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Opinion Pieces

Something Wicked This Way Comes

For the past sixty-one years Fortune magazine has published a list of the largest 500 firms in the world. An idiosyncrasy of the list is that it is published in order by revenue rather than by profit or by total assets. It will come as no surprise to most that Apple comes out as the most profitable firm in the world, achieving an incredible profit after tax margin of 23% on revenue of USD 234bn.

 

china-olympics-smallWhat may surprise some is that the next four positions – by profit – are occupied by four companies in the same industry from the same country. Amazing as it may seem, positions two through five are occupied by Chinese banks. The total profit after tax reported by the four largest Chinese banks in the 1 August 2016 edition of Forbes magazine is in excess of USD 136bn.

 

To put this into perspective: the total profit of the largest four US banks is only USD 80bn. A modicum of legwork will divine the following: JP Morgan came in sixth with USD 24bn, Wells Fargo came in eighth with USD 23bn, Citigroup came in thirteenth with USD 17bn, and finally Bank of America came in seventeenth with USD 16bn.

 

Putting aside the niggling doubt that must infect one’s perception in comparing American firms to Chinese firms – for example one has to ignore the fact that China is an autocracy, is notoriously opaque, and is prone to excessive government intervention – it still seems a legitimate pursuit. Given that these numbers are reported as accurate income and balance sheet figures by these firms, there is no reason not to compare them, irrespective of whether what emerges is sensible. In fact, merely by reporting them in a list as Fortune magazine does, it gives these numbers a certain degree of validity.

 

It does seem more than innocuous however, and somewhat incredible, that the four largest Chinese banks made nearly double the profit of the four largest US banks. US GDP ending Q3 2016 is reported as USD 18.4trn and Chinese GDP is reported as USD 10.9trn.

 

In simple terms, this allows one a comparative ratio for financial productivity – so to speak – of the US versus China. In the case of the US, the ratio between banking profits and GDP is 0.44%, whereas in China this ratio is 1.25%. That means that Chinese banks must be 2.9 times more efficient than US banks.

 

A couple of points spring to mind. Firstly, there is no possible way in which this could be true – US banks are older, wiser, more battle-weary and generally more visible worldwide than Chinese banks. Secondly, in running a large diversified bank, one has to have a certain minimum infrastructure in place, which is costly and requires highly-educated skill-sets to administer. This would account for the relatively high cost-to-income ratios observed in US, UK and European banks. Usually one sees numbers between 50% and 65% for this metric.

 

In order for Chinese banks to be 2.9 times more efficient than their US counterparts they would either have to have substantially better interest rate margins or they would have to have far less costly infrastructure and far fewer educated staff. Both are possibilities but nowhere near the three times efficiency pick-up implied by the official numbers.

 

In fact, what is far more likely than uncanny Chinese efficiency is simply that Chinese banks have not recorded provisions for the enormous debt overhang that they are failing to account for. The next financial crisis is possibly imminent and is made poignantly obvious by a cursory analysis of Fortune magazine’s data.

 

The International Monetary Fund estimated as recently as June 2016 that potential losses for Chinese banks’ corporate loan portfolios could be equal to about 7 percent of GDP. That translates into USD 760bn in actual losses. Recall that we used the same concept to estimate financial efficiency for Chinese banks, and that the profits of the four largest Chinese banks came out as USD 136bn. In other words, it would take five and a half years of sustained Chinese banks’ profits to absorb only their corporate loan losses, never mind the consumer loan losses built into their system.

 

So, on the one hand we have the regular financial press – Fortune magazine – awarding ranking honours to Chinese banks – and on the other hand we have the losses forecasted by the IMF.

 

Even if one were to factor in the political leanings of the IMF, there still remains two unfortunate conclusions: the opacity in Chinese statistical and financial reporting, and the obvious compelling improbability of Chinese operators being three times more efficient than US operators. These two realities lead to only one derisory conclusion: that the Chinese numbers must be wrong. What irks is the near absence of mainstream financial media focus on what would appear to be the next crisis made plain in numbers.

 

The buying power of the Chinese economy has led to a wilful myopia in the western acceptance of the Chinese story. Even the most basic analysis leads one to very disturbing conclusions. It is nine years since the near collapse of the financial markets. Yet the lessons apparently learned – primarily that excessive leverage in banking and exponential growth in property prices signalled a future overhang of severe magnitude – have already been forgotten.

 

There is not a single line of analysis in Fortune magazine on the irascible truth that there is no possible way that Chinese banks could be this profitable. Nor on the consequences of this blatant myopia. Something wicked this way comes. And it will be global.

 

 

 

 

 

 

 

 

 

 

 

 

4 Comments

  • Robert Sim

    Reply

    David,

    Business Day readers need to be exposed to some of the pieces you are writing about.

    The property bubble in China is scary. So are the bad loans to small and medium sized enterprises – never mind the big conglomerates.

    For years people have received loans NOT REPAID, with limited value collateral from their friends at the local bank. As i mentioned, it seems ROUTINE, that only interest is serviced and capital not paid back but rolled over.

    Maybe the savings rate of the people is the saving grace…… but all of them getting a haircut spells REVOLUTION. The masses will be restless.

    September 15, 2016 at 7:41 am
  • Kate

    Reply

    Really great Article – very insightful!

    September 15, 2016 at 1:07 pm
  • Tumiso

    Reply

    Hi David

    The most glaring and worrisome parts of your analysis must be this statement and the truth that it poses:

    What is far more likely than uncanny Chinese efficiency is simply that Chinese banks have not recorded provisions for the enormous debt overhang that they are failing to account for.

    With some curiosity regarding the provisioning of potential losses that may be suffered as a result of this debt overhang, is there any development underway within the financial reporting circles to ensure that there is wider codification of reporting methodologies? I am having difficulty piecing together the effects that a fallout could possibly have on the commercial interests many of the Chinese banks have committed to in the developmental agenda across Africa in particular.

    Would these losses and the recovery thereof, become another albatross to African states whose resources will be exploited for the benefit of the equity holders who have suffered blows to their financial fortunes?

    And is IFRS 9 not a globally-adopted standard for the recognition and disclosure of financial instruments in line with best practice?

    September 26, 2016 at 11:08 am
  • David Buckham CEO of Monocle (Author)

    Reply

    Hi Tumiso,

    Thank you for your question. To respond very simply: it is my view that Chinese banks, at all levels, have been encouraged not to account for their potential and actual losses by the pressure placed on them by the Chinese State. China has a desire to be recognised as sufficiently sophisticated and ‘open’ to meet the highest international standards of accounting, risk management, anti-money laundering etc. but they have little desire to be transparent. As one example, their stock exchange has been declined from entry into the MSCI index again this year after an effective ban was placed on selling in the midst of the market tanking 3-6 months ago. In terms of the Basel Accord, IFRS 9, AML laws, I believe that China would like to meet these standards, but is not transparent enough to meet them. If they were to meet IFRS 9 standards as an example, they would look substantially less profitable. For Africa this is bad news. Richemont has already announced substantial profit declines in its Cartier division owing to Chinese demand pulling back. In terms of investment in Africa, we are talking really about investment in getting resources out of the ground. When China experiences severe demand declines in secondary industries set up in China itself, owing to increased labour costs, and tepid worldwide growth, investing in Africa will become far less of a priority.

    I hope this answers your question.David Buckham.

    September 28, 2016 at 5:14 am

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