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Much of the recent hubbub surrounding China has been focused on its slowing economy, as well as various political developments. Recently, it was announced that China's PMI fell to 50.2 in June from 50.4 in May, the slowest growth this year and the eighth consecutive month of declining growth; a reading of above 50 indicates expansion in manufacturing activity, while a reading of below 50 indicates contraction.

Various economic experts have weighed in, from JPMorgan's Chairman of Global Markets, Jing Ulrich, declaring that concerns about China's slowing economy are misplaced, to Mizuho economist, Shen Jianguang, arguing, "Further monetary easing is warranted." The yuan has also significantly depreciated, another sign of a weakening economy: the yuan declined 0.92% this month to close at 6.3690 per dollar, the biggest monthly loss since it ended its peg to the dollar.

Then there are the political developments in China. The country is currently in the middle of an unprecedented huge transfer of power within its Communist Party. A huge political fiasco concerning Bo Xilai, once a major party boss, has riveted the world, exposed party divisions, and "damaged" China's image. A major political dissident, Chen Guangcheng, has also recently been in the news following a daring escape from house arrest. The subsequent diplomatic standoff between China and the United States ended when Chen was finally allowed to go to the United States to study, but also revealed the continued strength of dissident unrest in China to the rest of the world.

Yet, a development that has not significantly captured the attention of the world poses an alarming obstacle to long-term growth in China—problems brewing in its banking sector. More specifically, the problems include an alarming increase in non-performing loans, which can be partly attributed to falling home prices, local government debt, and government policy.

On the surface, China's banking sector is booming. Three of China's largest banks have reported record levels of net profit for 2011. The Bank of China's 2011 net profit increased 19% YOY while ICBC's 2011 net profit rose 26% YOY. China's four biggest banks reported a total 2011 profit of more than $90 billion, a 25% increase YOY. Chinese commercial banks, overall, made a cumulative net profit of 1.041 trillion yuan in 2011, a 36.3% YOY gain.

Despite the record profits and seemingly huge growth, significant problems continue to plague China's banking sector. For one, although profits are up, Chinese banks' exposure to bad loans are also significantly up. For example, in Wenzhou, the city's non-performing loan ratio increased from 0.37% last year to nearly 2% so far this year. Other banks, such as China Construction Bank and Shenzhen Development Bank also saw their NPL ratios rise to and soar above 2%.

May Yan, a Hong Kong-based analyst at Barclays Capital Inc., noted that non-performing loans at Hong Kong-listed Chinese banks may rise an average 40 percent in 2012. Moreover, Bloomberg has stated that "publicly traded Chinese banks' bad loans may jump 26 percent this year as the economy slows, while profit growth will be cut by almost half, to 15 percent, and the average net interest margin may shrink 4 basis points."

One of the major reasons for the drastic increase in non-performing loans is falling home prices. As China's economic growth slows down, demand is increasingly satiated, and the worldwide economy continues to detrimentally impact the Chinese economy, the Chinese government has become increasingly fearful of a pop in the full-fledged housing and real estate bubble. Thus, the government has facilitated a steady, controlled decline of home prices to cool China's huge housing bubble.

Although by no means a burst of the bubble, decreasing land and home values have led to more frequent defaults in a case similar to (but much less drastic than) the United State's subprime mortgage crisis of 2007-2008. Moreover, Chinese banks have significant exposure to the effects of a weakening housing market. Since 2009, about 40% of the lending by Chinese banks has gone to government-initiated infrastructure projects and the property sector.

Domestic economic growth has also played a large role in local government debt, which is the main reason for the increases in non-performing loans of Chinese banks. In the last few years, Chinese banks have increased their use of local-government financing vehicles, which accounts for more than $1 trillion worth of bank debts. What's alarming is that private estimates peg 20%-30% of these debts as non-performing and estimate that the exposure of Chinese banks to LGFVs is much higher.

The major catalyst responsible for connecting the two aforementioned factors of increased lending to local governments and property developers is none other than the Chinese government. Government policy has at times actively encouraged increases in loaning activity from Chinese banks as the Chinese government has long seen increased credit as a valuable instrument for economic stimulus. For example, the Chinese banks took a significant role in financing China's 4-trillion yuan stimulus to combat the effect of the worldwide economic crisis.

With encouragement from the government, Chinese banks created a huge surge of credit to local governments and land developers. As the European sovereign debt crisis continues and domestic growth in China slows, the Chinese government has again pressured Chinese banks to increase lending. The increases in lending have often led to less discretion in the selection of activities to loan, which in turn has led to higher chances of loans becoming non-performing.

The increases in non-performing loans, which overall account for only a small part of total loan activity, still have had significant repercussions for the Chinese banks. For the first quarter of 2012, China's big four banks all missed analyst projections for profit growth. Analysts forecast China's largest banks to report net profit growth of 14% on average in 2012, down from 25% in 2011.

Although China's banking industry is by no means near collapse, there is significant reason to worry about its ability to continue to grow and mitigate exposure to non-performing loans. Continued significant increases in the industry's non-performing loans will have significant detrimental effects on the industry and China's economy in the future.

Related tickers: (NYSEARCA:CYB), (NYSEARCA:RMB), (NYSEARCA:FXCH), (NYSEARCA:CNY), (NYSEARCA:DSUM)

Source: A Hidden Problem For China?