China Banks May Need ‘Sticky Tape’ to Hold Together

China's debt pile if growing fast despite years of efforts to contain it, a Reuters analysis shows.
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Sticky tape and chewing gum may be what's needed to hold Chinese banks together as they learn to operate in an environment of slower economic growth and generally tighter liquidity conditions, says one banking analyst.

Although inter-bank funding costs for China's lenders have fallen back this week after last month's unprecedented credit squeeze, concerns about future money supply continue to pressure banking stocks in Shanghai and Hong Kong.

(Read More: Is China Right to Brush Aside a Credit Squeeze)

"I just hope there's enough chewing gum and sticky tape to hold things together in the Chinese banking sector in the next couple of years," Mizuho Securities Asia's Banks Analyst Jim Antos told CNBC.

"The liquidity crisis that we've just had shows how difficult it is for the regulator in China to be managing for a lower growth scenario. They don't have experience for this and it was a blunder to have repo rates go up to 20 percent," he said.

Antos was referring to a spike in short-term borrowing rates in China's money markets on June 20 that the central bank tolerated in what was widely seen as a message to local lenders to rein in risky lending practices.

(Read More: O'Neill vs. Faber: Is China Liquidity Crunched?)

The key seven-day repo rate, viewed as a good indicator of market liquidity, was at about 4.25 percent on Wednesday, its lowest level since late May and down from a record high hit above 10 percent last month.

Feeling the Pain

Still, Chinese banking stocks continue to face pressure with the big four banks – Industrial and Commercial Bank of China, China Construction Bank, Bank of China and Agricultural Bank of China down 1 to 2 percent on Wednesday.

Smaller to mid-sized banks that are more vulnerable to tight liquidity conditions also remain on the back foot. China Minsheng Bank for instance is down roughly 20 percent from where it stood a month ago.

Analysts expect China's smaller banking stocks to underperform their bigger peers in the months ahead.

(Read More: Goldman Slashes Target for China Stocks)

According to Bernstein Research, the weighted-average performance of Hong Kong-listed Chinese banks was minus 7.9 percent in June – some 80 basis points below the broader Hang Seng stock index.

"As much as [bank] valuations are low and the dividend yield is high, for instance Bank of China has a dividend yield of 8.5 percent, you can't find investors interested," said Antos. "And why is that? It's because there's too much capital risk here, there's too much uncertainty, there's too much regulatory risk."

Manpreet Gill, senior investment strategist at Standard Chartered Bank, said that while there was value in Chinese banking stocks, he agreed that there were reasons to be cautious short-term.

(Read More: China Is Right to Tame Credit Growth: Moody's)

"Long-term, the presence of value can't be denied. But when you have policymakers bearing down on liquidity and keeping that very tight, ultimately the macro backdrop is not as supportive so we would be selective," he said.

Recent comments from Beijing's leaders suggest they are willing to tolerate a slower rate of economic growth as long-term reforms take place. That's just one more headwind for Chinese banks, said Gill.

"They [Chinese banks] are cheap but are they really cheap when you factor in much slower growth or the direction policymakers are going in? So the risk-reward is more attractive outside the state-owned sector and that's where we would be going in to," he said.

- By CNBC's Dhara Ranasinghe; Follow her on Twitter: @DharaCNBC