Hugh Young: Why I’m not investing in China’s banks

As creators of credit, banks are in a very privileged position. To create a loan, the equivalent of making a sale for other companies, banks just need to type a number into a computer and hit ‘enter'. This is a licence that frequently gets abused if banks throw caution to the wind.

When it does, the consequences can be painful, as has been evident in much of the developed world in the last three years. In years gone by, bankers were personally liable for the loans they extended. It has become patently obvious why this was the case.

In Asia, Japan's banking crisis which was precipitated by the collapse of its super-geared property market in the early 90s, recently entered its third decade. As for the rest of the region, the Asian financial crisis was extremely painful for a number of countries, though they all managed to grow themselves out of it very quickly, a luxury Japan - as an already developed country - did not have.

Banking crisis

Enter China. In some respects, China and its banks do not have the problems that Japan and the victims of the Asian financial crisis had. The likes of Korea, Thailand and Indonesia were all running large external deficits prior to the crisis that broke in July 1997. Their banks had balance sheet mismatches with respect to both currency and duration which caused equity to evaporate quickly.

China does not have these problems. As for the comparison with Japan, China is certainly over-banked - its M2 to GDP ratio of well over 200% is off the scale for a country with a GDP/capita of just $4,400 - but it probably has the capacity to absorb a banking crisis both in terms of the ability to lift bad debts off banks' balance sheets as well as to continue to generate growth. And yet, I feel very uncomfortable investing there.

Economic success

One cannot dispute China's economic success. Its GDP has grown 13 times from $466.9bn in 1992 to $6,039.5bn last year yet its stock market, as measured by the MSCI China index (gross dividends reinvested) has fallen by 13% in US$ terms since the end of 1992 (the inception of the index.) Clearly minority shareholders have not shared in the wealth creation which, as an investor, concerns me profoundly. A strong shareholder-friendly culture is paramount, at least it is if you want to make money.

Back to the banks. In the early 1980s, banks became the instrument through which the central government would operate fiscal policy. Banks would extend credit - under instruction from one or other ministry - to state-owned enterprises which had been established essentially to employ China's underutilised agrarian populous.