Ben Chu: Could China’s credit hangover prove to be a headache for HSBC?

Outlook

When a financial hurricane smashed into the Western world in late 2008, China somehow seemed to emerge unscathed. The Middle Kingdom has its banks to thank for that.

Acting under direction from the Beijing leadership, these lenders turned their credit taps on full blast to offset the shock of tanking global demand. Domestic investment and infrastructure spending surged, filling the hole left by collapsing exports and ensuring that GDP carried on growing at 8 per cent a year.

The by-product of this rescue was, by some measures, the biggest expansion of lending in a single nation that the world has ever seen. Between January 2009 and January 2012 China’s banks issued 25 trn yuan (£2.39 trn) in new loans, equal to around 50 per cent of the country’s 2011 GDP.

But something suspicious has also happened in the sector. Despite the tidal wave of new credit, the ratio of non-performing loans reported by the banks fell sharply. The ratio dropped from 6.2 per cent of total loans in 2007 to just 1 per cent in 2011. And that’s where it has stuck pretty much ever since.

It’s impossible to find an independent analyst who believes these bad loan figures. Financial history teaches that an economy can’t digest such a massive increase in credit over such a short period efficiently. A significant portion of that credit must, logically, have been wasted and the underlying loans must now be toxic. Plenty of ghost cities and empty roads in China seem to back this intuition up.

Analysts also point to an explosion of the shadow financial system in recent years, which has pushed the total level of private debt in the economy to above 200 per cent of GDP. They fear that the risks from the rapid growth in sales of opaque “trust products” could also end up blowing holes in the balance sheets of Chinese banks in the coming years.

Chinese banks are still reporting strong profits and reasonable capital ratios. But scepticism over the health of these institutions is reflected in the fact that their shares are trading below their nominal book value.

Tellingly, not even the banks’ managements are behaving as if they believe their official rosy figures. Research by the investment bank Grisons Peak shows Chinese banks (after prodding from the regulator) collectively raised $22bn (£13bn) in new equity last year to reinforce their balance sheets. And the boards of China’s bank have approved plans to raise an additional $57bn in total by the end of 2016. If the true bad loan ratio across China’s banks turns out to be as big as some analysts fear, that already chunky recapitalisation sum could grow significantly. Another analyst, ChinaScope Financial, has put the total equity hole as high as $100bn.

When a host of state-owned Chinese banks raised equity in the 2000s by partially floating in Hong Kong, they attracted a good deal of foreign interest. In 2005 Bank of America bought a $3bn stake in China Construction Bank. The Royal Bank of Scotland took a $1.6bn chunk of the Bank of China. In 2006 Goldman Sachs bought into the Industrial and Commercial Bank of China for $2.6bn.

Most of these foreign banks have sold out in recent years, booking good profits in the process. According to Grisons Peak the average compound return on these investments was north of 20 per cent.

Yet some Western banks have hung on. HSBC, for instance, still has the 19 per cent stake in China’s Bank of Communications (Bocom) it acquired in 2004. Bocom is eyeing a $6.6bn cash call by the end of 2016. Last month that figure was approved by its board. This could end up being costly to the UK-listed bank. One market rumour has it that HSBC could ultimately need to inject up to $2bn into its Chinese partner – although the bank declined to comment on that suggestion.

HSBC is carrying its Bocom stake on its balance sheet above the traded value of the equity. In 2012 it performed a stress test on this stake and concluded the valuation was sound. But things have moved on since then. The Chinese banking sector is looking shakier as GDP growth has moderated. Last year’s liberalisation of lending rates by the authorities is expected to damage banks’ profit margins. It’s possible we will get an update on the Bocom situation when HSBC releases its 2013 results next Monday.

HSBC has always maintained that its stake in Bocom is long-term and strategic, describing the partnership as a bridgehead into the lucrative China banking market.It brought into a previous Bocom cash call in 2012 to maintain the relative size of its stake. But timing is everything, even for strategic acquisitions. If China’s great credit binge does end as messily as many analysts think, HSBC could live to regret not following its peers and selling out when it had the chance to book a large profit.