China's Interest Rate Liberalization, Banking Reform and Implied Risks to Equity Investors

Last Friday’s PBOC Lending Rate Liberalization Had Little Impact on the Cost of Funding

Effective July 20, the People’s Bank of China (PBOC) removed the lending rate floor, previously set at 30% below the benchmark lending rate of 6%. In addition, the PBOC removed controls on bill discount rates and lending rates of rural cooperatives. The lending rate range for mortgages remained unchanged.

The new lending rate restrictions are essentially non-binding. According to the PBOC report, nearly 90% of outstanding loans have been priced at or above the benchmark rates. For the remaining 10-12% of loans, Citigroup C -0.65%‘s China bank analysts estimated that the discount relative to the benchmark would be less than 15%, with virtually no loans close to the 30% discount. For rural credit cooperatives, the lending rate ceiling is currently 230% of the benchmark. Therefore, the liberalization measures should have little impact on the cost of funding.The sentiment is very positive, however, indicating the new leaders’ intention to reform, even in the face of slowing growth.

Deposit Rate Ceiling Is a Binding Constraint

While the lending floor was not a binding constraint, deposit rate ceiling is. If the deposit ceiling is removed — which should be expected if financial market liberalization continues — there will be an immediate contraction of banks’ profitability as banks face higher deposit funding costs. The lowest yield, guaranteed long-dated WMP (WealthManagement Products) can be used as a proxy for the market deposit rate. We estimate the rate on such a product to be between 3.5-4%, 0.5 percentage points above the bank deposit rate.

The fact that the deposit rate is not yet fully liberalized reflects the government’s concerns over the erosion of bank profit margins as banks compete to attract a deposit base. Unlike American banks, most Chinese banks’ assets are loans rather than investments in securities. Chinese banks make most of their profits from the spread between the interest they pay on deposits and the rate they offer to customers. Government protection has kept the spread artificially high by international standards. Until recently, some Chinese banks have been among the most profitable banks in the world. Rate liberalization means the end of this protection and therefore declining profitability.

True Financial Market Reform Could Trigger a Potential Write-down for Equity Investors

Rate liberalization is just one piece of a bigger puzzle. True reform means opening up new and profitable lending opportunities to the service sector, including the healthcare, utilities and telecommunications industries, to private investment by eliminating SOE monopolies.

However, Chinese banks are at risk of becoming zombies due to a huge stock of nonperforming loans (NPLs) outstanding from the fiscal stimulus during 2008-09 and H2 2012, most of which was local government infrastructure spending funded by bank loans and shadow banking credit. Almost all of those projects were approved based on a sense of political necessity rather than commercial viability and financial analysis. Therefore, it is safe to assume that most of them are or will eventually become non-performing. The bank that advocated and lent the most to the stimulus package, likely Bank of China, has conceivably the worst assets among all state owned banks.

The irony is that zombie banks do not always translate into bad stocks (look at “Too Big To Fail” American banks). Banks can ‘extend and pretend’ and ‘delay and pray’ as long as the regulator allows them. The China Banking Regulatory Commission (CBRC) will let the banks evergreen their NPLs until the Politburo Standing Committee decides otherwise and until China’s top leadership is ready for a large-scale recapitalization of the majority of China’s banks.

While we believe that the gradual interest rate liberalization and implied contraction of banks’ profitability going forward are mostly priced in the current valuation of Chinese bank stocks, we think that the market (still) under-estimate the default risks of shadow banking credit, the actual non-performing loans from the stimulus package in 2008-09 and H2 2012, and risks to equity holders if banks are to be recapitalized.  The Chinese government is highly unlikely to allow the depositors of the banks to suffer haircuts if and when the banks become insolvent. Instead, it could write down some non-government-owned equity, as it did during the previous bank recapitalization.