How China's Bank Behemoths Make Money on the Debt War

  • Big banks may be ‘secretly happy’ with deleveraging: Bocom
  • Citi likes larger bank stocks, which benefit as net lenders

China's Banks in a Leverage War

As China ramps up its quest to conquer leverage, the banking sector is finding out that being a big fish pays -- literally.

While smaller lenders grapple with soaring money-market rates -- some are said to have defaulted amid the tight liquidity -- their larger counterparts are poised for a windfall. Bigger banks are benefiting from higher borrowing costs given their status as net lenders in the interbank market, a situation that has Citigroup Inc. to Morgan Stanley favoring their shares. Large bank stocks have already returned double that of their smaller brethren so far this year.

“Investors can long big banks, while shorting the small ones,” said Hao Hong, chief strategist in Hong Kong at Bocom International Holdings Co., a brokerage owned by Shanghai-based Bank of Communications Co., a medium-sized bank. “Large lenders might be secretly happy at what’s going on, while the smaller ones are hoping the central bank will always save them during cash squeezes.”

Chinese policy makers have been tightening conditions in the money markets since August, as a way of clamping down on the record leverage built up after the global financial crisis while avoiding negative ramifications to growth from boosting benchmark borrowing costs. The key money-market rate spiked to its highest level since 2015 last week, spurring the People’s Bank of China to inject hundreds of billions of yuan into the financial system as small banks were said to have failed to make debt payments in the interbank market.

Read more: China’s Leverage Love Affair Is Tricky to Break, PBOC Finds

Smaller Chinese banks are more reliant on short-term borrowing, a market dominated by big lenders like Bank of China Ltd. and Agricultural Bank of China Ltd., the country’s No. 3 and No. 4 listed banks by market capitalization.

Rising rates mean the larger lenders can charge smaller institutions more to borrow, leaving them with more cash to buy debt and thereby take advantage of climbing yields, according to Citigroup. Corporate bond yields climbed to a three-month high last week amid the cash shortage, while banks’ domestic liabilities jumped almost 15 percent at the end of February from a year earlier, according to data Tuesday from the regulator.

Big Benefits

Citigroup analysts Judy Zhang and Daphne Poon in Hong Kong recommended shares of Agricultural Bank and Bank of China in a March 22 note, given they are “beneficiaries” of the liquidity squeeze.

State-run Agricultural Bank, which is due to report first-quarter earnings late Tuesday, has risen 12 percent this year in Hong Kong, exceeding the average 10 percent return of China’s four biggest listed lenders and the Hang Seng China Enterprises Index’s own Asia-leading advance.

Meanwhile, Hong Kong shares of Chinese banks with a market value of less than HK$600 billion ($77 billion) have climbed an average of 5.4 percent, according to data compiled by Bloomberg. Complicating their outlook is the rising cost of so-called negotiable certificates of deposit, a key source of funding for small banks that may also face regulatory curbs.

Read more: Mounting Costs, Not PBOC, Could Slow China’s Bank Debt Binge

Nomura Holdings Inc. advises steering clear of smaller lenders that have a strong reliance on interbank funding, namely China Minsheng Bank Corp., China Citic Bank Corp., China Merchants Bank Co. and Bank of Communications. Nomura aren’t the only ones -- the number of analyst sell ratings on Minsheng and Citic is at a record high, with the two lenders’ short-term borrowing and repurchase agreements almost doubling in the past two years, according to company filings collated by Bloomberg.

The deleveraging campaign “deals the biggest blow to city and rural commercial banks, as they are more aggressive in building up leverage but less experienced in risk control,” said Liao Qiang, senior director for financial institution ratings at S&P Global Ratings in Beijing. “The divergence in big and small banks’ performance will continue.”

While China’s economy is showing green shoots, Ed Hyman, chairman of Evercore ISI, told Bloomberg TV Monday that debt levels are unsustainable and will disrupt the recovery. The country is “a mess, and at some point it’s going to blow up,” he said.

Another issue dragging on small banks is that returns on assets, such as bonds, haven’t kept up with the increase in funding costs, said Richard Xu, a managing director at the Morgan Stanley’s Asia unit in Hong Kong.

“But we don’t expect big banks to surge and small ones to tumble,” Xu said. The PBOC has an interest in maintaining order “because it can’t push ahead with any reforms when the market is in turmoil.”

— With assistance by Tian Chen

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