From the November 2007 issue of Research Magazine • Subscribe!

The Banking Bubble

China's two domestic stock markets caused a global panic in late February and early March when they dropped by nearly 10 percent in just a few days. Worldwide investor sentiment promptly rebounded, however, and when Chinese shares fell again in June and early July the rest of the world just shrugged.

China's decoupling from global stock markets was seemingly complete in August-September, when Wall Street suffered severe selling pressures and a bout of heightened volatility. While the Dow Jones Industrial Average went from a record level of 14,000 in mid-July to under 13,000 in mid-August, dragging down both industrialized and emerging bourses around the world, the Shanghai Composite index of Chinese stocks continued to rise relentlessly.

By mid-September, the main Chinese market gauge stood at 5,300, doubling from the start of 2007 and tripling from the same period last year. Since bottoming out in 2005, Chinese stock prices have now risen fivefold.

The Fabulous Banking SectorChina's Big Four large state-owned banks have been in the forefront of this rally. They certainly have been a godsend to Chinese investors, investment banks and the Hong Kong stock market, where most Chinese shares are traded.

Only a few years ago, the banking system was an Achilles' heel of the Chinese economic boom, with the Big Four banks weighed down by non-performing loans advanced to state-owned industrial behemoths on government orders. Now, however, they have led the way for a robust rally in mainland equity markets, while taking the IPO market by storm, both at home and in Hong Kong.

China Citic Bank became the world's largest IPO this year in the second half of April, raising $5.4 billion ahead of a simultaneous listing in Hong Kong and Shanghai. Before Citic came to market, this year's largest IPO took place in January and it involved another Chinese bank, Industrial Bank Co., which raised $2.1 billion.

Both, however, dim in comparison to last year's monster offerings by Bank of China, which raised nearly $14 billion in Hong Kong and Shanghai, and Industrial & Commercial Bank of China, whose $22 billion IPO was -- and still is -- a world record.

Moreover, this July ICBC became the world's largest bank, having surpassed America's Citigroup in terms of market capitalization. During August, as U.S. financial institutions suffered from the fallout from the subprime mortgage crisis, the gap between the two banks' market cap continued to widen.

Sustained Profit RunChina's banks have been enjoying a fantastic run in asset and profit growth, helping them grow out of their bad debt problems and underpinning high stock prices and hefty valuations. Since their IPOs, Chinese banking shares in Hong Kong have led the rally in "red chips," mainland companies listed on the local bourse. In Shanghai, where yuan-denominated Class A shares are available only to domestic investors, their prices have risen even higher.

While ICBC priced its IPO at 2.23 times its 2006 book value, Citic's put its market valuation at 2.75 times book value. Such valuations, which are the norm for the Chinese financial sector now, are as much as 50 percent higher than Chinese banks' Asian peers. But then again, which other banking system can boast consistent double-digit economic growth over the past decade? China's economy, in fact, is now growing at a nearly 12 percent annual rate. Bank lending to investment-hungry companies and free-spending consumers has been expanding by around 15 percent through mid-2005.

Banking profits have been rising at an even faster clip. In the first half, ICBC saw its net profit jump by 61 percent, while Bank of China posted a 52 percent profit rise. The other Big Four banks, as well as second- and third-tier banks, had similarly impressive gains.

Rising InflationThis, however, may create a problem for banks going forward. Rapid domestic economic growth -- along with a record run in the stock market -- has emerged as a key concern for the Beijing government.

To be sure, the authorities have been trying to cool the overheated economy for the past two years -- by limiting investment into booming sectors, allowing the yuan to appreciate and raising domestic interest rates. So far, such measures have met with only limited success. Growth, if anything, has accelerated, and inflation has picked up, measuring 5.6 percent in July -- the highest in a decade.

So far, higher interest rates are likely to mean higher profits for the banking sector, since the latest interest-rate increase has also widened the spread between the official deposit and lending rates. At their current levels, interest rates are still too low to dampen red-hot demand for borrowing.

But if this scenario feels a little too rosy it is because it probably is. China is enjoying a genuine economic boom, but it is also in the midst of a liquidity-generated financial bubble. The Big Four banks, as well as their smaller peers, are flush with cash, and their lending practices -- which have never been too rigorous -- are being relaxed as they try to attract borrowers.

The boom in the stock market has clearly been stoked by borrowed funds. In June, it came to light that some of the country's most prominent financial institutions made a series of illegal loans to two stock market speculators, amounting to over 2.5 billion yuan. This was probably only the tip of the iceberg.

Similarly, some Chinese banks are exposed to the subprime crisis in the United States. Bank of China through its Hong Kong subsidiary had subprime holdings of $11.3 billion. ICBC's exposure was $1.2 billion.

More to the point, Chinese banks are still part of the government-run state capitalist system. The current economic boom has helped them grow out of their massive bad-debt problem, but not entirely. Agricultural Bank of China, the weakest of the Big Four, posted profit growth measuring 65 percent in the first half, but its problem loans still make up nearly 25 percent of its assets.

It is highly unlikely that the Chinese stock market could maintain robust growth for long, in the face of selling pressures in the rest of the world, especially in the United States. Some analysts believe that the selling on Wall Street in August and September represented well-founded fears by investors that the U.S. economy is entering a downturn. The impact on the Chinese economy could be quite severe, after years of robust investment which built up the country's manufacturing base, increased production capacities and bolstered exports, especially to the U.S. market.

China's regulators have been long concerned about the unsustainable rally in domestic stocks. Their dilemma has been how to moderate their ascent without causing a damaging panic. At their current overvalued levels, however, Chinese stocks may be too overvalued, and investors too deeply in hock, for an orderly correction.

At the same time, an economic downturn -- the first in a generation -- could put the Chinese banking system to a major test. Many banks have lax lending standards and lack modern risk management systems. Moreover, both the Big Four state-owned banks and regional financial institutions are heavily dependent on the whim of politicians, both in Beijing and at the local level. They were ordered to make loans to bankrupt state enterprises before, and they may be forced to do so again if the domestic economy totters.

This is a sure-fire recipe to send Chinese financial institutions from health back to sickness.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007.

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