Off-balance-sheet lending has exploded in China, and deep problems are starting to turn up. Who will make good when loans go bad is a great unknown that could sting the global economy, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

China's banking crisis continues to worsen. But because this is a banking crisis that doesn't—on paper— involve China's banks, it's hard to say what the extent of the fallout will be.

To see the crisis, you have to look past the official balance sheets of China's banks to the gray areas of China's financial industry, because what's hiding there could have a broad economic consequences.

In January, China's four big state-owned banks issued a combined 370 billion yuan (about $59 billion) in loans. That was a huge increase in lending from the 163 billion yuan total in January, and puts China's banks on an unsustainable pace.

China's big four banks account for about 30% to 40% of lending in a typical year, so January's activity puts China's banks on a pace for somewhere between 11 trillion yuan ($1.7 trillion) and 15 trillion yuan ($2.4 trillion) in lending for 2013. Lending always surges in the weeks before the Lunar New Year holiday (which was Sunday), however, as businesses stock up on cash.

The People's Bank hasn't set a lending target yet for 2013, but it's expected to be in the vicinity of 9 trillion yuan ($1.4 trillion) as the Chinese government works to—modestly—stimulate the economy. That would still be a big increase from the 7.5 trillion yuan target in 2011, when the Chinese government was tightening credit to slow the economy, or from the 8.3 trillion yuan banks lent in 2012.

But although this data on bank loans and bank lending are still among the most followed indicators of government policy on economic growth, as well as People's Bank intentions on expanding or contracting the money supply, they capture less and less of the Chinese market for loans.

China's "total social financing" indicator shows bank loans hitting a record low of 52.1% of total lending in 2012. Ten years ago, bank lending made up 92% of total social financing. Estimates are that bank lending will drop below 50% in 2013.

It's not that bank lending has collapsed—in fact, it has been remarkably stable within the up-and-down channel set by government policy. Instead, there's been explosive growth in "trust loans" (a sixfold increase in ten years) and in bond offerings (up 64%).

And that's the shadow hanging over China's recovery and the global economy, which is why investors here need to keep an eye on it.

Beyond China's banks
What are trust loans, and what's behind their explosive growth?

Trust loans are essentially off-the-balance-sheet bank loans. While the interest rate that banks pay depositors—currently 3.25%—is set by government regulators, banks and savers can get around the restrictions by using wealth-management accounts that move money collected by banks off bank balance sheets and onto the balance sheets of trust companies and securities firms.

In a typical arrangement, the bank contracts with a trust or securities company. The trust or securities company uses the money from the bank to buy notes issued by the bank (backed by bank loans, for instance) or to buy other assets (loans from financial companies attached to local governments, for example).

The trust or securities company is paid a fee—0.3% on average at the beginning of 2012—by the bank. Savers get a higher interest rate—4.5% to 5%—than they'd get from a regulated account at a bank. (With the government's inflation target at 4%, the difference between regulated yields of 3.25% and wealth-management yields of 4.5% could be the difference between losing ground to or keeping ahead of inflation.)

Banks are able to keep customers happy and to move loans off their balance sheets and onto those of trust companies and securities companies. (Bank loans sold to trusts and securities companies don't count against a bank's lending quota.)

As you might expect, the advantages of this system of higher rates for savers, fees for trust companies, and off-balance-sheet lending for banks has led to an explosive growth in the assets at trust and securities companies. Each of the four big state-owned banks handles an average of 2 trillion yuan a year in off-balance-sheet business—roughly equal to the bank sector's formal government lending quota.

Efforts by government regulators to limit the percentage of assets that trusts could take from bank wealth-management accounts have worked to push these off-balance-sheet yuan to less-regulated securities companies.

Assets under management by Chinese securities companies rose to 1.2 trillion yuan at the end of December, up from 280 billion yuan at the beginning of 2012, according to data from the Securities Association of China. About 80% to 90% of that total, according to estimates put together by Bloomberg, was tied to banks and wealth-management accounts.

Estimates are that up to 30 trillion of the 66 trillion yuan in credit extended to all formal borrowers in China lies outside the banking system.

NEXT: The 2 Big Risks

. |pagebreak|

The 2 Big Risks
There are two big dangers in this situation.

First, there's a good chance that in reaching for 5% yields (instead of 3.25%), investors and savers have taken on more risk than they realize, and that this additional risk will rise up to bite them.

The promise of the wealth-management accounts to savers is strikingly similar to that during the mortgage-backed asset/global financial crisis: We have figured out a way, the banks, the investment trusts and the securities companies are saying, to pay you higher yields without requiring you to take on more risk.

Think about it: How are banks, profitable with controlled payouts of 3.25%, able to pay 5% and make the same or greater return? (They wouldn't be so assiduously pursuing this wealth-management business is if paid less than their existing business.)

A big part of the answer is that the banks are using the money they take in from wealth-management accounts to make loans at 6%, 7%, and even 8% by buying bonds sold by city governments.

In the first nine months of 2012, China's Caixin magazine reports, urban bonds raised 471 billion yuan for 401 projects. That was more than the 425 billion yuan raised in all of 2011. Half of all urban bonds issued on secondary markets, Bloomberg estimates, were bought by banks with money from wealth-management accounts.

These bonds are supposed to be low risk. They're guaranteed by local governments, and the assumption is that the national government stands behind these urban bonds (as in the US, the mortgage market was assured about the paper issued by Fannie Mae and Freddie Mac).

In another parallel with the global financial crisis, China's National Association of Financial Market Institutional Investors has raised questions about the high grades given by credit-rating companies to many of these bonds.

So far, the failure rate on these bonds has been extremely low—near zero. But that's likely an artifact of the very recent surge in issuance, since many of these bonds haven't been around long enough to fail. The effects of a collapse in the real estate market in many Chinese cities in 2010 and 2011, which devastated finances for local governments and the projects they financed, haven't fully worked their way into the market for these bonds.

Second, it's unclear what parties are on the hook and for how much if these products go bad. (Again, this reminds me of the derivative markets in the United States and Europe in the financial crisis, where no one knew for sure what the net positions of the big players were.)

Until very recently, the assumption and practice has been that trust companies do not let trust products default on investors. The trust company doesn't have a legal obligation to pay investors in the case of a default, but until recently a trust company would make sure investors were repaid, even if a borrower could not pay the trust what it owed.

In the competitive trust market, no trust company would risk its reputation by letting investors take a hit. Consequently no one in China has ever lost money on a trust investment. (The trust sector has assets of 7.4 trillion yuan.) Payments have been late, but they've always been made within the six-month grace period written into a trust contract—even if the trust company had to dip into its own pockets to pay investors.

But this appears to be changing. In January, Citic Trust, China's largest trust company by asset value, refused to guarantee payment to investors when two trusts that it sold ran into problems. Instead, Citic has moved to sell the collateral put up by borrowers and has told investors that selling the assets of the borrower was the last hope that investors would get their money back.

In one case, Citic has used a court order to put up for sale the land owned by property developer Shieldspear Group to recoup some of the 710 million yuan raised in 2010. In another, Citic has threatened to sell the collateral of a producer of steel coatings if the company can't bring its payments up to date.

In my opinion, the move by Citic is a reaction to what that company worries is the beginning of a wave of defaults that could overwhelm the trust sector's ability to make good investor losses out of the pockets of trust companies. This will open up a legal can of worms that China's courts and financial regulators are unprepared to deal with.

The courts will have to decide if trusts were sold with any implicit guarantee. And whether trust companies can be sued in the event of a default by a borrower. And how much legal responsibility flows back to the bank through affiliated trust companies and through investments that the bank sold to the trust company. (Complicating all this will be the clout of the politically connected wealthy who have bought wealth-management products.)

The big question is what regulators will do with all these off-balance-sheet assets. If banks were required to put them back on consolidated balance sheets, a rise in defaults could damage bank capital ratios just when China's banks are trying to meet new international capital requirements and to make further inroads into global financial markets.

Anything that required Chinese banks to buttress their capital requirements would reduce the money supply just when China was trying to increase the money supply to stimulate the economy.

The Potential Cost
On the precedent of past financial crises, and especially the Asian currency crisis of 1997, I think the odds are very low that Beijing will do anything that raises the bad-loan ratio at China's banks or that might force them to raise significant capital at this point in China's economic recovery.

In the aftermath of the Asian currency crisis, Beijing's financial regulators buried massive bad loans by creating new financial companies that bought the bad debt of China's banks and took it off the banks' balance sheets. Then, through complex transactions, these new financial entities buried that bad debt.

That effort wasn't cost-free. China's growth rate for gross domestic product dropped from 9.3% in 1997, before the crisis hit the country's financial system, to 7.8% in 1998 to 7.6% in 1999 before rebounding to 8.4% in 2000.

This time, China is starting from a weaker economic position—China's growth rate bottomed at an annual 7.4% rate in the third quarter of 2012—in a world where developed economies are still digging out from a severe financial crisis and the subsequent Great Recession.

And currently, China has much bigger ambitions for its banks on the global financial stage and for the global role of its currency. Those ambitions would be damaged by an Asian currency-style crisis—and fix.

I don't see a Chinese banking crisis crashing China's economy in 2013 any more than it did in 1997. But it certainly wouldn't be good for the share price of China's bank stocks, or for the important real estate and financial sectors in China's stock markets. And even if it knocked a percentage point or two off China's economic growth, that's growth that the global economy sorely needs.

I'd watch carefully to see how China's banking crisis develops and how serious it might become.
In doing that observing, I'd pay attention to bad-loan ratios at China's banks—the official reported rate of 2% or less is clearly understated, so I'd pay more attention to whether it starts to rise than to its absolute number.

I'd pay even more attention to companies in China's non-bank financial sector, such as Citic Securities and Haitong Securities—and their related trust companies—to see how much of the problem they recognize and how they cope with it.

And finally I'd look at moves by the People's Bank to see if China's central bank is getting nervous about bank reserve requirements. If the People's Bank should start to raise reserve requirements even while China's efforts to increase economic growth are unfurling, then I think we've got signs that the banking crisis is bad enough to worry Beijing.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. All my personal portfolio is invested in the mutual fund I manage, Jubak Global Equity Fund. That fund may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of September, see the fund’s portfolio here.