One Trillion Reasons to Buy AgBank Shares

There are many reasons not to buy the newly-issued shares of the Agricultural Bank of China: China’s economy is slowing; the country’s property market remains in bubble territory; China’s stock market, one of the worst performing in 2010, is down 25 percent this year; AgBank’s vast network of 24,000 branches staffed by 440,000 employees is inefficient; and the fact that past credit decisions by the bank have resulted in staggering losses are but a few of the major ones.

On the other hand, I can think of at least one trillion reasons to buy the stock — $1 trillion is the approximate amount of money that AgBank’s 320 million customers throughout China have deposited with the bank. A bank’s ability to gather deposits is always considered to be a key determinant of its value, particularly in a country where regulated interest rates provide banks with a cheap source of funding. In this category, there are few banks in AgBank’s league.

In China, the maximum rate of interest that a bank can pay on deposits is regulated, similar to the way interest rates were regulated in the United States until the early 1980s. (Remember the coffee pot your mother got when she made a large enough deposit? By law, the bank couldn’t pay her more interest, but it could give her an appliance!) For a demand deposit, the interest rate that banks may pay is currently capped at 0.36 percent in China. Depending upon maturity, banks may pay progressively higher interest rates, but the maximum rate is 3.6 percent for a 60-month time deposit.

At the same time that it fixes a bank’s cost of deposit, though, China also places a floor on the interest rate that banks may charge borrowers, effectively guaranteeing a “spread” between what banks have to pay for funds and what they can earn making loans. At today’s minimum loan rate of 5.31 percent, the spread ranges from 2.41 percent to nearly 5 percent. Quite literally, being in the banking business in China today is like having a license to print money. With 320 million customers and 24,000 offices across the country, AgBank has the infrastructure in place to keep growing its deposits, and therefore its income stream.

For foreign investors, this virtually guaranteed income stream becomes an interesting currency play. As the yuan rises in value, so does the underlying value of the income stream made possible by AgBank’s $1 trillion of low-cost deposits.

Despite criticism by many that China is not moving fast enough to re-value its currency, there is little doubt that the renminbi will appreciate against the dollar in the months and years ahead. From July 2005 when China released the yuan from its peg to the US dollar, to July, 2008 when the dollar peg was re-instituted in response to the global economic crisis, the yuan appreciated by approximately 21 percent against the dollar. If the yuan is undervalued by as much as 25 to 40 percent as many believe, AgBank’s income stream is almost guaranteed to be worth considerably more in dollar terms in the coming years.

Moreover, investors who buy AG Bank shares are buying shares at a discount compared to those of other Chinese banks. AG Bank’s Shanghai price represents 1.55 times book value as estimated by the IPO underwriters. That compares with 1.82 times for Industrial & Commercial Bank, 1.77 times for China Construction Bank, and 1.51 times for Bank of China. In Hong Kong, AG Bank’s offer price represents a 17 percent discount to the average among the three rivals.

What if AgBank’s loan officers take those deposits and make a bunch of bad loans? Many analysts consider AgBank to be the worst managed of China’s big four banks, so this is a very real concern. Even in this event, investors have downside protection. Heads may roll if bad loans are made, but the government is too concerned with the hundreds of millions of ordinary Chinese citizens who have deposited their hard earned savings in the country’s banking system to let any of the country’s major banks fail. That is the reason why, as recently as 2008, the government paid full value for 816 billion yuan ($117 billion) of bad loans on AgBank’s books, about a quarter of the bank’s total.

Despite the negative economic news that has derailed many IPO’s recently, AgBank’s huge deposit gathering infrastructure makes the bank a big beneficiary of regulated interest rates and future appreciation of the yuan. Buying AgBank’s shares gives foreign investors a way to benefit from both, which is one of the reasons, I suspect, that the bank has been able to pull off such a large IPO in these uncertain times.

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