Betting Against Chinese Banks Is Harder Than It Looks

by: Emerging Money

Traders convinced that China's banking system is on the edge of collapse can use ETFs to put their money where their mouth is - but the argument that these stocks are poised for disaster has gotten harder to make.

The headlines about Chinese banks drowning in bad loans have tapered off in the last few months as the world's second-largest economy once again looks like one of the better propositions in a slowing world.

Still, loosening currency trading rules demonstrate that Beijing is now taking a much easier stance on bank policy, giving these institutions space to let their problems fester over the long term instead of dealing with them in the here and now.

For some, this looks like a natural opportunity to short these banks into future weakness, making money on the ride. It's a simple trade on paper. Many of the major Chinese banks trade in the U.S. market, so anyone with a margin account can sell the stocks short.

Those with less patience for over-the-counter trades can simplify the process by shorting a larger basket of Chinese stocks via funds like the specialized Global X China Financial (NYSEARCA:CHIX) or even the broad iShares China 25 (NYSEARCA:FXI).

FXI is massively overweight the banking sector, with a staggering 44% of its holdings spread among just seven large lenders. Even CHIX is only marginally more concentrated, with the top six institutions in the fund accounting for 46% of its overall portfolio.

Betting on China's industrial and consumer sectors and against its banks would really just require a pair trade: long FXI, short CHIX.

Unfortunately, the easy money looks like it has already been made. Gigantic lenders have been beaten to the point where on either an enterprise value or P/E basis they look insanely cheap, limiting the extent to which they can move further down.

The biggest and hardest hit, Industrial & Commercial Bank of China (OTCPK:IDCBY), is currently quoted at a P/E under 3 and is trading at 0.60% of its enterprise value. Granted, the value of IDCBY's $1.2 trillion loan book may be wildly inflated, but the $440 billion in cash on its balance sheet should be more than enough to support what is now a paltry $92 billion market cap.

And the time to go short IDCBY was early last year, when its shares were above $17 - before they were cut in half during the summer sell-off.

We can list similar metrics for most of the giant banks in CHIX and FXI, although the P/E compression wasn't nearly as severe and you'd be hard-pressed to find names like China Construction Bank (OTCPK:CICHY) or Bank of China (OTCPK:BACHY) at that steep a discount to book value.

Remember, each of these banks accounts for maybe an 8% to 12% slice of the ETFs we're talking about here. And all are still 20% to 30% below where they were trading this time last year.

If you're convinced that we're closer to the top than the bottom, then short away.

Otherwise, with Pacific Rim giants eager to invest alongside Beijing in this sector, the opposite trade may be the interesting way to go.