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There was a time when Chinese banks were the sick men of the global financial system. Acting as an extension of the government, China's banks sputtered along for decades making loans to ailing government institutions with little hope of repayment. That's how they got the name "policy bank." The banks' mandate wasn't to make money. It was to carry out government policy at any cost.

All of China's banks have now been bailed out at untold cost to the central government. The last to emerge from Beijing's protective fold was Agricultural Bank. Ag Bank, as it's called, went public with the world's largest IPO, worth $22 billion, in July of this year.

All through the lengthy bank bailout, doomsayers have been predicting disaster for the Chinese banking system. Books like "The Coming Collapse of China" have gathered dust while banks were reborn and China rose to become a colossal economic power.

Sadly, it was a host of western banks that met their doom. As they went down, they very nearly took the global economy with them.

Now China's banks are in the news again. Beijing has raised interest rates once and bank reserve ratios twice. Reserve ratios dictate the amount of money that banks must hold in reserve relative to their loan portfolios.

Beijing's moves were expected, but they caused a major reversal in the soaring trajectory of the Shanghai Composite Index.

Is there still reason for investors to worry?

The Dark Side

There are dangers in the current situation.

China's major banks issued a torrent of loans in 2009 and almost matched that level this year. The 2010 loan target is 7.5 trillion yuan ($1.129 trillion). The previous year, Beijing really opened the floodgates with a 9.6 trillion yuan gusher – a $1.44 trillion blast of money to help China climb out of the global recession.

Sure enough, China was first out of the financial mire. Meanwhile, the U.S. is still struggling to convince its banks to revive lending to homeowners and small businesses.

There are two major problems with releasing a flood of money in the way China has done.

The first is the danger of creating inflationary bubbles. That has happened in the Chinese real estate sector. As I discussed previously, home prices have risen above the means of most middle-class Chinese. That means the bubble is unsustainable. The challenge is to prevent it from bursting in the way that America's real estate nightmare unfolded.

That's one reason Beijing is raising interest rates. The move is part of a major effort to cool the housing market and dampen a wider inflationary problem. Beijing has also taken a variety of steps to raise down payments and restrict ownership of second and third homes as a way of clamping down on speculators. The hope is that the bubble will deflate rather than burst. The Chinese are earnestly trying to avoid repeating America's mistakes.

The second problem is the danger of making bad loans. With money being lent at such a high rate, there are fears that many provincial governments borrowed money to set up unsustainable enterprises for short term gain. Some of those assets may have been repackaged, sold and moved off the books. There is no doubt that there will be some non-performing loans (NPLs) as these investments come to light.

Too Big To Fail?

Actually China's biggest banks are among the largest in the world by market cap. After bailing out the banks once, there is little chance that Beijing would want to repeat the process.

Instead, Beijing is tightening the screws almost weekly. China's big four banks recently announced that they would stop issuing property loans until the end of the year.

Higher reserve ratios will provide two benefits. They will shore up the banks' capital base against any bad loans. They will also pull liquidity out of China's inflating economy.

Actually, the health of the banks appears to be improving. For the first half of the year, all of China's listed banks registered a net profit increase of 46 percent. Third quarter results show continuing gains for all major banks.

As for the stability of the banks, that too seems to be improving. The China Banking Regulatory Commission has just issued a positive report card. The Capital Adequacy Ratio of Chinese banks, a measure of banking safety is on the rise. The CBRC says the banks score is up 0.5% to a capital adequacy ratio of 11.6 percent.

Reserve rate increases will likely improve this measure of health.

Bankers themselves have increasing confidence in the Chinese economy and their own industry. A survey called the "bankers' confidence index" jumped more than 9 percent in the third quarter. It now stands at an unprecedented 73.1 percent.

Sure, Beijing has trillions of dollars in reserve to bail out the banking system if it has to. But it doesn't look as if that will be necessary.

Yes. We can expect more interest rate rises and reserve ratio increases in China in the future. These always seem to come as a shock to American and Chinese investors, driving markets down. And nowadays, when Shanghai sneezes, New York stock markets catch cold.

We'll have to get used to these shocks from the east. Beijing will do what it must to hammer down inflation and protect China's banks. The alternative would be unthinkable and unhealthy for investors on either side of the Pacific.

Disclosure: No positions

Source: China Banking Shore-Up Not Necessarily Cause for Alarm