The Communist Party Bank Call

by: Christopher Balding

Chinese banks are stuffed full of bad loans owed by large state owned enterprises and local governments from a historic lending orgy. To keep their balance sheets clean, shadow banking has exploded as wealth management products, think the Chinese version of mortgage backed securities, are sold to institutional and retail investors. To compound these difficulties, the People's Bank of China is tightening credit recognizing the excessive growth in credit over the past few years. H-share financials in Hong Kong are beaten down and trading at valuations at 4 to 6 times earnings.

Now might be the time to consider a Communist Call on Chinese financials.

Unbeknownst to many outside of China the Communist Party is holding the Third Plenum of the 18th Chinese Communist Party Congress. Given the leadership transition that took place earlier this year, the Third Plenum is historically a time when the new leadership introduces a raft of new policy initiatives. This gives the new leaders the first platform to put their stamp on China pushing economic and political reform. Though the dates have not been announced yet, and may not until after it has happened, we can expect big policy pronouncements from Beijing in the near future.

The public leaks on the matter have Beijing setting expectations high for "unprecedented" policy reforms. My own sources with direct knowledge indicate policy reform will be much greater than what is expected. Regardless of the exact policy prescriptions or direction, this is one of the few times during the year when the Chinese central government will lay out a variety of policies for the next year.

The early economic policies promoted by the new leadership in Beijing do not appear to move China away from its historical growth model. Despite ongoing pronouncements of a great rebalancing away from investment towards a higher level of domestic consumption, there remains scant evidence in the data to support Beijing press releases. Fixed asset investment, real estate, and credit growth continue to far outpace growth in consumption and related indicators. After the SHIBOR liquidity crunch in June, Beijing has largely doubled down with additional stimulus and higher prices for land sales fueling local government revenue for cash strapped municipalities. Given what we have seen from Beijing since the power hand over, the probability of policy reforms that would move China significantly away from its historical model seem low.

There is a fundamental conundrum facing Beijing: Chinese economic policy cannot rebalance without enormous risks to growth. Given that real estate now comprises 16% of GDP, any fall in prices or building will have an enormous impact on total GDP. Any slowdown or even decline in investment, which comprises more than 50% of GDP, will significantly impact overall growth. If investment growth were to fall by half, still growing by more than 10% annually, consumption growth would need to more than double to a nearly 30% annual growth rate simply to keep Chinese GDP growth constant.

All this leads to the conclusion that Beijing is most likely to introduce pro-growth policies that largely rely on the historical Chinese growth model blueprint driven by investment and lending. My sources tell me there will be significantly new spending on energy, renewable energy, and infrastructure. Beijing will not make moves to tackle the supply glut in major industries like steel or announce tightening on bank lending because they cannot without major downside risks to growth.

Given the high likelihood that reforms will retain a strong pro-growth bias dependent upon the historical model, there is a high probability that banks will continue to be a large beneficiary of Beijing largesse. These benefits may take the form of additional public purchases of bad loans, maintaining the fixed interest rate of deposits, blessed mergers with share price jumps, or guarantees for favored firms, to name just a few, policy will be pro-growth that benefit banks. Beijing cannot tighten credit or significantly constrain banks, or shadow banking, without running large downside risks to growth.

H-shares of major state owned Chinese banks in Hong Kong are currently trading at a P/E of 6. Even though Chinese banks, like Bank of China (OTCPK:BACHF) (3988.HK) and the China Construction Bank (OTCPK:CICHY) (0939.HK), are up approximately 15% since the June SHIBOR credit crunch, given the expectation of market boosting policy announcements, bank shares remain cheaply priced relative to earnings and under heavy pressure from investor skepticism about earnings quality and concern about loan quality.

As an example, with the Bank of China currently trading at $3.63 HKD for a P/E of 5.83. The November call price of $3.80 HKD has an ask price of $0.03 HKD. Given the high probability of positive, market pleasing announcements of the Communist Party Plenum, playing a Communist option that they won't lead with a flood of bad news and bank constricting measures implies significant positive upside.

Make no mistake that Chinese banks face enormous risks and remain in full denial on the scope of bad loans. However, in the short to medium time frame, with the expected pro-growth strategies with beaten down valuations, Communist stock prices continue to increase. China may be an autocratic quasi-communist state, but they understand the importance of good market public relations and economic growth. Expect pro-bank policies and spending.

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.