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China's banks: The only certainty is uncertainty

August 11, 2011: 8:45 AM ET

Figuring out the health of Chinese banks is a blind man's game, but the risks to the sector are unmistakably piling up.

By Katherine Ryder, contributor

FORTUNE -- It's a familiar story to Americans, but now it may be unfolding in China.

From 2008-2010, China's largest banks made scores of loans to local governments and state-run companies. Exports had fallen in the wake of the financial crisis, so the government wanted to create jobs and boost local demand. As a result, developers erected high rises and shopping malls across the country and the Chinese economy grew at roughly a 10% clip. But some analysts and ratings agencies assert that lending standards weren't strict enough. Too many bad loans were made, they say. Financial reform didn't come fast enough.

Last week, Liu Mingkang, the chairman of the China Banking Regulatory Commission, announced that a recent round of stress tests proved that Chinese banks could handle up to a 50% drop in property prices. Banks, which fund themselves mainly through deposits, are growing their profits at 20% per year. Though the economy appears to be slowing, it is still estimated to grow around 9% this year, which could theoretically offset any losses incurred by bad loans.

Liu may well be right, at least in looking at the sector over the long term. Though some analysts balk at the lack of stress in the stress tests, the Chinese central bank essentially backs all deposits. Banking in China is still in its infancy, with huge upside potential. Few consumers use credit cards yet, which represents a major opportunity for financial institutions. And as China tightens its monetary policy, lending margins are tilting even more in favor of the banks.

In the near-term, however, the bears may win out. Three areas of concern stand out. The first is China's overly managed interest rate policy: Banks are only allowed to offer its customers a maximum 3.5% interest rate on one-year deposits. With China's inflation rate currently above 5%, Chinese companies and consumers investing in banks face the prospect of a negative real savings rate.

Three areas of concern

As a result, companies that want better rates of return are looking at trust companies, which are unregulated and have caught the wary eye of Chinese authorities, particularly as the government has attempted to cool the countrys supposedly overheating property market. The China Securities Journal reported that trusts invested about RMB 207.8 billion ($32.4 billion) in the property market in the first half of the year. The rate at which they're lending is upward of 20%, compared to the banks' 6.7%, a rate at which it is easier to roll over bad loans.

The extent to which these trusts will have a major effect on the health of the Chinese banking industry is a major area of disagreement between China's bulls and bears. The bulls say that trusts represent healthy interest rate competition, a way for corporations to put pressure on regulators to liberalize interest rate policy. The bears argue that trusts are an example of excessive credit in the aftermath of years of reckless lending, both of which will come back to haunt the Chinese economy over the next few years.

Another source of worry is China's Asset Management Corporations (AMCs), which present more measurable off-balance-sheet loan risk. In the late 1990s, the Chinese government needed a place to dump bad loans left over from the Asian financial crisis. AMCs were created to serve this purpose. But in 2009, instead of paying off the rest of the debt, the government rolled over all the AMC bonds another ten years. The depth of the potential losses in these vehicles remains unclear.

A final source of concern is the continued use of collateralized lending. Much of this collateral is typically in the form of land or property. In an economic downturn, Chinese banks might face liquidity issues, says Jason Bedford of KPMG, a consultancy.

All the same, Bedford thinks the fears about the bad loans lurking off the balance sheet are overblown. "I'm getting one or two phone calls per week from overseas asking me about this topic," he says, specifically referring to a July report in which Moody's (MCO) said the Chinese government may have underreported loans made to local governments by half a trillion dollars. Bedford says his own analysis doesn't support some of the claims in Moody's report, particularly those relating to credit risk.

And herein lies the problem in assessing Chinas banks: figuring out whose data to trust. The Chinese banking system trades disproportionately with itself, and much of the critical information about bank stability is colored by the data sources.There are so few foreign companies trading within China's capital markets that critical pieces of data can never be corroborated. No one knows whether asset prices are accurate, whether banks liabilities are accurately reported, or even the true depth of the lending market.

The only way to judge, then, is by examining it all -- banks' financial statements and information from national statistics bureaus, keeping in mind the motivations of the ruling party. Though the Chinese government is terrified of systemic risk, it also needs to control its banks in order to promote its ultimate vision of a harmonious society. This cause presents risks of its own.

A recent report from Roubini Global Economics says the most critical concern for Chinese banks is the recent deterioration of credit standards, but that a major side concern is the state's refusal to stop using the commercial banking sector as its personal piggy bank.

Though China's banking system has undergone decades of rapid and impressive growth, underlying cracks are starting to appear. China may have learned from America's mistakes, but it will inevitably make some of its own.

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