FSO Editorials: "The China Syndrome, Part 9" by Dr. Joe Duarte 07/02/2006

FSO Editorials

THE CHINA SYNDROME, PART 9
The Rural Banking Ponzi Scheme
by Joe Duarte, MD
Joe-Duarte.com & IntelligentForecasts.com
July 2, 2006

Editor�s note:

This analysis originally appeared at www.joe-duarte.com on June 27, 2006. In this series, Dr. Duarte has explored the dark side of the Chinese economic miracle, pointing out, based on sound research from credible sources, that there is more to the economic growth in China than meets the eye. Dr. Duarte clearly recognizes, that although there are clear and significant weak spots, and high risk for investors in the Chinese economy, there is no evidence that any crash, correction, or retrenchment in the phenomenon is likely in the short term, barring extraordinary circumstances. Yet, in this, the ninth installment of this highly informative series, yet another weak spot in the phenomenon is revealed. The premise of this series remains that there will be a significant decline in the Chinese economy at some point in the future, and that it will have extremely negative repercussions on the global economy. Yet, despite warning sign after warning sign, investors, especially sophisticated investors at leading investment banks throughout the world continue to pour billions into China.

Indeed, the more things change, the more they stay the same. See Archive for Parts 1-7

China: Rural Banking-Emperors And Clothes

In The Sticks

China's banking problems extend into the rural areas where billions of dollars worth of questionable transactions plague the already beleaguered banking systems.

According to the Wall Street Journal: "Some of China's biggest and most backward financial companies serve the rural population, 800 million people whose tiny savings create a vast supply of deposits but also opportunities for corruption and mismanagement."

The Journal added: "In a first step in addressing the problem, government auditors yesterday said they found irregularities involving 51.6 billion yuan ($6.45 billion) in the 2004 books of Agricultural Bank of China, one of the country's top four state-run commercial banks."

This is the latest round in what has become a routine set of revelations for a banking systems that would be belly up in a first tier economy such as the U.S. or Europe.

Several ratings agencies, including Fitch's and Moody's within the last several weeks have estimated the number of irrecoverable, non performing loans in China as above $600 billion, with some private forecasts suggesting that the actual sum may be as much as one trillion dollars.

The Rural Fuel

In essence, the rural banking situation may be the straw that breaks the camel's back, if indeed there is going to be a crash in the Chinese banking systems.

According to the Journal: "for the majority of Chinese who live outside the cities, the financial system is a source of social tension. A main concern: Deposits made in the countryside are lent out to fuel further growth in the booming cities."

The Journal reports that the Agricultural Bank of China and the Postal Savings Bank, two of China's biggest rural lenders, are at the core of the problem.

Both banks are part of the government's network of asset redistribution, a remnant of the centrally planned economy from the Mao era. According to the Journal: "Agricultural Bank of China, a key rural institution, is widely viewed as China's worst-performing big bank, with fully half of the banking industry's bad loans, according to official number," while "the Postal Savings Bank, which holds 1.23 trillion yuan in customer deposits at its 36,000 mostly rural branches - lends only to the central government."

The results of key government audits are familiar to those acquainted with the situation in China, but are worth mentioning: "Yesterday's report on Agricultural Bank of China, compiled by China's National Audit Office, found irregular deposits of 14.27 billion yuan, problem loans totaling 27.62 billion yuan and fraudulent issuance of debt securities valued at 9.72 billion yuan in 2004. The audit report tagged suspicious activities of 157 people in possible fraud cases totaling 8.68 billion yuan. In one instance, the report accuses the former head of a sub-branch in Sichuan province of conspiring with other bankers to fraudulently sign off on 132 million yuan in loans for brokers to pour into the stock market. A branch in the northeastern province of Shandong allegedly lent more than 600 million yuan to a university that auditors said had few means of repaying. A spokesman for the Beijing-based bank had no immediate comment."

Conclusion

The mind boggling array of corruption in China's banking system, and the world financial community's sanguine view toward the situation remains astounding.

Unless we're missing something, China's boom is being built, not just on foreign money, but on the savings of the rural community. Instead of redistributing the wealth, as Mao intended, the Chinese state banking system is siphoning the rural savings pool to finance the growth of the cities, and along the way, as many news reports document, line the pockets of executives and politicians along the way.

And while everyone knows this, nobody is doing anything about it, while somehow hiding their deer in the headlights look, and hoping that the Chinese government can do another banking bailout, and eventually transfer the risk to the international community through yet another hyped initial public offering.

What happens after the banks are bailed out, is anybody's guess, since the bad loan problem doesn't seem to be going away.

The only explanation that logic dictates is that Wall Street and the international banking and investment community is immersed so deeply into the Chinese economy, that despite its significant risks, no one can afford to bail out.

In other words, like a bad marriage built on deceit, and greed, there isn't a whole lot that can't be ignored if you drink enough alcohol or fool yourself into believing that all that money can't fix everything some day.

It is becoming increasingly obvious that unless something truly catastrophic happens, there is so much big money in China that only a collapse of the government will bring about the kind of economic crash that would befall any other government in the world whose financial house was this rotten.

Yes, even if the emperor has no clothes, or is scantily dressed, no one in the crowd has the courage to admit that they've been robbed blind by the seamstress, since they've contributed so much money to the emperor's wardrobe.

Unfortunately, although the investment banks can continue to prop up the house of cards, perhaps indefinitely, we would be very careful in participating too aggressively at this point, if we were individual investors.

Maybe, this is one case in which you can fool all of the people, all of the time; but then again, maybe not.

Joe Duarte, M.D.

Joe Duarte M.D. is founder and Editor in Chief of Joe-Duarte.com. Dr. Joe Duarte's Daily Market I.Q. is a premium service that provides daily intelligence, trading strategies, and technical analysis at www.joe-duarte.com. Duarte offers free analysis and news coverage at www.intelligentforecasts.com . Dr. Duarte is a board certified anesthesiologist, a registered investment advisor, and President of River Willow Capital Management. He is author of "Successful Energy Sector Investing" and "Successful Biotech Investing" (Prima/Random House). Duarte's analysis appears regularly in major outlets including CBS MarketWatch and Investor's Business Daily.