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Watching all the action going on in China right now may be sort of like glimpsing into the future. If that is the case, then the prospects for western banks towards the end of the year don’t look nearly as rosy as they have been since the market reached a bottom in March.

Monday, I pointed out that third and fourth quarter earnings for commercial banks and lenders will probably be less rosy than they were in the first half of this year, since people seem to be becoming more fiscally conservative. But even if consumers do decide to go on a sudden spending binge using their credit cards, a general policy of deleveraging such as the one taking effect in China will have to happen sometime.

Warren Buffet made a similar point in the New York Times yesterday when he wrote that the U.S. economy is spewing greenback emissions:

The United States economy is now out of the emergency room and appears to be on a slow path to recovery. But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself.

… Because of this gigantic deficit, our country’s “net debt” (that is, the amount held publicly) is mushrooming. During this fiscal year, it will increase more than one percentage point per month, climbing to about 56 percent of G.D.P. from 41 percent.

… Our immediate problem is to get our country back on its feet and flourishing - “whatever it takes” still makes sense. Once recovery is gained, however, Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

That scenario is exactly the one materializing in China lately. The consequences have led to a big market selloff. Unsurprisingly, banks have been hit hardest of all. As a result of reducing lending, China is ramping up its corporate bond market as a source of liquidity, in order to keep the GDP number climbing. The result is serving as a double-whammy to share prices of banks.

In Shanghai, shares in Industrial & Commercial Bank of China (OTCPK:IDCBF) and China Construction Bank (OTCPK:CICHF) have both slipped 17 percent since July, outpacing a general 10 percent fall in equity prices. Others have fared even worse. Despite succeeding in raising $1.6 billion in a Shanghai listing, China Everbright’s (OTCPK:CEVIF) Hong Kong-listed shares have dropped 24 percent since the same period, while the A-shares slipped 10 percent the day after posting reasonable first-day gains.

In the case of a similar policy scenario stateside, the problems brought about by a deleveraging mandate may be doubly-extended for U.S. banks, which are heavily reliant on market volume for their trading profits, and the blur of public-private debt to maintain a recovery stance.

Yet Washington policymakers show no signs of tightening the money supply. This week, two pieces of news should make anyone worried about the effects of necessary deleveraging sit up and wonder.

Monday, the Federal Reserve and Treasury announced that they will extend a lending program aimed at freeing up credit for commercial and residential real estate. Real estate investors maintain that the Term Asset-Backed Loan Facility is too small, while $184 billion in commercial real estate loans are maturing between 2009 and 2011.

Meanwhile, JP Morgan (NYSE:JPM) is propping up California’s credit rating with a $1.5 billion bridging-loan. Given that JP Morgan was beholden to the federal government only earlier this year, this is the strangest tangle-of-debt transaction yet. In effect, the federal government loaned JP Morgan cash (in the form of TARP funds), all of which it paid back by punting on the stock market, and part of the net proceeds of which it agreed to loan to the state of California in order to make another fee.

That’s a great example of how banks are still way too dependent on government debt; either in the form of borrowing it or issuing it right back to generate more profit.

Source: Consequences of China-Style Deleveraging Threaten Big Bank Recovery