China’s Strong PMI Data Has a Dark Side for State-Owned Banks

BEIJING (TheStreet) -- Bully for the London bankers at HSBC whose preliminary July gauge of Chinese manufacturing activity Thursday turned markets upbeat about China.

Too bad for state-controlled bankers in China who, through mandatory cheap financing, are paying a steep price for the improved factory output underscored by the latest HSBC-Markit Economic Research flash Purchasing Managers Index data.

And it could be too bad for investors with stock in Hong Kong-listed, Chinese banks that trade over the counter such as Industrial and Commercial Bank of China (IDCBF), Bank of Communications (BCMXY) and China Construction Bank (CICHF). It's worth considering that analysts in China have lately turned bearish on state banks in general. Some analysts, on the other hand, say they like China Merchants Bank (CIHKY).

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Bank financing helped fuel the factory buzz reflected in July's flash PMI of 52, the highest in 18 months, up from 50.7 in June. HSBC and the government will separately report their final PMI figures in early August.

Markit chief economist Chris Williamson wrote that Chinese factory orders are rising faster than exports, suggesting a strengthening domestic economy. He also cited "several signs that production will continue to rise in August" such as "the amount of inputs bought by firms for use in production (which) showed the steepest rise for one and a half years as firms rebuilt stock levels."

Why are manufacturers restocking? In part because state banks are under orders to step up lending, cut borrowing fees and otherwise make it easier for companies - especially small- to mid-sized firms - to finance their businesses.

The push for easier financing is part of the government's "micro-stimulus" strategy aimed achieving or coming close to Premier Li Keqiang's goal of 7.5% GDP growth for 2014. The government has also stepped up urban infrastructure spending since the beginning of the year, and in recent weeks gave at least 30 cities the green light to relax housing market restrictions in order to encourage construction and higher home sale prices.

Beijing's moves are particularly designed to offset an 18-month slowdown for the real estate sector.

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The government's financing orders are "positive to near-term GDP growth but neutral on banks" in China because they'll hit fee income and undermine long-term asset quality, said a Merrill Lynch report Thursday.

The State Council, China's cabinet, recently told state banks to give more loan support to the agriculture sector and small- to mid-sized companies. The government's policy banks and smaller, commercial banks are expected to follow suit soon, Merrill Lynch said. Meanwhile, the government's central bank and banking regulators have adjusted rules to promote business and mortgage lending.

The state-owned brokerage BOC International warned Thursday of falling valuations for most China's banks, but recommended stock in China Merchants and Agricultural Bank of China (ACGBY). Haitong Securities is also recommending China Merchants.

Thanks to "the government's intention to maintain economic growth and a loose liquidity environment," China's financial system "has not seen the major crisis that the market expected over the past three years," BOC said. "However, the valuation of China's banking sector has continued to decline."

Loose liquidity is expected to continue through the second half of the year, BOC said, so barring a major property market crash "the downside risks of the banks' valuations should be limited."

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"However, if property prices and sales volume fall sharply, the banks' share prices may drop significantly," the report said.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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