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The only way to avoid a financial crisis in China is for that government to kick-start growth. And that would be good for China’s banks and for investors—for a while, writes MoneyShow’s Jim Jubak, also of Jubak’s Picks.

What country does this describe?

  • The country’s banks are short of capital and will have to go to the financial markets to raise more this year—and in 2013.
  • Bank balance sheets have ballooned as a result of lending to real-estate developers.
  • Everyone believes that banks’ official accounts seriously understate the number of bad loans on their books.
  • And, finally, it’s just about impossible in this country to separate bank and government finances.

Spain or Italy? Of course. And you can work your way around Europe adding other names to the same list of guesses.

But the country I had in mind was China.

China’s banking problem isn’t as far along as those in Europe. Notice that I’m calling it a "problem" rather than a "crisis." But China’s banking sector is headed toward a crisis—and the government’s efforts to head off that escalation will be a major driver in China’s economic and monetary policy this year and next.

Want to understand how much stimulus Beijing will pour on its economy—and therefore whether you should be putting money into Chinese stocks or taking it out (and when)? Take a long look at China’s banks.

China’s Money Mess
If you understand the nature of China’s banking problem, you’ll understand why I believe that China’s government will move sooner rather than later, and more aggressively rather than more moderately, to stimulate China’s economy.

In the short run, China simply can’t afford to let a slowing economy make the problems in its banking sector worse. In the long run? Ah, that’s a very different question with a much more worrisome answer.

Let’s start with the strangest manifestation of the problems in the sector: the need of China’s banks to raise a huge amount of capital. In the past 12 months, according to Citigroup (C), China’s seven biggest banks have raised $52 billion in capital. Citigroup estimates that the banks are looking to raise an additional $18 billion in capital in the next few months.

To put that in the context of the Euro debt crisis, the $70 billion in capital raised or projected to be raised by China’s biggest banks compares with the $84 billion that the Irish government needed to recapitalize its banks, and the projected $130 billion to $160 billion that Bank Paribas recently estimated might be needed to recapitalize Spanish banks.

China isn’t yet in as deep water—especially when you remember that China’s economy is, at $11.3 trillion (at purchasing power parity, not the official exchange rate), about eight times the size of the $1.4 trillion Spanish economy.

But $70 billion isn’t a trivial amount of capital to raise, and the need by China’s banks to raise this much so quickly is startling. After all, China’s Prime Minister Wen Jiabao recently criticized China’s banks for making too much money.

In 2011, China’s four biggest banks reported a combined profit of more than $90 billion, a 25% increase from 2010. Agricultural Bank of China (ACGBY), the least profitable of the big four lenders, made $18.9 billion in 2011. That’s almost as much as JPMorgan Chase (JPM), the most profitable US bank, made that year.

So why do China’s banks need to raise so much capital—and how could they possibly be in trouble?

Following the Money
First of all, these tremendously profitable banks can’t use retained profits from their lending activity to build up capital against those loans. The banks don’t retain all of the profits, but instead pay out a high percentage in dividends.

In 2010, for example, when profits at the big four banks equaled about 500 billion yuan (roughly $79 billion), the banks paid out 144 billion yuan—28%—in dividends. Much of that went to the banks’ biggest shareholder, the Chinese government.

In the same year that the banks paid out 144 billion yuan in dividends, they also raised 199 billion yuan in capital on the financial markets.

In other words, China’s banks currently operate as a huge cash-transfer machine. China’s banks make profits lending at a large interest-rate spread—on average, 2.7 percentage points currently—because the People’s Bank of China has set a floor under what banks can charge on loans, and put a ceiling on what they can pay depositors. (The current 3.5% cap on interest on one-year deposits is running slightly below the most recent 3.6% rate of inflation.)

Much of that profit is recycled to Beijing, which in turn makes sure that the banks can raise capital in the financial markets by gently pressuring global institutions to buy into the bank offerings (with the understanding that doing business in China might be easier for institutions that participate) and by having state-owned companies step up to buy into the offering as well.

For the big banks, however, the system is starting to show some stress, because the balance sheets of these banks have been growing so rapidly. In March, China’s four biggest banks reported that total loans and other assets had climbed 14% in the first quarter, to $7.4 trillion. That’s roughly the size of the German, French, and UK economies combined.

Some of that balance-sheet increase results from the banks’ role in financing China’s $588 billion stimulus to combat the effect of the global financial crisis. Some comes from the sector’s participation in the country’s real-estate boom.

And some of it is more recent, as banks, in response to government worries about an economic slowdown, have again increased lending. New bank lending from the country’s big banks came to $160 billion in March, 21% higher than the consensus estimate of economists surveyed by Bloomberg.

And all those loans increasingly worry regulators. What if they start to go bad?

A Big Bad-Loan Problem
So far, official estimates of the bad loans in the portfolios of these big banks say this isn’t a problem. In fact, nonperforming loans fell in 2011 to 1.15% of loans, from 1.34% in 2010.

Nobody really believes that those figures accurately state the dimensions of the problem (just as financial markets and the Banco de España doubt that Spanish banks are accurately stating the amount of bad real-estate loans they hold).

Rather than fighting to improve bank accounting in China—a long and very difficult battle—Chinese regulators are pushing banks to increase their capital reserves. Under new rules, for example, banks will be forced to increase their capital levels to 11.5% of assets by 2013.

NEXT: Banks on the Edge

Tickers Mentioned: ACGBY, STD, BBVA, IDCBY, BACHY