Chinese Banking Woes

The Agricultural Bank of China, AgBank, began trading on the Shanghai stock exchange yesterday, and the results were mixed. The A-shares opened at 2.74 yuan/share before closing at 2.7 yuan/share (about $0.40). At the IPO, shares priced at the top of the proposed range, 2.68 yuan/share. AgBank will start trading its H-shares on the Hong Kong exchange tomorrow, and the bank is hoping for a better result.

There is some question about whether the underwriters will exercise the over-allotment option. If they do not, AgBank’s IPO is not likely to reach the $22 billion figure that would have made it the largest ever IPO. Still, at around $19 billion it would be the third-largest.

The Chinese government is trying to cool property lending and halt its economic stimulus spending, and both factors have weighed on the Shanghai index, which is off about 24% so far this year. Some 40% of AgBank’s A-shares were taken by cornerstone investors, most of which where state-owned firms that have agreed to hold the shares for up to 18 months.

Investors’  biggest concerns, though, revolve around the uncertainty in the country’s  banking sector. As the government tightens real estate lending, analysts expect the percentage of non-performing loans to skyrocket.

Many banks, including the country’s regional banks, have been moving loans off their balance sheets to avoid new lending limits imposed by the government. Taking a page from the book written by US banks before the financial crisis, banks are effectively securitizing the loans and selling them through trust companies.

The numbers are very large. In 2009, China’s banks packaged and sold about $261 billion worth of loans. In the first half of 2010, banks have packaged and sold more than $380 billion in loans. Banks have also kept more than $675 billion in first-half loans on their books. The central government had set a limit on new loans for 2010 at about $1.1 trillion, a figure that is less than $50 billion above lending for the first half.

The central government is determined to stop the banks from selling the packaged loans to trust companies, and is expected to set limits to stop the practice. So far the bank regulators have issued only verbal demands to trust companies to stop doing business with the banks, but additional regulations are on the horizon.

As the Chinese tighten lending rules, interest rates and borrowing costs will rise. The restricted access to capital will cool the Chinese economy, especially its still-hot real estate market, and reduce the country’s GDP growth. China’s second quarter GDP growth was 10.3%, down substantially from the first quarter’s 11.9% growth. That drop exceeded expectations of 10.5% growth.

China’s GDP growth target in 2010 is around 9%, so even more cold water needs to be applied by the government if the country is to meet that goal. The path the government has chosen to do that is to restrict the lending practices of its banks.

That’s what chilled the enthusiasm for AgBank shares, and that’s what will continue to restrain investment in the country’s equities.

Paul Ausick