Chinese Banks Post Gains Amid Questions

by: Peter Pham

The Industrial and Commercial Bank of China (ICBC), the world's largest bank in terms of market cap, posted a record 15% net income growth to $10 billion. Meanwhile, the other three major Chinese banks, Agricultural Bank of China (NYSE:ABC), China Construction Bank (CCB) and Bank of China (BOC) have also shown increasing profits in their latest quarterly filing. The four large Chinese banks, often referred to as the big four, have significant representation in iShares FTSE China 25 (NYSEARCA:FXI) and Global X China Financials ETF (NYSEARCA:CHIX).

The change in these banks' fortunes has come after the central bank gave permission to local banks to set their loan rates as much as 30% above the central bank's guidance and offer deposit rates that are up to 10% higher than central bank's. The state's deposit rate is 3% while the major Chinese banks are offering 3.25%.

The banks were therefore able to improve their net interest income and widen their net interest margin despite the two consecutive cuts in the interest rates in the third quarter and a new regulation that has caused significant cuts in fee and commission income and the ongoing speculation about the rising number of bad debts. The market for debt in China was obviously riskier than the PBoC anticipated and the loosening of interest rates allowed greater liquidity into a sector starving from mispriced risk.

The effects were evident in China Construction Bank's earnings release as traditional banking business improved across the board. It reported an 18% year-over-year rise in the Q3's net interest income to $14 million, which helped the bank boost its income while net interest margin improved sequentially by 0.03 percentage points to 2.74%. Fee and commission income remained fairly flat, rising just by 1.6% as opposed to the 40% rise in the year-ago quarter. CCB has also raised its level of provisions for bad debts in the third quarter by 21% to $1.34 billion.

However, this recent change of fortune for Chinese banks is likely to be short lived. The reduction in rates by the central bank will help the banks as it will reduce the carrying costs of poor-quality debt, which is clogging up their balance sheets while the nation develops some kind of a "soft landing," but it also prolongs the agony as it perverts the incentive to write-down the asset and deal with the situation head-on.

FXI, which tracks the 25 largest Chinese companies in the local equity market, is up 11.2% year to date. On the other hand, CHIX, which lays more emphasis on the Chinese financial sector, has been up 27.7% in the same period, easily outperforming the SPDR S&P 500 ETF (NYSEARCA:SPY), iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) and Vanguard MSCI Emerging Markets ETF (NYSEARCA:VWO) that are up 13.6%, 13.4% and 13.4% in the same period. But while CHIX price has risen, investors have been selling into strength as it has seen a net outflow of funds of $1.7 million. The other three Chinese and emerging markets ETFs are witnessing net inflows ranging from $5.5 billion to $1.7 billion from the beginning of second half of 2012 until the end of the first week in December.

The China HSBC Flash PMI, that collects data from 400 export-oriented manufacturing businesses, may have bottomed, rising above 50 in November, indicating that a weak expansion is under way in China's manufacturing sectors. In the third quarter, the country's economy was able to grow by 7.4% YoY.

Although officially, the four Chinese banks report non-performing loan ratios below 1% their Western peers such as Goldman Sachs (NYSE:GS) believe that the Chinese data cannot be trusted and the actual figure might be six times as high. Then again, who is Goldman to talk, frankly? The apparent irony here is that Goldman Sachs itself, as well as other American banks such as Citibank, Bank of America and JPMorgan Chase, had latest earnings reports rife with window dressing via massive loan-loss reserve reductions to boost pro forma earnings, while watching their asset portfolios decline in value, something that should be impossible in any real-world accounting scenario.

Nevertheless, the major Chinese Banks are on track to achieve, or even beat, the target of $1.28 trillion new loans in 2012, rising from $1.20 trillion in 2011. All together, the four banks' profits have risen by an impressive 15%, more than three times the growth shown by U.S. banks, which indicates that, in a best-case scenario, the Chinese economy has bottomed. But the cut in interest rates coupled with the increasing competition among banks for deposits, which comes at a cost of profitability, means that growth will remain challenging.

However, to improve the liquidity of the banking sector, which was falling short of cash that threatened the overnight lending markets, China has recently pumped $356 billion in a two-week reverse repo operation, considered a better option than lowering the reserve ratio requirement. This massive amount is the biggest injection that the country's banking sector has received since the country started the current round of QE in June this year.

Moreover, even if the country's economy is in recovery mode, there will still be a time lag until the economic indicators become apparent, therefore, at least in the short term, the business environment will be difficult. If China is successful in reflating its banking bubble it begs a question. Who is it going to sell to with the U.S. and the E.U. continuing to be mired in what is, at best, stagflation for the foreseeable future? Moreover, if the banking system is as strong as the numbers seem to indicate, why did the PBoC inject nearly $80 billion into it via reverse repos and OMO (Open Market Operations) in early November?

But, the flow of funds into the ETFs cannot be ignored and the fund flows have actually accelerated in the past month, so while the banks are continuing to struggle, the Chinese economy looks like it might be pushing ahead.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.