Are banks in emerging markets managed prudently or could they pose a risk to your investment portfolio? Given that financials are the second largest emerging markets sector after technology, they remain an important element of financial market stability. Therefore, with changes to shadow banking as well as increasing debt levels, especially in China, we investigated whether the businesses operating within emerging markets are fundamentally sound or potentially at risk.
Framing the Risks in Emerging Markets
Before we dig into the details, it is important to gain a broad perspective of emerging market financials. The largest country exposure is unsurprisingly China, accounting for 29% of the index, with the next 42% spread reasonably evenly between India, Brazil, Taiwan, South Africa and South Korea, whilst the remainder is divided among other nations. Therefore, while emerging market financials are certainly not isolated to the China story, they are heavily influenced by it.
Yet before one thinks of it as a diversified exposure, amazingly, 85% of the book value among emerging markets financials is now attributable to Chinese banks alone. Under this backdrop, it should be little surprise that the book value of the sector has grown very quickly over the past 20 years. In fact, as can be seen below, the book value in nominal terms has grown at almost three times the rate as the developed market equivalents, resulting in a sizeable premium to developed market financials.
A Fundamental View of Chinese Banks
The debt growth among Chinese banks has contributed to this rapid rise in book values, and while the headline numbers are well scrutinised by analysts and commentators, there are some important intricacies within it. Importantly, the unique nature of the Chinese banking sector means that they have increasingly engaged in “off-balance-sheet” lending, which is largely unregulated and can carry higher risk than what appears on the balance sheet.
The significance of this should not be underestimated, with total bank assets in China growing from less than 400% of GDP in 2010 to over 600% of GDP by the end of 2016 if you include the off-balance sheet items. This is undoubtedly a concern, and one that must be considered in both absolute and relative terms.
Understanding the China Debt Growth Story
To understand how this has happened, one should consider the regulatory backdrop, where banks, along with asset managers, have designed asset management products with numerous complex layers involving special purpose vehicles. But before we delve into what this might mean, it is important to contemplate the historical developments that have led to this situation:
Prior to the late 1970s, the Chinese banking system consisted of one bank—the People’s Bank of China. The Bank of China was part of the Finance Ministry, collecting revenues from state-owned enterprises and allocating to budget-approved investments.
In 1978, three specialised banks were spun-off: ABC, rural banking activities; BOC, foreign exchange and international transactions; and CCB, focused on the construction industry. A number of other banking institutes were established in the 1980s, including the ICBC, which is charged with industrial and commercial banking activities.
The moves to commercialise these banks occurred against a backdrop of earlier misdirected lending and poor bank performance.
During the late 1980s and 1990s, Chinese banks lent to many loss-making state-owned enterprises. These state-owned enterprises were reliant on bank credit to finance their activities. They had little incentive or ability to repay these loans, contributing to the boom and bust in the real estate and equity markets in the early 1990s.
By the late 1990s, bank non-performing loans had spiked, with the aggregate ratio of bad debts exceeding 30% among the large state-owned banks. At the time, these banks were severely under-capitalised and had only small loan loss provisions.
In 1998, the Chinese government restructured the four largest state-owned banks, injecting $33 billion into them, financed through bond sales.
Four asset management companies were established, one for each bank. These companies were tasked with purchasing, resolving and selling the banks’ non-performing loans. They purchased $168 billion non-performing loans between 1999/2000 at face value.
These were financed by selling low-yield bonds to the banks. All four banks underwent further capitalisation and disposed of their non-performing loans in the 2000s. They were then listed on the Hong Kong Stock Exchange.
During the 2008 financial crisis, the Chinese banking system was resilient to the direct financial effect of the global financial crisis. This can be attributed to their focus on a strong, growing domestic market and little exposure to offshore funding markets. In response to the downturn in external demand, the government implemented substantial economic stimulus, through rapid bank credit expansion.
A lot of this highlights the fact that Chinese banks have not been immune to poor lending, although have had to learn some hard lessons along the way. Therefore, the Chinese government should be well aware that it needs to reduce the risks building up in the domestic financial system, although given the restrictions surrounding capital adequacy ratios, it seems unlikely that they can bring these loans back to the banks’ balance sheet.
The risks are certainly worth emphasising, as even one of the People’s Bank of China governors pointed to the risk in the system, stating: "China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous.
"The structural unbalance is salient; law-breaking and disorders are rampant; latent risks are accumulating; and the financial system’s vulnerability is obviously increasing. China should prevent both the ‘black swan’ events and the ‘grey rhino’ risks."
A Holistic Assessment
In order to make a holistic assessment of emerging market financials, one must come to terms with this relationship between debt growth, book values and return-on-equity, as assets have grown rapidly while concerns over asset quality have been raised. Moreover, in order to justify the premium it trades at, one must get comfortable with the sustainability of Chinese bank asset growth, especially if regulations tighten and/or non-performing loans rise.
With growing risks, one should expect that the government will look to tighten liquidity, which could help bring stability but may hamper the return-on-equity. While we are yet to see any material shift, one way to think about the implications is to break the banks’ return-on-equity into key contributors. It is important to focus on the long-term sustainability of each, but also think about how we can incorporate off-balance sheet items into this assessment. The four key inputs as we see them are:
- Net interest margins
- Financial deleveraging
- Non-performing loans and credit costs
- Fee income
While net interest margins and financial deleveraging have dragged down return-on-equity over the past five years, non-performing loans and fee income have remained solid contributors. The question is whether this could turn, but also how the Chinese government may respond.
Bringing This Together
As valuation-driven investors, we must consider banks in emerging markets with a margin of safety. We know that since the 2008 financial crisis, Chinese banks have grown their assets significantly by lending to local governments and households. As long-term investors, we are not in the business of predicting when this may change, however we do know that as the government looks to tighten liquidity, banks face the prospect of holding more capital while potentially incurring higher bad-debt provisions.
When considered holistically and over the long term, one should expect a negative impact on profits over time with flow on effects to return-on-equity. Factoring this into our valuation assessment, we would expect that some of these higher costs will be offset by the huge economies of scale and the ability to expand by adopting technology, although see a “fair” return-on-equity closer to 9.5% rather than the 12% achieved over the past 20 years.
Given this backdrop, we find that banks in emerging markets likely deserve to trade at a modest premium to their book value, although much of this is already priced in and we commensurately don’t see much attraction in this sector given the potential downside risk. Furthermore, when combined into a broader conviction, we also find that the attractiveness of emerging markets as a whole is somewhat waning, albeit still reasonably attractive to many developed markets in relative terms.
