Future Chinese Stock Market Problems are being Created Now by its Banking Industry

May 16th, 2007

16 May, 2007 - Here’s a story I’ve been meaning to write about but just haven’t had the time. The People’s Bank of China last month increased their Reserve Ratio Requirement (RRR) 50 basis points to 11% in an attempt to reduce inflationary measures. Although I don’t know if China actually enforces this RRR (in the U.S. the RRR is 10% but in reality, legislation has been weakened to such an extent in the U.S. over the past decade, that many banks maintain a true RRR of less than 1%), the move, even if symbolic, is important because it signifies the concern on behalf of the Chinese government about the too rapid expansion of their economy.

Several months ago, I wrote that I wouldn’t touch any of the Chinese bank IPOs with a ten foot pole. Although in retrospect that seemed like bad advice as many of these Chinese banks that IPO’d on the Hong Kong market are now up 50% to 60%, I still maintain my position due to the same reasons I stated back then. There were plenty of other Chinese stocks with less inherent risk that also appreciated by similar amounts that were much stronger plays. Just because stocks appreciate by similar amounts do not mean that they stand on equal footing in strength, quality and risk. I still believe that the regulatory infrastructure that moderates risk in Chinese banks is far too weak and is a recipe for future disaster.

Anytime a banking system forgoes risk management issues in the pursuit of short-term profits that feed the bottom line, such an approach always leads to disaster. In fact, the current state of Chinese banking reminds me much of the situation in Japan that almost created a collapse of the banking system and ushered in a two decade long recession. In the future, Chinese banks will probably be among the best Chinese stocks to short when their short-term greed comes home to roost.

While loose credit and easy money makes everyone happy and all things appear rosy during spectacular economic growth as the Chinese economy is currently experiencing, it is the same conditions that sparked such rapid growth that will ultimately create a dire situation in the future. While there has been much recent press in the media about investor speculation creating a potential bubble in Chinese markets, I believe that the rampant speculation of Chinese banks in their own economy will play a much larger role in any future significant correction in the Chinese markets. As far as the timing? Like everything else, structural weaknesses always take some time to bubble to the surface, so short-term corrections are much more likely be triggered by profit taking, and the Chinese economy is still likely, even with any short-term corrections, to see an onward push into the 2008 Beijing Olympics. However, when the correction triggered by banking woes begins, it will much more likely be steeper and more prolonged.

Technorati Tags: Chinese stocks, Chinese banks

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J.S. Kim is the Founder and Managing Director of SmartKnowledgeU™, a comprehensive online investment course that uses novel, proprietary advanced wealth planning techniques and the long tail of investing to identify low-risk, high-reward investment opportunities that seek to yield 25% or greater annual returns.

Entry Filed under: China Investments