Recent developments in China have materially affected the short-term outlook of Standard Chartered (OTCPK:SCBFF). As the Chinese economy continued to falter due to weak services PMI numbers and large capital outflows, the government has intervened with a heavy hand in the financial markets, with state funds stepping in to buy equities and extending the ban on selling large stakes in public companies beyond the previous expiration date. The turmoil has affected sentiment surrounding Standard Chartered, as it has substantial operations in Greater China and Hong Kong.
Last week, Chinese authorities effectively banned StanChart, DBS, Deutsche Bank (NYSE:DB) and other financial institutions from settling clients' offshore yuan transactions for at least three months. On first look, this is terrible news for StanChart, whose new CEO Bill Winters has been focused on expanding the bank's renminbi services as a growth driver. In the first half of 2015, 8.5% of StanChart's operating income comprised of foreign exchange services, and we can expect this revenue stream to be severely impacted this quarter.
Furthermore, the falling confidence in China's overall economic health has pushed valuations lower across the board, and StanChart's shares - especially the Hong Kong-listed offerings - have tanked in response. Overall, we think this spells trouble in the near term, even though the long-term recovery story is still intact.
Tale Of The Two Yuans
For those unfamiliar with yuan trading, there are essentially two exchange rates - the onshore and offshore yuan rates. The People's Bank of China (PBOC) fixes a daily reference rate for the yuan traded within the Mainland's borders, whereas yuan traded offshore - mostly in Hong Kong - is a free float, which means these two rates tend to differ on any day. A spread between the two rates thus results, and the movement of the spread gives us important insights into the market's confidence in China's economy.
For the longest time, the offshore rate traded consistently higher compared to the onshore rate, as the Chinese government wanted to keep rates lower and boost the price competitiveness of exports. This meant there was a lucrative deal for businesses getting paid in yuan: they could get paid onshore at the lower rate, shift the money offshore and trade it in for a higher amount of US dollars than the onshore-equivalent. However, the widely-publicized troubles in China's economy means the onshore rate is now significantly higher than the offshore rate, which reflects the market's falling confidence in the yuan's value.
So how does this affect StanChart? Simply put, the PBOC is trying to devalue the yuan to reach an equilibrium but at their own pace. They are essentially trying to exert greater control over the cross border capital flows and volatility by restricting these transactions, the kind that StanChart processes in large volumes. The intervention here isn't anything new - the government has shown its willingness to use strong measures, such as the ban on selling large stakes in public companies (which was extended last week), to control the financial markets.
Impact On StanChart
We expect to see a modest top-line impact, but a proportionately greater impact on operating profit due to the higher margins of the foreign exchange business. The real concern here is that the PBOC may extend the ban beyond March if China's economy does not recover in the next few months. This would be similar to the ban on the sale of large stakes in public companies that was extended last Thursday.
The issue also brings up another long-term concern: Given StanChart's reliance on Greater China and Hong Kong, what are the long-term risks associated with the government's penchant for intervention in the financial markets?
The first point to note is that StanChart is not alone - other large Asian banks such as DBS and HSBC (NYSE:HSBC) face the same problems. Investors should see this as the 'cost of doing business' in China. Cross border yuan transactions are still a burgeoning market growing at tremendous pace, and we think the growth potential outweighs any short-term disruptions. However, as StanChart is undergoing a painful restructuring, the additional concern arising from this news will obviously weigh on the stock in the short term.
For the next few months, the yuan will only continue to fall as long as the offshore rate stays significantly lower. We all know what happened the last time a government tried to take on the currency markets - just ask the British government about their disastrous decision to defend the pound in 1992. Ultimately, the yuan will settle on a much lower level that reflects the confidence in China's economy going forward. The longer the government resists, the more volatile the markets will be. However, we are optimistic that this should blow over in the first half of 2016, which means the turmoil presents a great opportunity to accumulate a larger stake should the share price continue to fall.
Although these concerns are immaterial in the long term, the market has reacted strongly as the stock plunged late last week. We think the turnaround story is very much intact, but expect a bearish outlook in the near term as China struggles with its growth. Depending on whether volatility eases by March, the trading ban could be extended, which would certainly bode ill for StanChart. As it stands, we have a small stake and would look to add on substantial weakness.
Disclosure: I am/we are long SCBFF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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