Move Over Europe, China Banking Crisis Up Next?

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- The Europeans took a giant step toward solving the euro crisis by acknowledging its severity and asking for help. A similar response by China to their incipient "banking" woes would be nice, but the Chinese are entrenched in denial.

Then again the situation in China is very different from Europe. The Chinese government has total control over their provinces, they own the banks, they own the nation's "private property," politicians don't have to worry about being re-elected, they manage their exchange rate, investor protections are limited, and protesters know that free speech is not protected.

That doesn't mean there isn't plenty to deny. Unofficial reports on China's economy vary greatly from government sources.

Economic-related news coming from China is a page-turning thriller. Ponzi schemes, zombies, off-balance-sheet reporting, subprime and mafia-style lending; rising inflation, declining asset values, slowing growth -- it's all there. Add in government meddling in market mechanisms and official denials and China sounds like it has the makings of a perfect economic storm.

Much of the mayhem started with China's bid in 2008 to help boost domestic demand and revive the global economy with a $580 billion stimulus. In some ways it worked like a dream. China was responsible for 30% of global growth in 2010, making it the largest contributor and highlighting the influence China has on the world.

In other ways, the stimulus has had a number of less desirable outcomes:

(1) Domestic demand is heading in the wrong direction. In the late 90s, it was 45% of GDP. Last year it was 33%.

(2) Income inequality is on the rise. According to Bain, Chinese dollar millionaires doubled between 2008 and 2011 to 585,000.

(3) Half the stimulus was invested in the stock market and an already red-hot real estate market.

(4) Property prices were up 21% in 2010.

(5) Local governments have gone on a $2 trillion-plus borrowing and spending binge.

(6) Government investment levels of 25% of GDP drove 10% growth in 1980 vs. 50% and 10% today. Third-quarter 2011 growth was 9.1%, the lowest in two years. (7) Money supply (M2) has been increasing at 18.8% a year. This is a 66% rise since November 2008.

(8) In January 2001, inflation was 2%. In September it was 6.1%.

In the past year, the government has been trying to rein in the property market and inflation. Interest rates have risen to 6.56% and reserve requirements at 21.5% is one of the highest in the world.

Despite these measures, real estate has remained on fire. That's because China's shadow banking sector (SBS), which consists of some licensed but by many accounts more unlicensed, unregulated and illegal lenders is also on fire.

The Chinese save 30% to 40% of wages. Lately it's been fueling the SBS because people can't afford to save in the state-owned banks (SOBs). Fixed by the state, savings deposits earn 3.5%, while inflation is 6.1%. Shadow bankers, commonly pay around 12% on "deposits" while charging anywhere from 12% to 120% annually for loans.

Neither 6.56, 12, 25 or more percent has been a strong deterrent. The total value of loans has been skyrocketing. Officially, new loans represented 7.9, 7.95 and 6.7-7.5 trillion yuan in 2009, 2010 and 2011 respectively. Including the SBS loans the estimates are 11, 16.5 and 18 trillion yuan (Fitch estimate for 2011) in 2009 to 2011. This puts SBS loans at 50% of activity in 2010 and 60% in 2011.

The values in dollars and converted to purchasing power parity (PPP) clarify the enormity of the sums. From 2009-2011 total new bank loans were nominally $3.55 trillion and on a PPP basis $6.04 trillion. With shadow loans the figures are $7.13 trillion nominally and $12.27 trillion PPP.

Credit Suisse reported on Oct. 13 that non-performing loans (NPLs) at SOBs will probably approach 8% to 12% in the next few years, up from 4.5% to 5%. They said this could result in losses of 40% to 60% of equity capital. In August, according to Xinhua, China's SOBs had assets of $16.19 trillion, which would make losses of 40% to 60%, $6.76 to $9.71 trillion. The true value of losses though may never be evident to the outside. In a past crisis with over valued assets, loans were extended indefinitely and/or placed into "bad banks" without changing their asset value.

In September, Fitch said that NPLs in the range of 6% to 7% was enough to exhaust the "banks internal absorption capacity," thus necessitating sovereign support. In the U.S., a bank with NPLs of 5% is considered unsafe and unsound. Many have said that China's $3.2 trillion in foreign reserves gives it plenty to shore up the SOBs, but where are these reserves? Chinese regulations require that for every U.S. dollar held as foreign exchange reserves, the central bank releases the equivalent amount of yuan into the economy. (This is why M2 has been increasing so much.)What about the unregulated and illegal SBS loans? Can/will China shore them up, too? Half their loans are said to be in infrastructure and real estate. Abandoning infrastructure projects from any bank may not be a palatable option for maintaining social bonhomie, which could force the government to offer life support. The day of Chinese zombies may be approaching. Actually they've been around in the form of state-owned enterprises, including the banks, for decades.

The government is right to try to cool down real estate. In 2006, the average apartment cost $100,000. In 2011 it was $250,000 while average per capita income was $4,382. A rule of thumb in the U.S. is that a person can afford a home that is 2.5 times to 5 times their annual salary, with a 30% down payment. Today with a 30% down payment the average apartment in China is 40 times the average annual salary.

Curbing rising property prices though is part of the 2011 to 2015 Central Plan and this objective is now showing signs of progress. The price of new homes, versus existing homes, has been dropping because developers are offering incentives to move property in order to make loan payments. Also in October it was reported that property transactions were down a third in twenty major cities in the last year.

Some have said that a downturn in real estate could be devastating because construction is such a huge component of GDP. In the government's latest Central Plan 36 million housing units are to be built between 2011 and 2015. That should take care of that problem.

Decreasing property values will also aid the problem with rising income inequality and so will stock performance in Shanghai this year. Chinese officials knew that some people would get rich as a result of economic reforms but it has gotten out of hand. One objective of the 2011 to 2015 Central Plan was "increasing the low, stabilizing the middle, and curbing the high."

Last week, the government agreed to reverse a ban on loans to local governments but just for housing projects. (Property loans reportedly make up 25% of state-owned-bank loans.) According to a former high-ranking Chinese Communist Party (CCP) official, out-of-control lending to local governments is China's version of the subprime crisis.

In 2010, there were $2.16 trillion in SOB loans to local governments. This does not include SBS loans, and the locals have been reported as good SBS clients. Good news, bad news local loans are collateralized with real estate but appreciating property values have been used to support larger loans.

In May, Standard and Poor's estimated that as much as 30% of local liabilities would fail to be paid. The government has given a life line to residential property. As to other liabilities, particularly in the SBS, the Party has a reputation for being unsympathetic to local Party members who defy state directives.

The SBS is a real trouble spot, but it will have a knock on effect with SOBs. When the government ordered SOBs to curtail lending, they began packaging loans for sale to the SBS and recording these loans off balance sheet. This past week the government said it is heightening oversight on this practice. Could this lead to an attempt to liquidate shadow bank loans? And then what?

The increasing reports of both gangland style practices for delinquent SBS payers, and the executions and disappearance of shadow banking executives would seem to indicate that trouble is already brewing. A picture is being presented that is reminiscent of a Mafia influenced, government inspired "bankers" gone wild.

Consumers and businesses who have been investing their savings and cash reserves in the unlicensed SBS, with its Ponzi-like scent are at also at risk. Will/can the Party bail out the lawless? How about depositors and investors?

China might allow a repeat of a real estate bubble in the nineties that resulted in prices plunging 50% from their peak and avoiding the designation of NPLs, but it will not permit a repeat of the situation in 1989 when a combination of excessive state-directed lending and the lessening of price controls led to a $580 billion bank bailout and inflation reaching 18.5%. The haircut to GDP from this was 6-plus percent for two years and a 41% devaluation of the yuan (1989 to 1991) from 3.7 to 5.2 to the dollar. In 1993 it was devalued again to 5.8.

No doubt today is different. China's economy is 10 times 1990, inflation at 6.1% is a third, in 1989 the government came clean on the extent of their NPLs but that isn't in the cards today, and China is being pressured to appreciate the yuan, (even though some recent appraisals question if it's over valued at all). The magnitude of this problem though is greater too. Is it 10 times as large? Five times? Will we ever know?

What about inflation? Is it really 6.1%? Is China's measure of inflation the same as ours? Wages are increasing 17% to 20% annually. In the past three years average apartment prices are up 150% and M2 is up 66%. Wheat, corn and soy are up over 25% in the past year. Fuel is up 25%. (Food and energy prices are controlled by the state.)

If inflation is substantially higher, the Chinese government could be forced to take more severe measures to rein it in. Combined with a banking crisis, a bursting property bubble, a need to shift away from being export-led, lowered consumer spending from savings that have evaporated Ponzi-style or deteriorated from inflation this confluence of trouble spots could create a perfect storm. Maybe not. Carnage could be tightly controlled and limited to where China wants it. Speculators should be worried.

In March of 2011, Fitch said China faced a 60% probability of a systemic banking crisis by 2013. Ireland and Iceland were placed into a similar risk category in 2008 but these two countries are democracies and have true free market capitalism -- they play by different rules.

We may not see or hear much about a banking crisis, not in the short term. Right now the CCP is undergoing a changing of its elitist guard. Paramount Leader Hu Jintao and Premier Wen Jiabao don't want their legacy of China's economic rise tarnished. They also do not want rocky transitions for their handpicked successors.

We are, however, likely to see politically motivated repercussions that could affect growth. Transactions in the shadow banking system have largely been out of government control. It's driving the CCP crazy, because they live on control. After Tiananmen Square in 1989 the government dialed back political freedoms. This time they may be looking to dial back economic and political freedoms.

Propaganda, censorship, official denials, and the very different rules that govern China will make the news hard to follow. The media has been fingering slow growth in China on the developed world. Let's not kid ourselves; China's got big self-made problems. Last year, the world's second-largest economy with a jumbo stimulus led the global recovery. Now we have bits and pieces of the ill effects of a badly administered jumbo stimulus program. Much more news we shouldn't expect. Total control has its charm -- for a while. There has never been a nation that has ridden a path of total control to continuous economic growth or to becoming a developed nation.

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