China is creating bank capital out of thin air--and that's not good

08/31/2010 12:46 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com



You’ve got to give China’s most recent effort to increase the capital of China’s largest banks big points for chutzpah.

That’s not exactly an endorsement for these banks as investments, however. Or of the soundness of China’s troubled banking system.

On August 24 Central Huijin Investments, which is the domestic arm of the government’s sovereign investment fund China Investment Corp., sold $6 billion in bonds in the first of a series of bond sales designed to raise $27 billion that Central Huijin will then invest in the country’s big state-controlled banks. The goal, laudable in itself, is to increase the capital reserves at these banks.

Only one odd twist: Figures show that about 80% of the August 24 bond offering was purchased by those very same state-controlled banks. Central Huijin, which owns a controlling interest in such banks as China Construction Bank, Bank of China, and Agricultural Bank of China, had ordered the banks to buy bonds in the offering.

So while it looks like the banks are getting new capital to hold against their increasingly large portfolios of bad loans, in reality the banks will be getting their own money back.For accounting purposes the money will show up as an increase in capital on the banks’ books.

And assets will get created at both Central Huijin and the big banks without any new capital at all entering the banking system.

To return the favor Central Huijin has said that it will subscribe to the rights offerings of Bank of China, China Construction Bank, and Industrial and Commercial Bank of China. The sale of shares to existing investors through those rights offerings is intended to increase capital at those banks.

I assume that at some point that capital will get recycled back to Central Huijin when these same banks buy the investment fund’s bonds.

Regulators have required banks to keep more capital in reserve as a way to lessen risk in China’s banking system.

The game of musical capital that sends capital from the investment fund to banks and then back to the investment fund certainly does increase bank capital—on paper.

It’s pretty clear, though, that rather than cutting risk in the system, this game increases it.

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