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.