By Dr. Hans Black, Interinvest Review & Outlook

        After many years in the investment business we have gained an almost ingrained sense of skepticism when too many people become excited over any one type of investment or region. There is no better example today than the years long love affair so many investors are having with China. As a long-term admirer of China, one can only marvel at the changes that have taken place in that vast and densely populated country over the last 25 years. The post- 1980 leadership has understood only too well the strengths of the western system and has been absolutely admirable in their ability to build a truly model growing economy.
        We have nevertheless become increasingly skeptical over some of the machinations going on in China, from the collapse in 1998 of GITIC (the Guangdong International Trust and Investment Corporation) to an increasing sense over the past three years that the non-performing loan situation in China is totally our of control. In 2003, The Bank of China made a very public display of firing some of its own corrupt bank managers after which the bank itself needed an enormous capital infusion to stay afloat. While it is virtually impossible to get a solid grasp of the total size of the problem of the banking system in China, we are increasingly convinced that it is much larger than anything we have been led to believe. We find it also ironic that certain western banks have chosen this time to initiate large capital investments directly into the state-run banks thinking perhaps that they have now grasped the total size of the problem. Thanks to a good friend in Basel, who will remain anonymous, we have been given an entirely different set of numbers to worry about. We are being told that the bank loan problem in China is now approaching one trillion dollars, or fully four or five times larger than the numbers that have been discussed so often in many western merchant bank circles. By contrast, non-performing loans were in the vicinity of $150 billion in 2000. Although it is reported that the Chinese economy is growing at nine to ten percent every year, few are paying attention to the fact that the Chinese debt-to-GDP ratio is probably in excess of 150 percent and that any reasonable cyclical downturn, such as one created by a reluctance of North American consumers to go further into debt, will surely lead to a further explosion not only with regard to the overcapacity problems we have discussed in other issues before, but also to the truly overwhelming system-wide banking problems. On July 21 of this year China took measures to begin to freely float its currency, the yuan, by announcing a much anticipated change in its reserves and of course a daily fluctuation band. Would it not be ironic if in time the Chinese currency would fluctuate lower, particularly if our fears regarding their debt are anywhere close to reality?
        As an outsider looking in, it would appear that the large banks in China are doing absolutely everything they can to keep thousands of poorly run enterprises afloat. Companies that suffer from chronic over-production and no profitability are being kept alive with fresh money so that they can service the loans that were given to them previously. This is one way of reducing the bad loan problem from the 40 percent level of 2000 to the official 20 percent of 2005. Now western banks are sending even more money to China. Institutions such as Bank of America, HSBC, JP Morgan and more recently the Royal Bank of Scotland are all sending their share to take advantage of what must be surely great profit potentials.
        This very expensive attempt to purchase minority stakes in Chinese domestic financial institutions will in all likelihood become headlines when they fail in the years ahead. Indeed, the more we study the situation we are absolutely awed by the truly marvelous ways in which the Chinese have propelled bookkeeping beyond even what the Japanese were able to achieve in the early 1990s. It is worth remembering that Japan went through years of financial engineering in order to hide the very considerable problems that were buried deep in their financial system. Nevertheless, China is presently the subject of awe and envy, adorning the covers of Time, the Economist and the latest edition of Foreign Affairs.
        Often asked what keeps us up at night, the answer can only be an unequivocal "the Chinese banking system."
        Editor's Note: Dr. Hans Black is editor of the Interinvest Review & Outlook, P.O. Box 51462, Boston, MA 02205, 1 year, 12 issues, $125. Interinvest is a global money management firm. www.interinvest.com.