Who is buying Chinese bank shares?

Few segments of global equity markets have been more reviled in recent years than the shares of China’s big state banks. As corporate debt levels in China ballooned, especially among state-owned enterprises, and economic growth slowed, international investors shied away from the H-shares of state banks listed in Hong Kong, fearing an almighty accumulation of unrecognized bad loans on their balance sheets. This caginess was reflected in bank valuations. Take Industrial and Commercial Bank of China, China’s largest bank by assets, for example: from a price to book ratio approaching 5x in late 2007, the valuation of its H-shares tumbled to just 0.65x in May of this year—a slump mirrored in the valuations of the other big Hong Kong-listed mainland banks.

But since May things have changed. Hshares in ICBC have climbed 30%, easily outperforming the broader Hong Kong market, which has gained a relatively modest 17%. The shares of other Hong Kong-listed state banks have also risen strongly, in a rally which has pushed the P/B ratios of the Chinese banks up to between 0.65x and 0.9x. But although fears of an immediate debt crisis in China may have receded in recent months, international confidence in the transparency and solidity of state banks’ balance sheets remains shaky to say the least. So who is buying?

The answer can be found in the flow data for the southbound channel of the ShanghaiHong Kong connect scheme, which provides mainland investors with a sluice gate in China’s capital controls through which they can buy Hong Kong-listed stocks. For most of the first 18 months after the scheme’s 2014 introduction, southbound interest was relatively limited. There was a brief surge of enthusiasm in early 2015 when the mainland market was booming. But when the bubble burst, interest cooled, and for most of last year mainland investors held less than half the RMB250bn aggregate quota of Hong Kong stocks allotted to them under the scheme.

In the last few months, mainland interest in buying Hong Kong stocks has revived. Heavy southbound flows saw the unused balance of the aggregate quota shrink from RMB117bn in early May to less than RMB45bn in early August. With the trend implying that southbound purchasers would reach the ceiling of their permitted quota well before the end of the year, last month the mainland authorities took advantage of the announcement of the launch of the complementary Shenzhen-Hong Kong connect scheme to scrap the southbound aggregate quota entirely, no longer setting a limit on the value of Hong Kong stocks mainland investors can hold (although restrictions still apply to the individual stocks approved for purchase and on the pace of buying).

When mainland interest in Hong Kong-listed shares began to pick up, international investors generally assumed that buyers would focus on

however, “new economy” stocks such as internet giant Tencent, which is not listed on China’s domestic market. In fact, between the beginning of May and mid-August, almost two-thirds of southbound flows—some HKD53bn went into bank shares. Some went into HSBC, regarded locally as both a yield play and a hedge against possible renminbi weakness. But the bulk went into ICBC and China Construction Bank, with HKD25bn going into CCB alone.

It is unrealistic to imagine that mainland retail investors are behind these flows. Such heavily-concentrated buying smacks of China’s “national team”, the group of state funds headed by China Securities Finance Corporation and Central Huijin Investment which last year weighed in to support the collapsing mainland A-share markets. If so, and if the national team is indeed buying the Hong Kong-listed shares of Chinese state banks in such heavy volume, the question is: Why?

There are a couple of possible reasons. The first is that the mainland authorities are anxious to make a success of the opening of China’s domestic A-share market to international investors via the northbound channels of the stock connect schemes. So far however, international investors have been distinctly underwhelmed; as of midAugust they held less than half of their allotted quota of mainland stocks.

That’s no surprise. Many of the blue-chips listed in Shanghai are also available in Hong Kong, and at much cheaper valuations. So mainland officials may well reason that to promote international interest in the mainland market, they must first close the valuation differential with Hong Kong. And the easiest way to do that is to buy the Hong Kong shares of the big mainland state banks, which make up a third of the H-share index by capitalization. If that is indeed their intention, they have been partially successful. Since May, the overall A-share/Hshare premium has narrowed from 40% to 23%.

The second possible reason is that the mainland authorities are preparing China’s state banks for a future recapitalization to strengthen their balance sheets. However, Chinese regulations forbid state-owned companies from selling shares at below book value, in order to avoid “losses of state-owned assets”. As a result, if the authorities want to issue new shares to help recapitalize the banks, they must first push up their P/B ratios. And if they want to issue new shares via a secondary offering in the international market, that means buying enough Hong Konglisted stock to push the P/B valuation of the H-shares above 1x.

These two explanations are by no means mutually exclusive. And the implications as far as international investors are concerned are much the same. If the hypotheses are true, mainland purchasers will carry on buying the H-shares of Chinese state banks until either the valuation discount to Ashares closes or until H-share valuations climb above book value. In short, it looks as if the buying momentum will continue.