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Many commentators and economists feel that state-owned banks are wonderful things. After all, they do have tremendous advantages when a government is trying to manage an economy. Still, in every country where they exist, state-owned banks tend to get out of hand and run up massive amounts of bad loans, often politically motivated, that eventually end up the responsibility of the taxpayers. In certain countries there is an even more insidious effect. They distort depositor behavior sending money where it should never be.

One supposed benefit of state-owned banks is that they are not subject to the fears that haunt normal bankers. In times of financial stress, when most banks stop lending even to each other, state-owned banks can be counted upon to splurge and help stimulate the economy. This is exactly what happened in China. In 2009, the government ordered its state-owned banks to triple the amount of loans. This splurge went on in 2010 and 2011, when new loans were double the average amount of lending prior to the Great Recession.

It is not just China. In the U.S. the mortgage lenders Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) backed nearly half of all outstanding U.S. home loans. Fannie Mae owns or guarantees nearly $2.8tn of home loans and is the largest provider of mortgage credit in the U.S. They are also expensive. So far it has received $116 billion from the U.S. Treasury to make up for loses as a result of bad loans.

In India the central bank, the Reserve Bank of India, has raised interest rates to tame inflation. The result is a slowing economy and more bad loans. Predictably these bad loans have fallen disproportionately on the state-owned banks who take in about three quarters of deposits. While the three largest private banks, posted good results and bad loans actually dropped, the state-owned banks had a different experience. The largest, the State Bank of India, saw its bad loans rise by 140% and it was forced to set aside $610 million to cover the problem.

Bad loans at private sector banks are beginning to accelerate. Last summer Brazil's biggest lender, Itaú Unibanco predicted that the default-rate forecast for 2011 would be 4.5 percent. Their most recent forecast was a default rate of 5%. Public sector banks in Brazil have been pumping money into the Brazilian economy at five times the loans made by private sector banks. One would assume that their bad loans would at least be proportional most likely much higher.

Despite these alarming numbers and precipitous drops in the stock of the private sector, banks in India and Brazil, investors and economists do not seem worried about China. On the contrary, they look at an increase in bad loans as good news. Their analysis goes something like this: even though bad loans at the Chinese banks are predicted to rise by 40%, the Chinese simply roll the bad loans over. The Chinese have been doing this since the 1999 recession, when they created bad banks like Cinda, whose bad loan bonds were extended another 10 years.

Since deposit rates are capped by the government at about 3 percentage points below lending rates, the state-owned banks have guaranteed profits. In theory, the state banks in China are a monopoly, so depositors are supposed to accept low deposit rates. The low rates act as a sort of tax on consumers. They allow Chinese banks to earn massive profits, which can cover the bad loans. So despite the slowing of the economy Chinese banks shares in Hong Kong have increased 50% since last October. Investors are positive that if things really get bad, the government will step in with its magic money wand and make all things better.

But there is one thing that neither the Chinese government nor investors have counted on: the market. Unlike some other investors, depositors in China are acting rationally. Like their cousins in developed countries, they are chasing higher yields by investing in riskier assets and the market in China is providing these assets.

In China depositors are purchasing a growing array of "wealth management products". They are also stashing money in the huge unregulated shadow banking system. The state banks are hemorrhaging deposits. Last September the big four" state banks lost Rmb 420 billion ($66.6 billion) worth of deposits, four times their lending. The shadow banking system has been estimated at over 5% of GDP, but there is no accurate information.

By distorting the incentives, the state banking system has sent money outside the regulated system to a place where statistics do not exist. While the regular state banks might be able to avoid a crash, the shadow banking system cannot. When that crash occurs, there won't be any warning.

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