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Over the past half year, growing concerns over inflation, credit tightening, off-balance sheet loans and bankrupt local government financing platforms have highlighted the difficulties that may lie ahead for China's banking system. But amidst this whirlwind of negative news, another set of risks has been almost totally ignored: the looming liabilities of China's policy banks.

In 1994, China restructured its banking system to create two distinct types of state-owned banks: commercial banks, tasked with retail deposits and lending, and policy banks, which were to serve as government-directed lending arms for politically important projects. Much ado has been made of China's commercial bank lending spree in 2009-10, when China flooded its economy with 17.5 trillion yuan ($2.7 trillion) of new loans to offset a collapse in exports during the global recession.

But China's recent policy bank lending has arguably been even more aggressive. Often dangled as sweeteners to secure energy deals or buy political influence, policy bank loans have been dispersed globally with little regard to the credit-worthiness of the projects (or borrowers), from bankrolling serial defaulters such as Argentina and Ecuador to teetering economies such as Greece, Portugal and Venezuela to regimes and small businesses alike throughout southern Africa and Central Asia.

Domestically too, policy bank loans continue to serve as little more than a political slush fund, financing virtually all of Beijing's most ambitious infrastructure projects including the Three Gorges Dam, the massive South-North Water Transfer Project, the country's Strategic Petroleum Reserves and most recently, the country's affordable housing program. If a high profile project needs money, policy bank loans have become the all-purpose stopgap to keep them going.

Such lavish lending, however, is not without consequences. While policy banks have made a concerted effort in recent years to strengthen internal controls and risk management practices, the mass proliferation of these loans -- which now represent nearly one trillion dollars of the riskiest loans in China's banking system -- combined with an archaic legal and accounting treatment that hides these banks' true liabilities, may soon spawn a new crisis inside the world's second largest economy.

Policy Banks: The Most Profitable Banks on Earth?

China has three designated policy banks, the massive China Development Bank (CDB) and two smaller brethren, Export-Import Bank of China (China Exim) and Agriculture Development Bank of China (ADBC).

CDB, China's second-largest bond issuer after the Finance Ministry, is now also the country's single largest overseas lender with over 4.7 trillion yuan ($720 billion) in loans on its books--more than twice that of the World Bank--and the volume of its foreign currency loans has risen eightfold over the past five years. Yet even with such ramped-up lending levels, CDB's annual report claims its non-performing loan (NPL) ratio remained below the 1% mark for the 23rd consecutive quarter through 2010, good for a hefty net profit of over 35 billion yuan ($6 billion).

China Exim's results, according to reports, have also been spectacular. Despite outstanding loans of nearly 900 billion yuan ($140 billion), spread over 100 countries and regions, and a four-fold rise in lending volume over just the past five years, the bank's president announced in June that its NPLs through 2010 had dropped for the 11th consecutive year, while its profits had risen fourteen-fold since 2008. ADBC, meanwhile, announced that its profits had increased by over 900% since 2006, while its NPLs had fallen from 10% to under 3% during the same period.

With these robust numbers, China's policy banks are either the best-run banks in the world, unusually lucky, or else their financials utterly fail to reflect the banks' underlying exposure. After all, how is it possible for policy banks to loan hundreds of billions of dollars to some of the world's riskiest borrowers and yet regularly announce double-digit earnings growth and sterling NPL ratios often less than 1 percent?

The simple answer, of course, is that the massive expansion of total lending contributed significantly to the reduction in NPL ratios, at least in the short term, simply by increasing the denominators. "Flexible" Chinese accounting principles have also played a role. But a more fundamental issue is also at play: So long as Beijing insists on treating policy banks as sovereign lending arms that operate outside the traditional banking system, a categorization no longer justifiable or even in China's self-interest, investors will have an incomplete picture of the true health of the banking system -- which, with over 100 trillion yuan in assets, now represents the largest in world history.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Continue To Part 2 >>

Source: The Crisis Ahead For China's Policy Banks: Part 1