China's Ponzi-Like Banking Policy

Hoping to lure investors into a massive bank IPO and other financial stocks, China is pouring cash into its banks. That could mean big profits—at first.

Maybe it isn't precisely a Ponzi scheme, but China's banking policy sure comes close.

China has made headlines this year by repeatedly raising the reserve requirements for its banks to a current high of 17%. The moves have raised fears among global investors that Beijing might overreact and slow China's growth enough to send the world economy reeling. But acting to raise reserve requirements has also given China's banking regulators a reputation for foresight and prudence that contrasts favorably with the inaction of the bank regulators in many developed economies who chose to sit on their hands while asset bubbles inflated.

That reputation may not be deserved, though.

Requiring banks to keep more capital in reserve, rather than lending it out, means China's banks have less money to lend. That means fewer loans for real estate speculators and developers, for the bosses of money-losing factories, for stock market speculation by individuals, and for Chinese corporations.

At least in theory.

In practice, however, China's banks have been told by the government to make almost as many new loans as in 2009, the year when everyone agrees bank lending ran amok.

How can they do that if they have to keep more in reserve? Simple. They raise capital in China's stock markets by selling new shares.

China Rebuilds a Great Pyramid

Here's what brings the scams of Charles Ponzi to mind: In the 1920s, Ponzi ran a scheme that promised investors a 400% return on their money from a plan to arbitrage the difference in postal prices between Europe and the United States for international reply coupons. Ponzi's plan never worked, but he was able to attract a huge pool of cash from his victims by paying out big returns to early investors with money handed over by later investors. The key to Ponzi's scheme was paying out investors' own money to attract more investors.

In the case of China, ask: Who would buy an offering of bank shares when the government, very vocally, is cracking down on lending? And when government officials are warning daily about the dangers of bad loans in the banking system?

No one, that's who—unless government-sponsored, controlled, or owned investment funds were putting up cash that promised investors huge future returns.

So, for example, China's national pension fund has invested $2.2 billion in the Agricultural Bank of China in the run-up to the bank's initial public offering. That IPO is expected to be the world's largest ever, at $30 billion. And, of course, it helps to sell shares if you can show that the government—via the National Council for Social Security Fund—has put money into the bank. (The national pension fund has money invested in all of China's largest publicly listed state-owned banks.)

After the $2.2 billion investment, the pension fund will be the third-largest investor in the Agricultural Bank of China.

The top two? China's Ministry of Finance and the country's sovereign wealth fund.

You think that a few investors might buy this IPO because they think the government won't let the price go down? They think the IPO game is fixed using government cash, and they want to play. (For more on China's interesting history of using government cash to bail out banks that are drowning in bad loans, see my March 11 column, "Is China Actually Bankrupt?")

And on the evidence, those investors aren't wrong. Even as the Shanghai stock market is suffering through a true bear market, with stocks down more than 20% from their November 2009 highs, China's IPOs have been delivering huge profits. So far in 2010, Chinese IPOs have raised $25 billion, three times more than IPOs in the US. In their first month of trading, Chinese IPOs have gained an average of 32%.

So why wouldn't a Chinese investor buy in an IPO from the Agricultural Bank of China or a stock offer from any other Chinese bank?

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When Less Really Is More

Of course, investors deep down might know that at least part of these gains are coming out of government coffers. But, as Charles Ponzi knew, the sight of enough cash can prevent most people from acknowledging what they know to be true.

Let's look at some numbers that explain the nature of China's Ponzi-like scheme.

In 2009, state-owned Chinese banks made 9.6 trillion yuan ($1.4 trillion) in new loans. That blew past the initial official target of five trillion yuan for new loans in the year and was twice as much as banks extended in new loans in 2008.

Everybody agreed that China had a problem. The economy finished the year growing at a 10.7% rate. Inflation has looked like it's getting ready for takeoff. Chinese real estate prices climbed in April at the fastest rate ever.

So the Beijing government has hit the brakes, in theory.

On May 3, the People's Bank of China raised reserve requirements an additional one-half percentage point, to 17%. The move was the central bank's third increase in reserve requirements this year. By requiring banks to keep more capital on hand rather than lend it out, the action of the People's Bank would remove 300 billion yuan ($44 billion) from the economy, Deutsche Bank estimated at the time.

And in reaction to the runaway lending of 2009, Beijing officials ostentatiously set a lower quota for new loans in 2010. Banks would be prohibited from making more than 7.5 trillion yuan in new loans in 2010. That was a reduction in new lending of 22% from 2009's total.

But remember, in 2009, government-owned banks lent out twice as much money as they did in 2008. The initial new loan quota in 2008 was just 3.6 trillion yuan, the same as in 2007. Toward the end of the year, Beijing raised the quota to about five trillion yuan.

So compared with a different benchmark, the 22% reduction in the 2010 quota from 2009's peak new loan level is actually a 50% increase from the final quota level in 2008 and a 108% increase from the original 2008 and 2007 quotas.

That "reduced," "tightened," and "restrictive" loan target for 2010 actually represents a huge level of new loans.

This presents two problems for China's banks. First, they are being asked to extend a huge amount in new loans at the same time they're being required to reserve more capital against these loans. Second, the runaway lending of 2009 has resulted in many banks, especially those in the rung just below the biggest state-owned banks, facing deteriorating capital ratios.

In first quarter reports filed with the Shanghai stock exchange, China Citic Bank (OTC: CHBJF), for example, showed that its capital adequacy ratio had fallen to 9.34% at the end of March, down from 10.14% at the end of 2009. The China Banking Regulatory Commission raised its minimum capital requirement for this class of joint stock banks to 10% at the end of 2009.

The solution to both of these problems is the same: Raise more capital. One estimate is that China's publicly traded banks will have to raise 200 billion to 300 billion yuan ($29 billion to $44 billion) in 2010. That figure doesn't include the $30 billion the Agricultural Bank of China plans to raise in its IPO. These banks are looking to raise nearly half of all the capital raised in the Shanghai and Shenzhen stock exchanges in 2009.

And the banks' need for more capital won't end with 2010. The Industrial & Commercial Bank of China (OTC: IDCBY) recently estimated that China's four big state-controlled banks that have already gone public will need to raise 480 billion yuan ($70 billion) in capital to meet regulatory requirements over the next five years.

Last in Line: China's Retiring Workers

You can expect Beijing to muster all of its considerable resources to make sure that these banks raise the capital they need. To see what I mean, take a look at the Agricultural Bank of China's IPO again: In addition to big investments from the national pension fund, the Finance Ministry, and the country's sovereign wealth fund before the IPO, financial analysts in Shanghai and Hong Kong say big state-owned companies such as China Life Insurance and Baosteel are likely to buy shares at the IPO.

With that kind of guarantee from state-controlled capital, you can bet that this IPO not only will go to market on schedule during what is a terrible market for the shares of most of China's companies, but also will rise in price after the first day of trading.
If I were an investor living in China, I'd want a piece of this game. After all, if the agency set up to be the retirement safety net for China's workers is putting those workers' cash into deals like this, why not take the profits now, since the fund itself might not be around to pay out in the future. (And the lesson of any Ponzi scheme is that the first investors get paid and the last investors take the losses.)

Plans call for the national pension fund to double its assets under management to two trillion yuan within five years. That promises plenty of cash to keep the capital markets open for China's banks.

Think the fund will do as well for China's retiring workers? For more on the almost dead certainty that no government will be able to afford to keep its promises to retiring workers, see this blog post.

At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column.

See the complete Jubak’s Picks Portfolio here.

Jim Jubak has been writing Jubak's Journal and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a 2008 book, "The Jubak Picks," and writer of the Jubak Picks blog. He's also the senior markets editor at MoneyShow.com.