Chinese Banks: World's Top Subprime Mess

09/25/2007 12:00 am EST

Focus: GLOBAL

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

Nicholas Vardy, editor of the Global Guru, says bad loans on the books of Chinese banks pose a far greater threat than US subprime mortgage debt.

Eye-popping market capitalizations notwithstanding, Chinese state-owned banks are a financial disaster that makes the US current subprime sector look like a rounding error. Estimates of bad loans on the books of China's banks by the leading rating agencies in the world range from 40% to 60% of China 's current GDP.

That would be the equivalent of about $5.6 to $8.4 trillion of bad loans in the US banking system. By way of comparison, the US savings & loan scandal of the early 1990s cost the US government less than 3% of GDP. No wonder that Moody's Global Credit Research rated the average bank financial strength rating of E+ for Chinese banks, one of the lowest on Moody's global scale.

Yet the initial public offerings (IPOs) of Industrial & Commercial Bank of China (ICBC), Bank of China, China Construction Bank Corp., Bank of Communications Ltd., and China Merchants Bank Co., have raised more than $47 billion from share sales since June 2005. ICBC has a market capitalization larger than Citibank itself.  [These banks are traded in Hong Kong but comprise 25% of the iShares FTSE/Xinhua China 25 Index ETF (NYSE: FXI)—Editor.] 

[And] indeed, the growth in profits of Chinese banks is impressive. ICBC's first-half net profit rose 62% from a year earlier to $5.4 billion. Bank of China's net profit for January-June rose 52% to $3.9 billion. Record profits are fueled by record loan growth.

And those who have invested early have seen their original stakes double or even triple in value. It's always hard to argue with a skyrocketing share price. (FXI closed above $173 Monday, just shy of its all-time high—Editor.)

China bulls will argue that—thanks to a combination of capital injections and improved operations—a bank like ICBC has cut its non-performing loan ratio to about 4% from a high of 34%. Yet Moody's notes that many former non-performing loans have been simply reclassified as "special mention" and often represent a huge part of Chinese banks' borrowing activity.

The reality is that once the Chinese locomotive slows, the risk of bad loans skyrockets. Fitch estimates that even in a moderate economic slowdown, 10% of loans could turn bad. A severe slowdown would send the entire banking sector into a tailspin.

And the repercussions are likely to be much worse: loans to the Chinese private sector and non-financial government enterprises now are clocking nearly 160% of GDP versus about 120% in 2000. Much of China's $1.3 trillion in reserves could be eaten up by banking bailouts.

As one analyst put it: "China's leaders make loud and frequent noises about how they are pushing ahead with the reform of the country's government-controlled banking system. But many Western bankers say that it could take as long as 15 to 20 years before the banks develop a Western-style credit culture and efficient operations."

Here's the problem: this analysis was published in the International Herald Tribune on April 22, 1995. The world's number-one subprime problem won't disappear overnight.

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