Chinese Banks Lose Luster in Hong Kong as Price Gap Shrinks

(Bloomberg) -- A rally for Chinese banks listed in Hong Kong has cut their price gap to mainland shares in half -- and that seems about as much as investors are willing to tolerate.

In the five months through September, a gauge of the big four lenders' Hong Kong shares jumped 15 percent as southbound cash poured into the stocks, trumping the Hang Seng Index's 11 percent advance. The banking stocks are now giving up some of their gains after the discount to their Shanghai valuations narrowed to the least in more than a year.

The declines signal that price equilibrium between Hong Kong and mainland shares -- a prospect that's been burning arbitragers for years -- may still be a long way away. With inflows into the city's shares via a link with Shanghai drying up and concerns over rising bad debt weighing on the sector, a revival of the rally in Chinese banks looks unlikely in the near term.

"Based on fundamentals, the sector's slowing and there's no big catalyst," said Pauline Dan, Hong Kong-based head of Greater China equities at Pictet Asset Management, which oversaw about $154 billion at end-2015. "People are still concerned whether the non-performing loan cycle will deteriorate further or improve."

China Construction Bank Corp. recorded HK$33.4 billion ($4.3 billion) of net southbound purchases in the five months through September, while Industrial & Commercial Bank of China Ltd. lured HK$17.8 billion of net inflows. That helped the two stocks to jump 12 percent in August alone. Other companies favored by mainland buyers included HSBC Holdings Plc and Tencent Holdings Ltd.

The rally has sapped the relative appeal of Chinese banks's H shares. The big four traded at 5.3 times reported earnings on average in Hong Kong on Thursday, compared with 5.8 in Shanghai. Just six months ago, the gap was 1.2 percentage points. The equities' dividend yield in Hong Kong has dropped to 5.8 percent from as high as 7.1 percent in May.

Construction Bank and ICBC have now fallen more than 6 percent from their September highs, exceeding the 5 percent decline by the Hang Seng Index.

"The valuation gap is not very attractive," said Iris Tan, a Shenzhen-based analyst at Morningstar Inc. who's among the top three forecasters for five H-share banks. While there are still some opportunities in joint-stock lenders like China Citic Bank Corp., "investors tend to have a stronger preference for large banks due to their strong deposit base and much smaller shadow bank exposures," she said.

Caution over Chinese banks grew following Postal Savings Bank of China's September initial public offering, the biggest worldwide since Alibaba Group Holding Ltd.'s in 2014. With the help of state companies that acted as cornerstone investors, the Hong Kong offering was priced at at least 1 time book value, compared with the 0.87 average for H-share banks, fulfilling a requirement that state firms' IPOs be priced above net assets. Despite having a larger retail client base and higher credit quality than most of its peers, the stock has since plunged 9.5 percent.

While valuations are lower in Hong Kong than Shanghai, the city's bourse remains attractive for Chinese firms due to a long queue for mainland IPO approvals. Zhongyuan Bank Co. is planning a $1 billion first-time sale in the city, IFR Asia reported on Monday.

With mainland investors curbing their appetite for Chinese banks, global funds are unlikely to come to their rescue amid concern over the nation's $25 trillion pile of public and private debt. While the official bad-loan ratio is 1.75 percent, there's skepticism about the veracity of the reported figures, given overdue loans are often not being recognized as non-performing loans. Charlene Chu, a partner at Autonomous Research and former Fitch Ratings analyst, has said her work suggests the NPL ratio may be at 20 to 21 percent, or even higher.

"The cautious underweight is still the consensus" among international investors, said Ben Bei, an analyst at CIMB Securities Ltd. in Hong Kong.

--With assistance from Kana Nishizawa To contact the reporter on this story: Justina Lee in Hong Kong at jlee1489@bloomberg.net. To contact the editors responsible for this story: Richard Frost at rfrost4@bloomberg.net.