China's banking sector had an eventful end to May as the Chinese authorities bailed out Inner Mongolia’s Baoshang, the first government takeover of a bank in two decades. Then came another bombshell for its city commercial bank peer Bank of Jinzhou, when Ernst & Young quit while auditing the delayed 2018 financial statements.
The events have certainly made the market nervous. Outstanding additional tier one (AT1) dollar notes traded down by three to five cash price points in the secondary market last week, giving back some of the gains from a rally earlier this year that followed a sell-off in Chinese bank capital in 2018.
Credit analysts see Jinzhou as one of the weakest city commercial banks to have dollar AT1s outstanding. That view played out in secondaries, as the bank’s $1.496bn perpetual non-call 2022s plunged from mid-80s to trade in the 70s over the last month.
But these jitters will serve as a much needed reminder.
The quality of Chinese banks varies greatly across a diverse range, with two extremes. At one end, there are the state-owned ‘big four’, Bank of Communications and Postal Savings Bank of China, as well as a dozen joint stock commercial banks, including China Merchants Bank.
But the banking sector is also filled with well over 1000 regional lenders with much smaller balance sheets and poorer asset quality. ANZ-compiled data showed that, including Bank of Jinzhou, 18 banks have delayed the publication of their 2018 results. Some have even delayed their annual reports for two or three consecutive years.
Such divergence points to stress in the system, especially in times of stricter regulations and a possible economic slowdown. The smaller banks are laden down with non-performing loans and have emerged as a key risk to the Chinese economy.
Many of the small and midsized lenders from the mainland had been taking advantage of a vibrant offshore market in the past couple of years, selling over $20bn of AT1s, according to Dealogic. But it was not just a volume story.
Most of them — not only Bank of Jinzhou but also the likes of Bank of Qingdao and Bank of Zhengzhou — managed to price $1bn-plus at 5.5%, or even lower, in the cases of Bank of Chongqing and China Zheshang Bank. China Merchants and Postal Savings — the latter while raising a whopping $7.25bn in a single tranche — even came in with mid-4% handles. Many of the bonds ended up in the hands of the issuers’ Chinese peers.
The bonds have, rightfully, widened since pricing, but bankers and analysts still say that at the levels they are trading — above 90 cents, in most cases — investors are not properly compensated for their risk.
China has stressed that the seizure of Baoshang is just a one-off. But it is 89% owned by the Tomorrow Group, whose founder Xiao Jianhua disappeared from a Hong Kong hotel two years ago. Xiao owns stakes in other smaller Chinese banks, such as Harbin Bank, Shenyang Bank, Taian Bank and Weifang Bank, and the market is wary of their vulnerabilities. Harbin Bank had been mulling its offshore AT1 debut for over two years.
Recent developments like Baoshang and Jinzhou, though disturbing, offer a warning that there are pockets of weakness in Chinese banks, and a distressed event is never impossible. It serves as a reminder that when it comes to Chinese AT1s, no matter how bullish the bond market may seem, credit differentiation is still key.