Chinese stimulus cannot mask financial sector problems

In the wake of disappointing economic data last week, the Chinese government has decided to implement measures to spur the economy. And while these measures may make Chinese banks attractive in the short-term, it will do little to solve the underlying problems in the Chinese financial sector.

Image courtesy SF Brit: http://www.everystockphoto.com/photographer.php?photographer_id=127219

Pudong, Shanghai

Saturday, the People’s Bank of China reduced the reserve ratio requirement for Chinese banks for the third time in the past few months. This move will have the effect of injecting roughly ¥400 billion ($63 billion) into the Chinese economy (FXI, quote).

After last week’s underwhelming trade, retail, and loan data, as well as subsequent lowered growth projections by analysts, the Chinese economy looks to be in need of some stimulus.

The Chinese government is keen to ensure growth, particularly over the next few months, as the country is in the midst of a political transition and an economy humming along at a brisk pace decreases the risk of political turmoil.

Although the majority of data last week was sub-par, inflationary data was a lone bright spot coming in at 3.4%; low in relative terms. With inflationary pressures dissipating, the government has more leeway to loosen liquidity restrictions without the risk of unsettling the prices of staples like food.

As fellow Emerging Money writer Michael Gayed wrote this morning, these cuts could allow Chinese financials (CHIX, quote) to outperform in the short-term. The FXI, whose largest weighting is financials, could also see a short-term upswing.

However, liquidity improvement measures do not obviate the very real risks of large writedowns on bad loans that Chinese banks face. Both Jim Chanos and Jonathan Weil have speculated that the health of Chinese banks is much worse than it appears on a superficial level because of the circular lending nature of the Chinese system. Chanos quipped on Bloomberg TV that  “the Chinese banks ought to be sending a thank-you note to Greece and Spain every month for keeping them out of the limelight.”

Weil claims that banks such as Industrial and Commercial Bank of China have bad loans going all the way back to the 1990′s that have little chance of being paid back in full. While banks continue to receive interest payments on some of these loans, the principles are rolled over but show few signs of ever being repaid. However, on their balance sheets, these loans are not marked down and reported at full value, which potentially overstates the health of ICBC and other Chinese banks.

In sum, investors with a long-term time horizon should stay away from Chinese banking stocks and ETFs with Chinese financial exposure for the time being; however, traders may see a bounce in these names over the short-term.

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