Money won’t come cheap as Chinese banks boost capital by issuing hybrid securities

PUBLISHED : Wednesday, 21 May, 2014, 11:49am
UPDATED : Wednesday, 21 May, 2014, 11:49am

Chinese banks are poised to raise a record US$120 billion in the next two years to shore up their balance sheets in the face of slowing growth and rising bad debts, but the funds could prove expensive and hurt earnings as investors demand a premium.

For the first time, banks will raise capital by issuing preference shares and other so-called hybrid securities, a funding technique that avoids the need for issuing ordinary shares into a badly hit stock market.

In the past two weeks, Agricultural Bank of China and Bank of China announced plans to raise about US$29 billion in preferred shares between them.

The banks are rushing to replenish their balance sheets to meet new global capital rules known as Basel III.

The Chinese government has been rigorously enforcing these regulations in its efforts to ward off a financial crisis following a huge run-up in debt since 2008 and a marked slowdown in economic growth.

Analysts investors are expected to drive a hard bargain given the concerns about China’s opaque financial system and the worrying rise of toxic debt.

“Given the size of the proposed capital issues and the concerns about transparency in the Chinese banking system, it may be hard to price aggressively versus the Western structures currently out there,” said Ivan Vatchkov, chief investment officer of Algebris Investments (Asia).

The first few deals should give banks an idea of the returns that investors will demand on hybrid capital securities. China Citic Bank International, a Hong Kong-based affiliate of China Citic Bank, sold capital securities in the offshore market last month at an interest rate about 1 percentage point over that available on the bank’s subordinate bonds.

Benchmark five-year subordinate debt from China’s top-rated banks trades at a yield of 5.25 per cent, suggesting banks will have to price yields at about 6.3 per cent for preferred shares to lure investors – a side effect of an economy growing at its slowest pace in decades.

Given the size of the proposed capital issues and the concerns about transparency in the Chinese banking system, it may be hard to price aggressively versus the Western structures currently out there
Ivan Vatchkov, Algebris Investments (Asia)

Some analysts warn that forcing banks to pay hefty yields on new hybrid capital instruments would not only pressure their profitability but also threaten their ability to continue lending aggressively as bad loans rise in a slowing economy.

Chinese banks’ non-performing loan figures rose to a two-year high at the end of last year, according to official data.

However, the risk that investors may lose their money in a potential banking collapse is slim, as many of the state firms have an implicit government guarantee.

Total assets of China’s banking industry reached about US$24 trillion – more than twice the size of the country’s economy – at the end of last year, according to the China Banking Regulatory Commission. That is why investors are confident the government will prevent a Greek-type debt crisis from ever emerging.

China’s Big Four lenders enjoy the equivalent of single-A ratings from credit rating agencies such as Standard & Poor’s and can fund relatively cheaply in the bond markets.

Investors in preference shares, however, demand a premium for the added risk that their holdings may be converted into common equity if the bank’s capital ratio falls below the trigger level.

Last month, China unveiled rules on commercial bank issuance of preferred shares, paving the way for lenders to begin fundraising to enable them to withstand an expected rise in bad loans.

In all, analysts estimate China’s lenders are likely to raise at least US$55 billion through these bond-like products in the next two years. That is on top of plans to raise up to US$64 billion in Basel bonds that banks have previously announced, taking the total to almost US$120 billion over two years.