China: No Bursting Bubble, Buy The Banks

August 03, 2015

The Big Picture

Before laying out the case, some scene-setting is required.

First, the scale of China’s global ambitions should not be understated. Their goals are gigantic. Importantly, China has a strategic objective of massively increasing its significance as a world financial power (in addition to having major economic and trade influence).

A better financial system is crucial if China wants to transition away from the rapid industrialization phase where the target was building up as much infrastructure as possible. Now the aim is a higher-quality growth phase with a focus on maximizing the return on investing.

Two outward thrusts are noteworthy here. One is the “Belt and Road” initiative; an infrastructure program with the goal of creating China-financed transport links across Central Asia to Europe via a “Silk Road economic belt,” and across Southeast Asia to the Middle East and Africa via a “Maritime Silk Road.”

If executed correctly, the new infrastructure would greatly enlarge the economic ecosystem within which China operates, creating investment and trade opportunities far beyond the initial infrastructure projects. Efficient transport and communications infrastructure effectively lowers the cost of moving goods, people and ideas around. Economic activity is boosted and smaller countries become clients of the central power that built it.

The second longer-running initiative is the promotion of the Chinese renminbi as a major global currency.

Clearly, if China is to become a serious financial power, it must have stable capital markets. A strong renminbi is key here, not least to finance trade and outward investments in its own currency. This is already happening. The renminbi has stealthily been one of the world’s strongest currencies in the last decade and now accounts for about 35 percent of China’s total trade (a tripling from three years ago).

The next stage is to achieve “reserve currency” status. The first milestone will be inclusion in the International Monetary Fund’s Special Drawing Rights basket—perhaps as early as November 2015.

Focus On China’s Banks

Why is all this important for China’s banks? Simply because many of these initiatives will supply longer-running support for China’s financial sector. More productive infrastructure and increasingly stable capital markets will only increase profits and stability.

The good news doesn’t stop there. At the current juncture, several positives exist for China’s banking sector.

First, the broad sell-off in the Shanghai index disguises a huge bifurcation. Financials have lagged far behind other index constituents, but were much more resilient during the acute phase of the decline.

Relative to the rest of the Chinese market, bank shares are extraordinarily cheap. The top 20 financial holdings of Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | D-61) have a weighted average price/earnings multiple of just 12 versus the broader Shanghai Stock Exchange A Share Index at roughly 20.

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