My Blog

August 5, 2008

Falling oil prices in the international markets haven’t helped local stock markets as much as they had in the recent past.  Oil fell earlier today to below $120 a barrel for the first time in three months, but the SSE Composite nonetheless dropped 51 points, or 1.9%, to close at 2690.  As in the recent past, the decline was led by property developers and brokers, which is particularly striking since we received confirmation today of last week’s rumor that the PBoC would relax the lending caps by 5% for national commercial banks and by 10% for local commercial banks (who are presumed to be more likely to lend to the struggling SME sector).  This means they can lend up to 105% or 110% of their lending caps, which should be good news for funding-pressed property developers.

For me however the most interesting news today was a report by Bloomberg on the possible acquisition of Germany’s Dresdner Bank by China Development Bank, the largest of the Chinese policy banks.  According to the article:

China Development Bank is competing with Commerzbank AG to buy Allianz SE's Dresdner Bank, Germany's third-largest lender by assets, three people familiar with the matter said.

China Development Bank, which funds the nation's public works projects, has conducted due diligence on Dresdner Bank in Frankfurt, said the people, who declined to be identified because they aren't permitted to publicly discuss the matter. The 23.3 billion euros ($36.6 billion) Allianz paid for Dresdner Bank in 2001 is more than six times the biggest overseas acquisition by a Chinese company.

It is probably unlikely that CDB actually makes the purchase.  Aside from the fact that the CDB, and Chinese institutions in general, have lost a lot of money so far in their acquisitions of foreign financial institutions (Bloomberg reports that their $19 billion of investments are now worth only $12 billion, including a $1.7 billion loss on CDB’s $3 billion purchase of a stake in Barclays), European governments have been very reluctant in the past to permit the acquisition of major domestic banks by foreign banks, even when the foreign bank is European. 

The fact that CDB is owned by a non-European government, and a government of a country that is largely, and increasingly, distrusted by Europeans, makes this a pretty tough transaction to approve politically.  Still, the fact the CDB is even doing due diligence on the deal must provide a frisson of thrill to investment bankers everywhere – it certainly indicates the global ambition of Chinese banks. 

If the deal were to happen it would be a very interesting transaction, not least, in my opinion, because of its impact on the valuation of CDB.  In the January/February issue of the Far Eastern Economic Review, I published a piece (“Buying Into China’s Volatility”) that uses an option framework for understanding the high valuations placed on Chinese banks by the international markets.  I argued that the very high valuations reflect not investor perceptions that the banks are in good shape but rather the desire of investors to bet on the expected volatility of the Chinese economy. 

In that discussion, which was extended in four consecutive October entries on my blog, I pointed out that insolvent financial institutions are usually the most effective vehicles for optional plays on an economy that is changing rapidly.  This fact explains the very high market valuations placed on troubled banks, not just in China but in a whole host of other developing countries experiencing major economic reforms (my own experience came from advising the Mexican government on the privatization of its largely insolvent banking system in 1990-92).  Insolvent or barely solvent bank share prices are not “encumbered” by intrinsic value (the excess of asset values over liabilities) and consist purely of time value, which is highly sensitive to changes in expected volatility.

The option framework makes two useful predictions.  First, and most obviously, since bank share prices are not anchored in intrinsic value, like they must be for highly solvent companies, their share prices will be extremely volatile.  This is because they will largely reflect changes in time value, whose value is set almost wholly by changes in expected volatility (and intrinsic value is usually far less volatile than time value).

The second prediction, which emerges from the first, is that if a Chinese bank were to make a large acquisition of a foreign bank its stock price would drop dramatically.  This is because a large acquisition abroad would significantly reduce the expected volatility (diversifying assets and earning streams always reduces expected volatility).

Since CDB does not have outstanding stock (it is preparing for an IPO), we will not be able to see the direct impact of a Dresdner acquisition on its share price if the acquisition does go through, but I would predict that when CDB stock is finally made available in the market, after its IPO, it will trade at a much lower multiple if the acquisition has been completed.  Investors will explain that lower multiple by complaining that unlike with the other large Chinese banks, with CDB they are not getting what they want – a pure play on the growth of the Chinese economy.

Note that I am not simply predicting an averaging out of valuations.  If a Chinese bank valued at three times book acquired an equally large foreign bank valued at two times book, it would not be a surprise if the new bank traded at less than three times book – say 2.5 times book.  What I am actually predicting is that the new entity will trade at a far lower valuation than the average of the two because of the impact of diversification on the very high time value implicit in the Chinese bank’s share price.  Intrinsic value for the two entities will actually rise (diversification usually increases intrinsic value because of its positive impact on financial distress costs), but time value will decline (diversification always harms time value).  Since Chinese bank share prices consist mostly of time value, the loss in time value will be much greater than the gain in intrinsic value, and the net impact will be a big loss for shareholders.

That doesn’t mean, however, that the CDB’s biggest shareholder, the government, will object.  Aside from the political considerations, the government has a very complicated economic relationship with its banks.  It is effectively the guarantor of the banks (or, in option terms, it is short a put option on the underlying assets), so that as guarantor it benefits both from the increase in intrinsic value and the reduction in time value brought about by diversification.  Reducing banking volatility is always a net benefit for the government – it is only the outside shareholders who will suffer.

Comments (6) for "Will China Development Bank ...

Very interesting post. I had to think about what you said for a while to wrap my brain around it. I think it's worth noting that while an acquisition of Dresdner by CDB will make creditors and guarantors of CDB (including the Chinese government) better off, it will probably make creditors and guarantors (including, at least implicitly, the German government) of Dresdner worse off. So there are legitimate, non-political reasons that the German government would oppose an acquisition of a German lender by a foreign bank whose long-term solvency is in question. By Richard Warfield - 8/5/2008 7:23 AM

Richard, I think the guarantee by the Chinese government of CDB's obligations means that even if the bank has serious asset quality problems its solvency is relatively secure. I would also imagine that Dresdner would be held as a separate entity via a holding company structure and its credit risk separated from that of CDB. In that case the CDB onwership would reduce risk, not increase it. By Michael Pettis - 8/5/2008 3:42 PM

I suspect that oil prices have lost their edge. Just a day or two ago, oil dropped and the US market did nothing. It took the Fed to state that they were not going to raise the lending rate to cause a 3% jump in all markets. My interpretation of the Chinese market is that it is playing off the US markets and the concern is of a global slowdown. If the US consumer comes back, then the Chinese markets will do better. If not... Then more of the same. jegan ;-) By Unknown - 8/6/2008 1:07 AM

Professor, I agree that CDB would not be permitted to default on its liabilities; however there is at least a reasonable probability that it might become insolvent in the sense that the value of its liabilities come to exceed the value of its assets (excluding the Dresdner stake). If this were to happen, wouldn't the management of CDB (and the Chinese government) have a strong incentive to find a way to extract value from the high-quality assets in the Dresdner subsidiary in order to prevent bankruptcy? This could be done by paying a large dividend to the parent, guaranteeing some of the parent's liabilities, etc. The only limitations would be those imposed by German banking regulations. By Richard Warfield - 8/6/2008 1:59 AM

My worry is that it is far from clear that Dresdner has better asset quality than CDB. Buying a bank is something you have to do very, very, very carefuly, and Chinese banks have tended to get burned on this. The thing that you always have to keep in mind is why is the guy at the other end of the deal willing to sell to you. I known someone in the field that mentioned that the very fact that a foreign government would let you take control over a bank should make you think twice about buying it. The better the shape of the bank, the less likely that you will be able to get any of it. By Twofish - 8/6/2008 1:29 PM

Ha ha I think you're right, Twofish. Just like I'd never want to join a cub that would have me as a member, I would never want to buy a large foreign bank whose government regulators would want me to own it. By Michael Pettis - 8/6/2008 1:48 PM