Chinese RMB Yield Curve

The yield curve adjustment in US market was the biggest event last week and the effect has rippled through to other part of the world. While China is a red hot subject nowadays, how come nobody talks about the Chinese RMB yield curve? Do you have any idea as simple as the shape of the curve?

You probably are not interested because RMB is not a freely traded currency, and you are not allowed to buy RMB bonds.

But are you investing in Chinese H-share or A-share based ETF such as Morgan Stanley A-Share Fund (CAF), iShares FTSE/Xinhua China 25 Index (FXI) or iShares FTSE/Xinhua A50 China Tracker (2823.HK) ?

Do you know all those funds are having a significant proportion of their assets invested in Chinese banks and insurance companies?

For example, the following list shows the 25 constituents of FXI, almost 40% of its assets are in Chinese banks and insurance companies



So how does this relate to the RMB yield curve?

If you are indirectly owning so much Chinese banks assets, you may be interested to know how do Chinese financial institutions manage credit risk, how do they perform mark-to-market financial assets valuations, how do they report VaR (Value-at-Risk) or CAR (Capital Adequacy Ratio) which are critical measurements of banks’ health.

In other part of the word, yield curve is the most fundamental element to derive discount rates for cash flow projection, which itself is the basis for any financial assets valuations.

However, you may be very surprised to learn that this seems to be obvious matter is a brand new policy just imposed last week ! On 15 June CBRC made an announcement that banks should make reference to RMB yield curves in financial assets valuation and reporting starting from Oct 2007. Before this is enforced Chinese banks are not referencing to RMB yield curve and they derive their own discount rates based on arbitrary and subjective measures. So there is in fact not a common point of reference when we interpret reports from different Chinese banks. Is the credit management of one bank better than the other as indicated from its annual report? I am not too sure.

It is still a very long road to a mature capital market in China. What we have seen in the A-share market is just a beginning of the overall Chinese capital market reform. Without a solid equity market foundation it would be difficult to move forward to develop a corporate debt market. RMB yield curves are in fact incomplete because secondary market for corporate bonds is inactive. Without a well developed debt market the Chinese goverment would find it difficult to solve banks’ non performing loan problems because there is not a vehicle for a more balanced distribution of risks to different classes of investors. Bank loans are currently the major source of funding for all Chinese firms. Based on PBOC statistics, in 2006 Chinese firms raised a total of RMB 4000b, of which RMB 3300b (82%) were bank loans, only 5.6% (RMB 230b) was from equity market.

My View

1. China is speeding up in debt market development which is crucial to the overall health of Chinese economy
2. A healthy stock market is the fundamental requirement for debt market development, I cannot believe the Chinese government will do any stupid things to destroy what they have painfully developed over the past few years. Tackling the astronomical sum of non performing bank loans and ultimately listing all banks were huge achievements. Though the system is far from perfect, it is a one way road, the Chinese market can only be healthier.

Finally, here is the RMB yield curve in case you are interested.

A Review of My Previous Prediction on Chinese Banks Performance

On 6 Feb 2007 I’ve written an article “Chinese Banks: A Non-Traditional Approach to Predicting Their Performance” in which I described how I rate 3 Chinese banks' future performance based on their historical non performing loan (NPL) problems and my argument is simply “bad habit dies hard” especially in China where management appointment is more based on relationship (though it's changing).

At that moment while all analysts were promoting ICBC (saying ICBC is the largest bank in China, ecomomies of scales, with the most advanced IT system, etc) and BOC (saying BOC is the only Chinese bank with international presence), I analyzed them using a totally non-traditional approach and rated China Construction Bank (939.HK) as the best performer versus ICBC (1398.HK) and Bank of China (3988.HK)

Today I’ve revisited their relative performance both from the date of my article and also their recovery capability after the Feb market correction.

The following charts will speak for themselves

From the date of my article on 6 Feb (click for a clearer image)


From the early March market correction (click for a clearer image)


In my last article I said:

“..We also noticed that CCB was also the first state owned bank listed overseas. This is by no means a coincident. The Chinese leaders have to ensure the success of the first listed so as to set a stage for the others, as such it is reasonable to assume that the leaders should have selected the best bank to be the pioneer. Who else would have better insider information than the Chinese leaders? It would be your decision to bet with the Chinese leaders' choice or analysts' DCF models…”

In general I do not believe in DCF models, I think even the CEOs CFOs themselves are unable to tell you what are their firms' grow rates for initial years/terminal growth rates, nor could anyone predict the interest rates for next 10 years (or whatever horizon in the model), while DCF analysis is very sensitive to those assumptions how valuable is this time-value based modelling of a firm's fair price? I would rather use P/E comparables if I want to have a gut feel of a firm's value.

In my analysis of the Chinese banks, my approach is totally unscientific. While it's a common belief that historical data cannot predict future performance, that may not be completely true for China and I would continue to give my vote of confidence to our great Chinese leaders than forecasts based on DCF models!

Here is my previous story again in case you are interested.


Disclosure: I own CCB (0939.HK) at the time of writing this article.

Chinese Banks: A Non-Traditional Approach to Predicting Their Performance

中文版請按此

The most commonly used traditional valuation approaches are DCF model and PE comparables, and each has its own intrinsic flaws. In DCF method, analysts are required to make assumptions on a firm's initial growth rate; terminal growth rate and in interest rate trend. The outcome share price is also highly sensitive to those assumptions. Analysts generally will adjust those parameters until the result is within a reasonable range. I always doubt the usefulness of DCF model as there are so much guesswork involved.

In using PE comparables, market PEs are affected by supply/demand of the stock and investor's sentiment about a particular sector. Hot sectors (like PRC companies recently) are unavoidably overpriced.

As we all know, stock price is a reflection of investor's view about a company's future earning power, historical performance data hence would be of little value in forecasting a company's future. In most cases this is absolutely correct, however, as we know China is an interesting country and counter-intuitive things do happen.

For the three listed Chinese state-owned banks, I believe their historical performances do have predictive power to their future performances. My rationale is based on the following three China specific factors:

The Duty To Support Government Policy

Chinese state-owned banks [Industrial & Commercial Bank of China [ICBC], Bank of China [BOC], China Construction Bank [CCB], Agricultural Bank of China [ABC]] carried the role as China's policy banks. By 'policy bank' it means their activities are more of political rather than commercial in nature. For example, if the government's policy is to support the agricultural sector, banks will offer policy lending to farmers and companies within the sector without proper consideration of commercial risk. That explains the astronomical size of NPL (Non Performing Loan) inherited with the banks before their listing. Although they are now listed (in Hong Kong as H-share) and are supposed to operate in a more business oriented fashion, I believe their obligations to support government policy still remain. That is why foreign investors are still restricted to own no more than 19.9% of share in those stated owned banks so that government can still maintain control of the board and management.

Management and Company Culture

Even though the banks have invited foreign financial institutions as strategic investors as part of the listing process, they are only minority shareholders and their capability to influence the management are in doubt. Though banks such as China Construction Bank and Bank of China had replaced their senior management teams and recruited professional management from overseas, in those huge state-owned enterprises with long history, it's easier said than done to change the company culture to a truly professionally run organization.

Tale Of Two Markets

Lastly, banks are having their hands tied in improving credit risk management due to the immature credit market as opposed to the rapid developing equity market in Shanghai and Shenzhen. The introduction of SHIBOR (Shanghai Interbank Offer Rate) last month is a significant milestone in China's credit market, however, it will still take a long time before instruments such as interest rate swap and credit default swap [CDS] are available and become popular. Those instruments are essential to the securitization and efficient transfer of banks' credit risks to market participants.

Because of the above reasons, I believe there be no significant changes in the banks' future relative performance comparing to their past and hence historical data can offer certain amount of predictive power.

As the biggest problem with all banks is non performing loan [NPL], I would use NPL as a major parameter to rank the banks' historical performance.



As can be seen from the table, in 2002 (which was the year prior to the government's capital injection to package the banks for listing) China Construction Bank's non-performing loan ratio (22%) is the lowest among the three, while that of ICBC is the worst. To take into account of the different branch network size, I created the ratio [(nonperforming loan %) / (number of branch)] and that will give us a feeling how worst is the situation per branch per bank. With this ratio Bank of China is the worst performing bank.

Now let's look at their profitability. As the tax rates of the banks also differ, I've used pre-tax profit as comparison. (It is expected that in 2008 the Chinese Government will reform the tax policy and all banks will have the same tax rate.) Similarly I computed the per branch profit contribution per bank. Again China Construction Bank performed the best.

From the above analysis, CCB is historically the best performing bank in terms of both credit management capability and profitability, while Bank of China is the worst.

We also noticed that CCB was also the first stated owned bank listed overseas. This is by no means a coincident. The Chinese leaders have to ensure the success of the first listed so as to set a stage for the others, as such it is reasonable to assume that the leaders should have selected the best bank to be the pioneer. Who else would have better insider information than the Chinese leaders? It would be your decision to bet with the Chinese leaders' choice or analysts' DCF models.

Evan though there is no direct channel to invest in CCB, we can still indirectly invest in ETFs with Chinese exposures. Before we make our investment to those ETFs, it would be wise to take a look at their top 10 holding first.

歷史能預測未來? 以歷史不良貸款率推測中國三家上市銀行的未來表現

Click here for English version

在估計一間公司的市值時，一般會用現金流估值模型(Discounted Cash Flow DCF)或PE比去估計。但這兩種方法都有其壞處。現金流估值方法中, 分析員需要對很多參數作出估計，例如加權平均資本成本(Weighted Average Cost of Capital WACC) ；初段增長率 (initial growth rate)；末期增長率 (terminal growth rate)；利率走勢等等。計算出來的股價對這些參數的敏感度(sensitivity)又往往較高。比如說，只要把末期增長率提高一個巴仙，預測的股價便會作出很大的反應。分析員一般會用反向工程的方法(reverse engineering)去對這些參數作出調整，直至估值模型得出來的結果跟他心目中的價位吻合為止。

另一個常用估值的方法，就是用相同行業公司的市場PE作為參考，這個方法的好處是計算頗為簡單，但是，市場PE受往往受當時投資者情緒及股票供求關係所影響。如果當時投資者對某一種行業比較睇好，那行業的PE便可能會被過份高估。

眾所周知，股價是投資者對一間公司未來的賺錢能力的反映，所以一般會覺得歷史數據對市值預測沒有多大用途，在大多數的情況下這是絕對正確的。但這也是基於一個假設，這假設便是歷史不代表將來。

歷史是否肯定不代表將來呢？對於中國幾家國有銀行來說，歷史數據可能對他們未來的表現有一定的啟示及預測作用。這是基於以下三個特殊的原因:

第一，基於中國的國情，國有銀行以往一直有承擔國家政策的責任，也是因為這樣產生了龐大的政策性不良貸款。雖然已上市了，但我深信他們仍是有執行國家政策的責任。這由它們的股權仍然比較集中於數家政府或其有關的機構也能推斷出來。這就是說這些雖然已經上市了的銀行，它們仍是不可以完全地以商業模式運作。

第二，有關風險管理能力方面，中國的銀行仍是在幼兒班階段，雖然差不多每間銀行都有國外的銀行作為戰略性投資者，但是他們都是小股東，沒有實在的能力去影響董事局或管理層。有些銀行例如建設銀行，在上市前曾經也轉換了一些高管，但是在這些龐大的國企裏，企業文化並不是更換數個領導便可以改變。就算真的會改變，亦不是三五年間的事。

第三，就算銀行本身的管理能力有所提升，在風險管理方面也不會短期內能夠改善。這是由於在中國市場上根本沒有提供所需的工具去讓這些銀行去作風險對沖或轉移。中國的資本市場發展在過往兩年突飛猛進，但主要的發展仍是在股票融資方面，企業債的發展仍是相對落後。市場上根本沒有一套客觀的、以風險為基礎的利率機制。上月中國剛推出的SHIBOR (上海同業拆息利率) 實在是中國資本市場發展的一個里程碑。但是，從現在到推出風險管理所需更複雜的工具，例如，普及化的利率掉期合約(interest rate swap) [試驗性的利息掉期合約已經推出，但市場深度並未足夠]；信貸違約掉期合約 (credit default swap)等等，我相信還需要數年時間。在這些工具推出之前，銀行想做好貸款風險成本計算，實在是有心無力。

我搜集了幾家國有銀行歷史不良貸款有關的數據，基於這些數據我大膽地對這些銀行的未來表現作了一些推測。

從上表可見，在２００２年時，亦即是國家注資去解決問題貸款並包裝上市前，建行的不良貸款率(22%)是相對地低的，工行的不良貸款率(25%)顯著地高於建行。建行亦是第一間到香港H股上市的銀行。由於三間銀行的分行數目都不同，我建立了一個不良貸款率/分行數目的參數。這參數亦即是說每一分行對銀行整體的不良貸款率的「貢獻」。以這參數來作比較，這三間銀行質素最好的是建行，中行相對是最差的。

再看看他們的盈利能力，因為三間銀行的稅率都不一樣，這裏我用了稅前盈利來作參考, 反正預計在２００８年，隨著稅務政策改革它們的稅率將趨向一致，所以我覺得稅前盈利的參考價值更高。同樣地我計算了每間分行的盈利能力，建行在這方面亦跑出了，第二位的是工行，表現最差的是中行。

得出的結論是，建設銀行在未來數年的盈利能力及壞賬管理方面都應該是做得比較好的，相對地中國銀行表現是最差的。

領導人先讓建行上市絕對不是隨意的，由於他是第一家上市的國有銀行，國家肯定要使她上市成功以作為其他銀行的模範。所以在質素方面建行肯定是最好的，試問有誰會比國家領導人更了解這些銀行真實的營運情況呢? 分析員或國家領導人誰比較可信，請你自己想想。

最後，再看看這三間銀行目前的PE是否跟我的結論吻合:

可以見到，建設銀行目前的PE是三間銀行中最低的，這跟我的結論剛剛相反，究竟我的分析是否有錯? 請大家過一兩年後再給我評分吧！