China’s coattails are safer than houses

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THE deflation of a property bubble might seem like an unfortunate event for the banks that helped finance the boom, but when was anything in China ever simple?

Shares of the country’s giant state-owned lenders have made a strong start to the year. The rally offers clues on relative risks and the limitations of going solely by the numbers in a market where political factors are often paramount.

China Construction Bank Corp and Agricultural Bank of China Ltd climbed more than 9% in Hong Kong trading so far in January, leading gains by the big four state-owned lenders.

Meanwhile, stocks of private-sector property developers have been crashing amid widening defaults and distress.

Sunac China Holdings Ltd is down 12.7% since the start of the year; MSCI China’s real estate sub-index has lost 30% in 12 months.

For years, overseas investors shunned shares of the country’s biggest state-owned banks on suspicion that their bad loans were far higher than disclosed, the legacy of a post-2008 lending splurge aimed at sustaining economic growth after the global financial crisis.

Many of those loans went into construction and real estate activity. The result has been perennially low valuations for their equity: The big four trade at basement price-earnings ratios of 3.5 to 4.2 times, and their dividend yields have been above 5% for much of the past decade.

Bank of China Ltd currently trades on a dividend yield of 7.9% and Industrial & Commercial Bank of China Ltd (ICBC) offers 6.8%, compared to 1.8% for the MSCI China. Unusually high dividend yields are typically a sign that investors see a risk payout will be reduced or eliminated altogether.

Yet, the large state banks have been remarkably steady payers: None of the big four have missed a dividend in the past decade.

That’s helped to buoy shareholder returns through a period of dismal stock performance. ICBC shares have lost 12% in the past 10 years.

Factor in reinvested dividends, though, and the total return rises to about 55%. All the big four have outperformed Hong Kong’s Hang Seng China Enterprises Index

over the period on that basis, though they trail the 88% total return for the MSCI China (which has had broader representation of fast-growing technology companies).

The stalwart payout performance of state banks, in the face of investor scepticism, offers an interesting contrast with the bond market, where — until last year’s shakeout — overseas fund managers were falling over themselves to lend to private-sector property companies at generous rates.

For much of the past decade, developers were able to sell dollar debt to foreign investors at yields of around 5%.

Those have now ballooned to 20% or more in many cases after companies including China Evergrande Group defaulted, and as declining industry sales and prices put financial pressure on others.

Comparing dividend and bond payments — separate asset classes with fundamentally different characteristics — might seem like financial analysis sacrilege.

But there’s a disconnect here. Equity investors appear to have been overstating the risk to dividend payouts at the state-owned banks, just as bond investors were understating the repayment risk of privately owned developers.

Certainly, the bond market has now gone through a radical reappraisal.

The nature of China’s political economy suggests the banks might have deserved a little more trust.

In a country where economic statistics are notoriously unreliable (as the premier himself has noted), non-performing loan ratios may or may not have been higher than reported.

That, though, is a less salient consideration than the centrality of banks to the functioning of the Chinese system.

Quite simply, state lenders occupy a vital place in the economic food chain — and a much higher one than privately owned developers.

Dividends are discretionary; companies have no obligation to pay them. It isn’t so simple in the Chinese context, though.

In a unitary state run by the Communist Party, executives of state-controlled companies have less of a free hand than they might expect if they were in a democracy.

Government shareholders expect their dividends from state companies; apart from anything, it’s policy.

In 2012, the Shanghai Stock Exchange brought in a regulation that required companies to pay at least 30% of their profits as dividends or explain why not.

Since then, dividend payout ratios of the big four have remained closely bunched near (and always above) that threshold.

All this should provide comfort to outside shareholders, who in effect are hitching a ride on the state’s coattails. It may not be exciting — huge state banks are never going to provide the kind of earnings growth that innovative young private companies can — but it offers a measure of downside protection for income-focused equity investors.

And now that President Xi Jinping is re-emphasising the primacy of the state sector and bringing technology companies to heel, there are probably worse places to be.

Will the future be like the past? All bets are off if the real estate implosion worsens to the point it becomes a systemic threat.

In the meantime, hanging on to the state’s coattails at least looks safer than betting on houses. — Bloomberg


This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.