China's banking, and "shadow" banking system is getting more media attention than some might like as concerns have risen about the health of the sector. How are wealth managers thinking of the issues?

With another Chinese New Year coming around, it has prompted wealth managers the world over to think about some of the risks and rewards to investing in the Asian giant or in businesses linked to it. And some of the recent headlines have been disconcerting, particularly in the case of banking.

A few days ago - as reported on this and other news outlets - a wealth management product sold via ICBC, the Chinese bank, almost defaulted, setting a nasty precedent, although in the end there was a bailout. The whole event (see here) has caused some frayed nerves. The wealth management products sector, part of a large, “shadow banking” system in China about which exact data is hard to get, has worried regulators in China for some time. According to one report by Reuters, the shadow, or "underground" financial system accounts for around 8 per cent of China's $9.4 trillion economy.

Then there are concerns that a country seeing double-digit GDP growth rates for a decade - albeit slowing more recently to around 7-8 per cent – has been able to mask some underlying weaknesses; a banking system operating under state control has shielded shaky balance sheets from analysts’ eyes (as well as those of journalists). In some ways banks are said to have so many cross-subsidies and political guidance from above that they cannot be really thought of as fully capitalist entities.

As if to stoke concerns, recent macro-economic data suggested a deterioration. China’s manufacturing sector has contracted for the first time in six months, according to the HSBC China Manufacturing Purchasing Managers’ Index™. The index dropped to 49.5 in January, down from 50.5 in December. It was also slightly lower than the early indicator Flash reading of 49.6, released on 23 January.

On a more positive note, though, the moves made by the ruling Communist Party late last year to reform the economy and inject market disciplines into banking and finance should be positive in the long run. Time will tell. The tricky issue, however, as seen in other countries, is the passage from old to new. Some statistics can make readers queasy: A report in 2012 by the International Monetary Fund noted that “close to 50 per cent of GDP” is accounted for by investment, with a one-in-five risk of an economic crisis. That is more than double the share seen in, say, the US or Continental Europe (though arguably investment in these places could use an increase). Even allowing for hype about “bridges to nowhere” and talk of empty cities and the like, such a level of investment is bound to drive concerns about “mal-investment” that often come when the real cost of debt financing is very cheap and risk is mispriced. “Normalising” to more “Western” investment proportions is going to difficult. (Not everyone buys the idea that over-investment is a major problem; Matthews Asia, the fund management firm headquartered in San Francisco, has challenged the notion of high mal-investment risk.)

Perhaps such growing pains and setbacks are inevitable and need not lead to irreversible problems. A lot of China’s investment has come from domestic sources rather than from abroad. It will take time for the economy to re-balance and most bank crises, when they occur, lead to restructurings and eventual economic resurgence. That is the view of Goldman Sachs, for example. Benoit Mercereau, managing director, Investment Strategies Group within Private Wealth Management at the US firm, recently told this writer and other journalists at a presentation about its investment views. He said his firm sees a high probability of a major banking crisis in China during the next few years – although making an exact prediction on timings is hard.

Mercereau said he is reluctant to be overweight Chinese banks; that does not meant Goldman is completely avoiding such banks and related investments, as there are opportunity costs in staying out of a country/sector during such a period, he said.

“When China’s investment stood at 47 per cent of GDP, the IMF estimated that this over-investment had raised the probability of a crisis from 8 per cent to as high as 20 per cent. Given that investment has now risen to over 50 per cent of GDP, the possibility of a crisis has only increased,” he said, when asked on this point.

“In China, there has been some capital invested in projects and in businesses that may ultimately prove insufficiently credit-worthy,” Mercereau said.

Japan
In all this, the memory of what happened in Japan looms large, although there are nuances and differences too. It has taken Japan two decades to get close to recovering some of its swagger after shares and property prices crashed at the end of the 80s. At a presentation of investment ideas last week, Canaccord Genuity Wealth Management, the likelihood of a nasty reverse in China’s economic fortunes was mentioned as a key risk. So much of China’s emergence after the late 1970s as an economic power has been around spending on infrastructure and exports; it now needs to be on a more balanced, domestically-driven path, said Robert Jukes, global strategist at the firm.

His colleague, Edward Smith, agreed. “Chinese debt is potentially a very large problem and a lot of that has been fairly unregulated. There is the possibility of a policy miss-step along the way,” he said.

Chinese banks seem to be giving other investors concerns. Dale Nicholls, who is portfolio manager of Fidelity Funds Pacific Fund, is giving them a wide berth, in contrast to other sectors he likes, such as the IT sector. “Ongoing regulatory risks and rising ‘bad’ debt levels means I am avoiding banks,” he said in a note.

“They look cheap, but in my experience the early days of a credit cycle is generally not the best time to own banks. I think we still have quite a way to go here and would not be surprised if we hear negative news that non-performing loans come in higher than many expect. Banks will also need to shoulder some of the burden for the wealth management products they have sold which are unable to meet promised returns. In addition we have the specter of deregulation which is likely to put pressure on returns for the sector. Given all these risks I would rather look elsewhere for my investments,” he said.

The Year of the Horse could prove to be more interesting than some might hope.

(Editor's note: yours truly was born in 1966, which also happened to be a Year of the Horse.)