Will China Mean An Annus Horribilis For HSBC Holdings plc And Standard Chartered PLC In 2016?

I reckon some of the FTSE 100‘s big banks are looking like big bargains for 2016. But HSBC Holdings (LSE: HSBA) and Standard Chartered (LSE: STAN) aren’t among them. And the reason? In one word, China.

In 2014, around 80% of HSBC’s profits came from Asia and that was mainly Hong Kong, China and economies dependent on them. And at Standard Chartered the figure was similar, again with China and its dependencies making up the bulk. But now? China is in trouble.

A few years ago few of us really understood the extent of the structural problems there. I know I certainly didn’t, and I thought the government’s growth target of 7% per year for the next few years was reasonable. After all, China was opening itself up to private enterprise and the grip of central control was slowly-but-surely loosening.

But no…

Except it wasn’t. Now that economic reality isn’t going as well as the people in control ordered, they’re tightening their grip again. Once the party leaders were extolling the virtues of the country’s fledgling stock market. But now they’re blaming the free market enterprise leaders for a stock market bust that was inevitable after the failure of state-ordered attempts to keep the surges going.

Guo Guangchang, often spoken of as “China’s Warren Buffett“, was once lauded as a champion of China’s push for wealth. But he’s now seen as one of the chief scapegoats for 2015’s stock market crash and has been facing lengthy police questioning.

The BBC’s China editor Carrie Gracie made the point this week that “no economy has achieved high income status with a closed financial system“. And though China’s centrally-controlled capital allocation and state-sponsored stimulus have been responsible for recent annual growth in excess of that 7% per year, it’s hard to avoid the obvious conclusion that capital can’t be allocated efficiently by such means and that centrally-planned growth is just not sustainable.

And that points to the real drag on China’s economy – its state owned enterprises (SOEs). They’re horribly inefficient behemoths, financed in part by forced loans from the country’s banks, bogged down by unserviceable debt, and unable to compete in a free market environment. But getting rid of them isn’t on the table, as they’re what give Beijing’s rulers the economic control that keeps them in power.

Giving up power?

I can’t see the Chinese government accepting the need to wind down its SOEs any time soon, despite the obvious fact that the move from state ownership to private ownership has stimulated genuine long-term economic growth in every country that has tried it. But until it happens, any long-term 7% annual growth target remains an illusion.

And in the meantime, we really can’t tell how much toxic debt (from both state-directed lending and China’s still-overheated property market) banks like HSBC and Standard Chartered really hold. Right now I wouldn’t touch any company heavily invested in China, and certainly not the banks.

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Alan Oscroft has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.