Is Now the Time to Buy China?

By ETFguide.com  OCT 31, 2013 3:00 PM

China's five biggest banks have increased their loan reserves: is this a sign of trouble to come or just a prudent move to clean up budget sheets?

 


Earlier this month the top Chinese banks reported that they increased their loan loss reserves by 300% over prior year reserve levels.

As reported by Bloomberg, the five biggest Chinese banks including Industrial & Commercial Bank of China Ltd. (OTCMKTS:IDCBF), China Construction Bank Corp (OTCMKTS:CICHF), and Agricultural Bank (OTCMKTS:ACGBY) have increased their loan reserves to 349.9B Yuan, or 1% of total loans outstanding upping the reserves over 22B from last year’s 7.6B Yuan increase.

Is this the first sign of a Chinese banking system that is in worse shape than most realize, or is this just a prudent move by these banks in cleaning up their balance sheets?

Different Country, Different Rules

China’s laws are different than most of the rest of the world when it comes to loan loss provisions.  Historically Chinese banks had to get approval by the Finance Ministry to write off bad debts.  Courts also were typically involved. 

In 2010, these rules were revised to make writing off underperforming loans easier for the banks, and they are taking advantage of it.

The accounting behind bad debt write-offs puts pressure on today’s earnings while helping clean up the balance sheet of bad debts over the long term.  When a company creates a loan loss reserve, it results in negative earnings for the quarter offset by a balance sheet account that reduces the outstanding debts balance. 

By writing off loans, Chinese banks are cleaning up their balance sheets but at the expense of putting more pressure on their income statements, which may be one reason the Chinese banks have been falling in price.

Chinese Bank Risk

The fundamental question is how many of these loans are actually bad and how much more will these banks write off down the road? 

At the height of the U.S. financial crisis, loan loss reserves reached as high as 3.5% of total loans outstanding from a starting point around 1.25% of total loans outstanding in 2006.

One particular Chinese bank, Bank of Communications (OTCMKTS:BKFCF) , has already increased its loan loss provision by seven times to almost 5B Yuan the first six months of this year, lowering its earnings significantly more than if the company had kept that bad loans on its balance sheet.

But overall, Chinese banks still have only reserved 1% of their total loans outstanding as the China Banking Regulatory Commission warns of a potential economic downturn. The Commission is now urging its banks to write-off more bad loans as earnings are ample at the current time. Some thresholds now call for bank loan loss reserves to head to 2.5% of total loans outstanding.  

There is no secret of the ghost cities and the risks the country and banks took in building up its infrastructure as growth threatens to slow to its lowest level since the 1990s.  Is it possible the next financial crisis will actually come from Asia -- a place most least expect?

What the Charts Say

The following chart shows the recent breakdown in price of Chinese stocks and ETFs.  Shown on the top is the iShares China Large Cap ETF (NYSEARCA:FXI) and in the middle is the broader Shanghai Stock Exchange Index (SHA:000001).

Both of these indices recently broke down from their uptrends, showing the recently slowed momentum in Chinese stocks.

Another sign of China slowing down is both of these indices peaked in early 2013, but unlike the other markets around the world, they have not made new highs.

This non-confirmation is similar to one we pointed out between the VIX (INDEXCBOE:VIX) and the S&P 500 (INDEXSP:.INX) just before we captured a 30% gain in the volatility index.  That trade is outlined by our article, "Can Stock Market Volatility Stay Tame" published on 10/11.
 


Trading China

FXI recently broke down from its trend in place since the summer, but it then found support at its 200 day moving average.  Meanwhile the Shanghai Index as a whole also broke down from its uptrend but its 200 day moving average did not act as any kind of support.

The final chart in the graphic above shows the relative strength of FXI to the Shanghai index.  FXI’s leadership recently broke down, suggesting it will continue to lead lower.

Since FXI’s 200 day moving average has held, it is not yet time to sell out of Chinese stocks, but a breakdown in price below its 200 day moving average would align FXI with the Shanghai Index as a whole in a declining trend and warning of a renewed downtrend in Chinese companies.

If and when that 200 day moving average breakdown of FXI does occur, buying the ProShares UltraShort FTSE China 25 (NYSEARCA:FXP) would capitalize on a renewed downtrend in Chinese stocks and ETFs.

China may be the canary in the coal mine as its banks are now the ones at most risk of a continued global slowdown.

Editor's note: This story by Chad Karnes originally appeared on ETFguide.com.

To read more from ETFguide, see:

Beating Low Yields in a Low Rate Environment

The Dow Committee Again Gets It Wrong

Are Vix Traders Riding the Wrong Roller Coaster?

No positions in stocks mentioned.