must be transmitted via the banking system. However, this has not prevented a circumvention of letter and spirit of the rules.
A recent example of this has been actual lending growth exceeding target growth. To constrain lending growth, the cash reserve ratio set by the PBoC, China’s central bank, reached 20% last month. Yet, this has not been as effective and is attributable to banks selling loans to 3rd parties, namely trust companies. Bank deposits currently earn negative real returns. Trust companies, unable to accept deposits, have been purchasing loans and packaging them into higher-yielding wealth management products for sale through the banks.
This has had several implications for the financial sector overall. At the banks, lending growth measured by bank on-balance sheet loans has effectively slowed; deposit growth has decelerated, but is not yet of concern as the loan-to-deposit ratio for the major banks is well below 70%, and fee income has increased strongly from the sale of wealth management products. The life insurance sector, whose development has been key alongside that of banks, has also been affected. Insurance products offer the Chinese saver a higher return than traditional bank deposits while developing retirement savings for a rapidly aging population. Sales of insurance products through the banking channel have been negatively impacted for two reasons – regulatory changes which initially removed insurance sales personnel from bank branches but since reversed, and crowding out by the substantially higher-yielding trust company products.
Trust companies are currently more lightly regulated than either banks or insurers, conferring a valuable advantage. While the sale of loans eases the risk on bank balance sheets, it is unclear whether any future losses on packaged loans will revert back to them or be limited to trust companies alone. Loss protection on the products is said to be in place, but may be offered by even more lightly regulated entities with unconfirmed ability to pay. All of this is a notable departure from the Chinese approach to regulatory oversight of the sector.
Following the explosion in lending over the last two years, the risk of adverse loan loss development remains a concern, particularly for a material change in economic trends. Packaged loans have not altered risk in the banking system, but simply moved it around. The demand by Chinese savers for higher-yielding products, particularly given their limited choices and negative real returns, is understandable. However, the risk of adverse loan loss development is now high for both packaged loan investors and the financial system, and demands more careful analysis and oversight by the regulator. Recent stock performance weakness in the Chinese insurers (China Taiping Insurance 966 HK, China Pacific Insurance 2601 HK) should reverse as companies continue to build out their agent networks. Recent strength in the banking sector (ICBC 1398 HK, China Construction Bank 939 HK) is overstated.
Disclosure: Long China Taiping Insurance (966 HK). I have no positions in any other stocks mentioned, and no plans to initiate any positions within the next 72 hours.
