The Next Banking Storm

By ASSIF SHAMEEN | MORE ARTICLES BY AUTHOR

Hong Kong's banks look headed for trouble, thanks to heavy exposure to China.

 

Emerging Markets

For months, investors have been focused on Chinese banks' huge exposure to local governments, as well as to speculative real estate. Now they are turning to Hong Kong, where another banking storm might be brewing.

Hong Kong lenders may have dramatically increased their exposure to China just when concerns about that economy were mounting. Ratings agency Fitch warned recently that it could soon downgrade the credit standing of Hong Kong's banks because of their fast-growing commitments to China.

Banks in Hong Kong have historically been among Asia's best-run, best-capitalized financial institutions, often the envy of their peers. Indeed, they emerged from the financial crisis two years ago with their reputations intact. But now, with China's economy slowing, bank margins are under pressure, deposit costs are rising and there is a liquidity squeeze, warns Nomura Securities Daniel Shum.

ON TOP OF ALL THAT, the banks appear to be extending new loans like there's no tomorrow. Bank loans in Hong Kong grew by a whopping 26% in August, compared with the level a year earlier. Fast loan growth like that is often a prelude to credit-quality problems.

The main driver of this growth, says Ismael Pili, a bank analyst for Macquarie Securities, is "trade finance and Chinese companies that are borrowing in Hong Kong for operations or assets overseas." Mainland Chinese outfits have been on a borrowing spree to buy assets elsewhere in Asia, Africa, and even Europe and the U.S., to take advantage of low interest rates in Hong Kong, whose currency is pegged to the U.S. dollar.

Trade financing by Hong Kong banks grew 102.3% in the first half of this year, compared with the total in the corresponding period last year. And loans outside Hong Kong grew 37.9%. "These are scary numbers because we have never seen Hong Kong banks grow loans to non-traditional sectors this way or as fast," says Michael Werner, a Sanford C. Bernstein analyst.

THE RAPID LOAN GROWTH appears to be coming in response to lower interest rates and, as a result, lower profit margins for banks. "Banks had little choice other than to go out and just expand their loan volumes," Werner asserts.

Of course, the lending surge won't necessarily produce bad loans. "Asset quality is high with no immediate sign of deterioration," says Martin Wardle, Partner at KPMG China in Hong Kong. "With strong loan growth some increase in losses is to be expected but we don't see this being significant." Morgan Stanley has a Sell on Bank of East Asia (ticker: 0023.HongKong) because its weak profitability makes it the institution most vulnerable to even a small bit of credit deterioration. The investment firm also recommends avoiding smallish Wing Hang Bank (0302.HongKong).

But some well-capitalized bank stocks have been hammered so badly that they're starting to look attractive. Nomura's Shum recommends buying BOC Hong Kong (2388.HongKong), a subsidiary of Bank of China. He sees the stock rising more than 40%, to HK $28 (US$3.61). It trades at 11 times next year's estimated earnings and 1.4 times book value. The shares yield 5.8%.

Jumping On

Asian markets joined the global rally, with Hong Kong and Thailand in the lead.

ASSIF SHAMEEN covers Asian markets from Hong Kong