Only Fools Will Be Bullish On Chinese Banks

The 26-page section on risk factors in Agricultural Bank of China Ltd.''s stock prospectus gives a good sense of just why the global investor should still approach China''s lenders, and this one in particular, with a bit of caution. 

The soon-to-launch mega-offering for AgBank, as it is known, aims to raise between $20 billion and $30 billion in a dual listing on the Shanghai and Hong Kong stock exchanges, potentially making it the biggest initial public offering in history. 

The prospectus offers some comforting news. AgBank reported a 26% gain in net profit last year over 2008 to $9.52 billion, and a 17% profit rise in 2008 compared with the previous year. Those numbers, posted by what is widely considered the weakest of China''s four biggest banks, point to the sector''s appeal as a direct play on China''s long-term growth. 

Less comfortingly, the prospectus reminds us that AgBank owes its respectable nonperforming-loan ratio of 2.91% at Dec. 31, largely to a government-sponsored cleanup of its bad loans in 2008. As of Dec. 31, 2007, that ratio was 23.57%. 

"In the future, we do not expect to make such similar government-sponsored disposals on such a large amount or on similar terms," the prospectus warns. In other words, you''d better trust that they have learned how to make loans that borrowers actually pay back. 

Item two: AgBank notes that in 2009, as a result of a government-led economic stimulus program, it and many Chinese banks posted record-high growth in lending. "This may adversely affect the quality of our loan portfolio," it adds. This highlights the point that AgBank is to some extent, like all major Chinese banks, an arm of the state that must lend when it''s told to. That isn''t a great basis for long-term profitability.
Another risk factor particular to AgBank is its exposure to "county area banking," that is, lending in poor rural areas. "Historically," he bank says, "the County Area banking business has generally presented relatively higher risks and relatively lower returns than the banking business in the urban areas." 

AgBank lends to these areas because that is its government mandate. This aspect of its business "will be for some time a headache for them to find a sustained profitable business model," says Qiang Liao, a bank credit analyst at Standard & Poor''s in Beijing. "That''s why people view [AgBank] as a bit more risky than other major Chinese banks."
Like all Chinese banks, AgBank''s business will face a big challenge if China moves to deregulate interest rates. This is what AgBank means when it warns that it "may not continue to enjoy certain favorable PRC [People''s Republic of China] government policies." Fixed minimum spreads between interest and lending rates buoy Chinese banking profits, but few believe those spreads will last forever. Most expect the shift to be gradual, but how it plays out is hard to predict. 

Maybe the biggest risk for investors in a bank like AgBank, with its network of around 24,000 branches, is corporate governance. 

The bank itself warns "we may not be able to detect and prevent fraud and other misconduct committed by our employees or third parties." That goes also for "money-laundering and other illegal and improper activities" that "could expose us to additional liability and harm our business or reputation." 

These aren''t hypothetical problems: AgBank confesses that misconduct by its employees in the past has "included, among other things, theft; exceeding the scope of relevant authority; inappropriate accounting treatment; embezzlement or misappropriation of customer funds; mishandling of customer deposits and settlement of payment transactions; improper extensions of credit due to break of internal guidelines; fraud; and acceptance of bribes." 

China has made tremendous strides in cleaning up its banking sector. And there is much to admire in the way these lenders have made good money while avoiding exposure to the financial wizardry that roiled their Western counterparts during the financial crisis. But China''s lenders still carry some baggage that can make the AgBank prospectus an occasionally eye-popping read.