The Fallacy of Market Value for Chinese Banks
From Cover, issue no. 350, Jan. 14th 2008
Original article: [Chinese]

As of January 2nd 2008, the world’s top three banks in terms of market value were all Chinese state holding banks—the Industrial and Commercial Bank of China (ICBC), the Construction Bank of China (CBC) and Bank of China (BoC).

Their meteoric rise in value has made Chinese proud, and their achievements are encouraging to other Chinese businesses, but we believe that these heights in the global rankings will be hard to maintain, especially as China faces tall challenges in sustaining its blistering economic growth and developing a market-oriented interest rate.

To some extent, over-valuation is one of the main reasons why the Chinese banks have overtaken Europe and the United States-based banks if measured by market value. ICBC's Market P/E ratio is almost 45, CBC is 23, and BoC is 31. But the average figure for European and American banks is 10. Alternatively, calculated by primary capital, the world’s largest banks are Citibank, HSBC and Bank of America, with China’s state holding banks fallin somewhere between fifth to tenth. But on the basis of market value, HSBC, Bank of America and Citibank rank fourth, fifth, and sixth respectively-- all behind China's three largest banks.

The development of China's state banks has been exciting, and reforms in the industry have been recognized by international investors, as reflected by their listings in Hong Kong. But  we must be aware that these valuations are based on the expectation of China’s rapid economic growth, and not based on them enjoying high profitability or their management talent becoming world class.

It is also undeniable that these domestic banks’ stocks are full of bubbles. They are also listed in the domestic market, but their A-share prices are much higher than their H-share ones, which is closely linked to the bubble which swelled last year. Their A-share price has risen at least 30 percent, and although this is still lower than the A-share market’s overall growth, they are still clearly overvalued.

Some optimists see a steadily growing economy, ballooning financial assets, and increasing demand for integrated financial services together as having driven rapid growth the banking industry, itself often regarded as the weather vane of the Chinese economy. While the three Chinese banks have annual profit growth of over 30 percent, that figure for the above-mentioned international banks stands at less than 10 percent. With this in mind, the current market capitalization as it reflects the value of the Chinese banking industry in the long run may seem reasonable.

But there’s no such thing as an ever-growing market. The Chinese banking industry will eventually be confronted by two forces likely to act strongly against it's vitality.

The first relates to the macro-economy. The Chinese economy has been growing steadily and rapidly over the past several years, a phenomenon which has obviously provided a favorable environment for domestic banks. But in view of the economic cycle theory, growth in the coming years will inevitably slow down. If one day annual GDP growth falls below 8 percent, various symptoms will emerge successively—businesses will face a harsher market, which in turn will lead to the reemergence of massive bad debt, itself a significant bane for the banks.

The second relates to a more market-oriented interest rate. The current high profits of domestic banks are guaranteed by the huge interest spreads facilitated by the government. In the coming years, however, the market will surely play a more significant role in setting interest rates, which will narrow that spread and erode profits even more.

There’s now clear evidence that great challenges are awaiting Chinese banks. Once their performance is reigned in, high market expectation can’t be sustained, and accordingly, share prices will fall. What we should do now is not waste time celebrating their rankings, but instead, realize the remaining gap between Chinese banks and international ones. Priority should be given to reform, innovation, and core competitiveness so that more room for development can be made.