Chinese banks: the metrics don't matter

It’s that time again: first half financials by China’s big four banks.

From the FT:

Chinese banks have again produced sparkling results, though they were unable to dispel concerns that their good fortune might yet turn to trouble because of non-performing loans and a slowing economy… The story for much of the past year has been the divergence between Chinese banks’ record results and the unshakeable doubts in the market that the bill for their past lending excesses has yet to come due.

“We continue to see decent results but the numbers will not convince the bears that there isn’t a NPL problem. It’s just that we’re not there yet,” said an analyst who wished not to be named.

What is with these people? I’ve talked with plenty of financial analysts bemoaning how investors are unnecessarily bearish on Chinese bank debt worries. They say: have you seen the loan-to-deposit ratio/capital buffers/loan-loss coverage ratio? To which I respond: what does that have to do with anything?

I won’t even begin to poke holes in these metrics (Tsinghua University professor and CER contributor Patrick Chovanec does that very nicely). My point is more macro: These aren’t real banks, so investors shouldn’t price their equity like real banks.

Yes, investors should still price their equity at the discounted present value of anticipated future dividends. But whereas the value of future dividends in Western banks depends on their ability to efficiently allocate resources to maximize future profitability, the value of future dividends in Chinese banks depends to an overwhelming degree on government policy.

Chinese government policy is, in turn, dictated by a plethora of factors, the most important being to keep the economy humming along. With the country’s inflation at 6.5%, lots and lots of murky debt outstanding, the odds of the U.S. falling back into recession at 40%, another round of QE possibly in the works, and the eurozone mired in turmoil - is it really so crazy to substantially discount the future profitability of Chinese banks this year?

These week’s earnings announcements still haven’t shifted market sentiment, because investors didn’t buy into a Chinese company. They bought into Chinese policy.

About the Exchange Rate

To understand the current exchange rate dynamics, it is easier to consider a useful analogy. This blog has developed an uncanny reputation for creating wacky analogies over time, but I think they've been useful with regards to getting the message across.

Having a weak currency has one major adverse implication for Kenya, with a high urban population, imports become expensive and thus inflation pressures mount. From a national security perspective, this is extremely dangerous. Note that the prices of crude oil have eased off their April high's of $116 per barrel, but your fuel costs haven't adjusted. This is simply down to a weak currency.

Exchange rates are driven by three major factors which are listed below;

1. Trade Balances - When Kenya imports oil for instance, it has to buy dollars as oil prices are quoted as $/barrel. Alternately, when a foreigner buys Kenyan tea, he has to buy Shillings as the price of tea is quoted in shillings. Therefore, by simple deduction, imports result in shilling outflows and exports result in foreign currency inflows. If exports exceed imports, the country has a positive trade balance and thus there is more demand for its currency resulting in a stronger currency. The alternate is true when imports exceed exports. In Kenya's case, imports exceed imports by a whopping Kshs 537 billion (USD 6 billion) or almost a fifth of GDP. In fact, the trade deficit has hovered at around 15% of GDP for the last twenty years. You can now automatically tell that our currency from a trade perspective faces enormous pressures.

2. Capital Flows/Interest Rates - In response to the currency crises that emerged not only in Kenya, but generally in East Africa, heads of EA Central Bank's led by Prof. Ndung'u raised interest rates. The CBK did it by raising the CBR rate (now called the discount rate) from 6.5% to 8.00%. The thinking behind this is that, if you raise rates in Kenya, foreign capital will flow into the country seeking higher yields. Given that the interest bearing instruments are denominated in shillings, the foreigners will have to purchase shillings thus strengthening the currency. Therefore capital flows, through the interest rate mechanism do have a bearing on currency movements.

3. Psychological Factors - This feeds back into our analogy, and to a great extent explains our current currency issue. Sentiment does affect the markets and often overlooks the two main fundamentals listed above. If economic agents and owners of capital become wary of the shilling, their actions could lead to a weakening of the shilling. Just like the girl, sentiment could lead to a realisation that the fundamentals are flawed and that this "relationship" is not worth it. In a recent blog post, I identified some flawed fundamentals and suggested that the shilling is bound to get weaker. Indeed it did. All the economic actors took short positions against the shilling and their actions exacerbated the already dire situation.

Prof Ndung'u once wrote that;

"The policy instruments that matter most for export success lie outside the realm of monetary policy. These include the reliable provision of productivity-enhancing public inputs and the protection of private economic returns from investments"

These remarks can easily be translated to "Kenya will only achieve success, if it focuses on its fundamentals". The CBK's actions were a stop-gap solution, but the country will have to improve its productivity and international standing to reduce the chances of future speculative imbalances that weaken the currency. 

Thoughts on Capital Gains Tax

Just a thought! In the recently read budget (2011/12), an interesting point came out. Hon. Uhuru Kenyatta mentioned that property dealers were from now on to be paying capital gains tax. The proviso was that if it is stated in the company's articles of association and memoranda that the company actively seeks to buy and sell land and other property for profit, then this profit which is a capital gain would be taxed as regular business income. 

To my lay readers, capital gains is simply an increase in the value of an asset. For example, if you buy a house for Kshs. 1 million and sell it at Kshs 2 million, then you have made a capital gain of KShs. 1 million. In other countries, this gain is usually taxed at a given rate say 30%, so you'd have to give the taxman Kshs 300,000.

Now at first sight, it seemed like a sensible thing to do. If you tax capital gains to real estate companies, it could both reduce real estate speculation, as well as increase government revenue. My issue is, where does it stop? The treasury has just released a can of worms. 

Arguably, capital gains are made by people who are in the business of making capital gains. It doesn't just fall upon some lucky guy walking down the street. Making capital gains is something that businessmen plan for and take advantage of. Therefore, as much as it may make sense to tax real estate companies on their capital gains, the buck, if the treasury is being fair, shouldn't stop there. Asset managers, insurance companies, private equity firms should all be taxed on their capital gains. If the treasury's reasoning on taxing real estate capital gains is to be implemented fairly, then it can be argued that the aforementioned parties are all in the business of making capital gains and as such, their capital gains should be taxed as regular business income. Food for thought for those at the treasury.