Thoughts on China's Insolvent State Banks

Seeking Alpha ^ | 5/11/2010 | William Gamble

[SeekAndFind]

How do you define a bad investment? Perhaps the best definition has to do with the relationship between risk and reward. We are seeing -- in a very dynamic way -- this tug of war being carried out in Greece. Government bonds are by definition guaranteed by a sovereign entity, so should be risk free. At least that is the basic idea as far as US Treasuries are concerned. Of course no sovereign entity can go bankrupt and court orders are generally ineffective methods of enforcement, so the use of law to limit risk does not generally apply to these types of investments.

One of the reasons why investors lost money on the Greek bonds has to do with the promoter of the issue. Greek bonds were obviously sold by the Greek government whose incentives are not just those of profit and loss. The Greek government does not have to worry about balancing its books, because in theory it has the power to tax people in sufficient amounts to pay off debtors. But that is exactly the problem. The Greek government is loath to enforce taxes against its tax dodging citizens to benefit creditors, for the very solid reason that if it does so, soon there will be a different Greek government. Since Greece is a sovereign state, unlike a normal debtor it cannot go out of business nor can it restructure in bankruptcy. Worse-- as a member of the European Union and the eurozone, there is the moral hazard that its financial profligacy will not fall on its own taxpayers, but the taxpayers of other countries.

The Agricultural Bank of China [ABC] is one of China’s big four banks. Along with the Industrial & Commercial Bank of China [ICBC], China Construction Bank [CCB] and the Bank of China [BoC], these four banks control over 70% of China’s banking activity. Like almost every bank in China, the big four are mostly state owned. ICBC, CCB and BoC all went through successful IPOs in 2005 and 2006. At the time these IPOs were viewed as the investments of the future and, in fact, they initially achieved their promise. ICBC’s stock did increase by 160% in the first year following its IPO, rising from $3.36 up to $ $8.35 near the Shanghai Exchange’s top in October 2007. Since then it declined over 60% and has recovered to $4.61. Unlike it sister banks, ABC did not have an IPO and remains 100% state owned.

In contrast to other stock markets the Chinese stock market has not lived up to expectations for its recovery. The stodgy US market has increased 81% since March of 2009. The sexier emerging Indian stock market has increased 110% and is 14% away from its all time high. While it is true that the Chinese market has recovered 70% since its October 2008 low, it is off 11% since its post crash high in November 2009. In contrast, the US and Indian stock markets have increased 13% since November. The Chinese stock market is still off 50% from its all time high while the US market is down only 22%.

Still the ABC looks like a sure bet. It is huge. It has 24,000 branches focused in rural areas and it has 350 million customers, more than the entire population of the United States. Even after the IPO, the bank will be owned mostly by the state. In theory, its legendary poor finances have been cleaned up by a $19 billion bailout and as an instrument of the state, it cannot go bankrupt. But like Greek bonds, that is exactly the problem.

ABC, like its sister Chinese state banks, does not have to make a profit. It does have to follow the directives of the state. Over the past year this has meant making huge loans. The size of the loans ($1.4 trillion and counting) was not the only problem. The loans went to the pecking order of state owned enterprises and local governments according to rank and political connections often with local branch managers. Much of this money will never be repaid. The new toxic assets will be added to old ones left over from the last recession.

In short, the banks of China are all insolvent including ABC. There will not be any banking crisis or massive bailout in China, but there will be consequence. By keeping the spread high and deposit interest rates high, the Chinese have kept their financial system afloat at the expense of households. By passing the cost of this debacle onto their citizens with an indirect tax, the Chinese will suppress domestic demand, which will prevent the rebalancing so needed in the global system.

But the ABC IPO will go forward. As an example of a horrid investment it is hard to beat, but as a dream no doubt it has value.

-- William Gamble has been active in the international business as a consultant, lawyer, investor, and corporate counsel for the past thirty years. He holds two law degrees, an executive MBA and has attended several universities in the United States and France. He has been a member of several state and federal bars. He has spoken five languages, visited over 40 countries and climbed Mt. Kilimanjaro. He has developed an original methodology derived from law and economics and game theory to determine the economic efficiency of a legal infrastructure. His premise is that economics is not just about capital and technological constraints. It is also about political-legal institutions, such as the protection of property rights and the enforcement of contracts that are critical determinants of sustainable economic growth and investment opportunities. His methods allowed him to successfully predict the crash of the Chinese, Russian, Brazilian stock markets along with the price of oil. He has appeared on many television networks including, ABC, CNN Asia, CNN FN, Bloomberg, Fox, CNBC and NDTV Profit in New Delhi. In addition to television, he has appeared on NPR, Bloomberg, and over 60 radio stations throughout the US. He has also appeared in Canada on the CBC and in China on Voice of America. His most recent book Freedom: America’s Competitive Advantage in the Global Market was published in 2007.

[C19fan]

I have been reading about insolvent Chinese banks for the past 20 years.