There's a saying that a plan is just a list of things to go wrong. While a frightening thought for anyone who considers themselves organized, it's a very frightening thought for China -- the world's largest planned economy.

It's no secret that under government directive, state-owned Chinese banks went on a lending spree in the first half of 2009. According to data from the People's Bank of China, Chinese banks loaned approximately $1.1 trillion in the first half of the year, almost doubling the amount of loans made in all of 2008. The reason? The Chinese government wanted to head off any potential downturn in the Chinese economy that might be caused by declining global demand for China's manufacturing exports. Remember that the Chinese government prizes stability over all else, and a slowing economy would have meant widespread unemployment and unrest.

The good news for China is that this plan largely worked; its economy posted near 9% GDP growth last year. The bad news is that no one can flood an already frothy economy with money and not expect repercussions. As the Bank of International Settlements noted in its analysis of China's lending program, "The rapid credit growth in the first half of the year was unavoidable associated with an easing in credit standards, which could reduce the quality of banks' balance sheets in the future." What's more, after slowing down in the back half of 2009, the pace of lending in China is on the rise again as the global recovery stumbles. The People's Bank announced earlier this month that lending in April topped $113 billion, a 51% sequential and 31% year-over-year increase.

We've heard this story before
One needn't look far to see the consequences of easing credit standards. Here in the United States companies such as Countrywide Financial, Golden West, Lehman, and more made a mint for years extending credit to less-than-creditworthy individuals. But as housing prices fell, defaults piled up, and these companies could not survive as independent entities.

From there it took nearly $1 trillion in stimulus efforts and the $700 billion TARP to keep the collateral damage from spreading to Citigroup (NYSE: C), Bank of America (NYSE: BAC), and Morgan Stanley (NYSE: MS). If you read accounts such as Andrew Ross Sorkin's excellent Too Big to Fail, it's clear that in this time of crisis, the viability of these giant financial institutions were all at one time in question. And while we still don't know exactly what ornery creatures lurk on the balance sheets of these companies (so buyer beware), it is clear that the U.S. is more stable today than it was at this time last year.

The U.S., however, is lucky in two ways (so long as you don't worry about our financial future). We can print our own money, and the world continues to buy our relatively low-risk bonds. If China were to see such a magnitude of fallout from its 2009 lending spree, how might it fill the capital void?

The Blueprint, not just a Jay-Z album
Michael Pettis, a noted commentator on China and a professor of finance at Peking University's Guanghua School of Management, asked a similar question last month when he wrote, "Who will pay for China's bad loans?" He notes that when China saw a spike in non-performing loans (NPLs) 10 years ago, the government responded by keeping borrowing rates low, selling bank equity to government institutions financed by government bonds, and mandating a wider spread between the lending and deposit rates. As a result, the people who paid to solve China's last banking crisis were "households ... in the form of very low returns on their savings." And Pettis expects that these people may be forced to foot the bill again.

Pettis, however, too quickly writes off a powerful tool at the Chinese government's disposal that it experimented with a decade ago: the selling of bank equity to government institutions. In fact, we may have seen this strategy resurrected in the March announcement that China Mobile (NYSE: CHL) would be purchasing a 20% ownership stake in Shanghai Pudong Development Bank (SPDB) for almost $6 billion. Although companies such as China Mobile don't have enough cash to be a long-term solution if events take a turn for the worst, they could at least buy the government some time.

What the ...
China Mobile is China's largest and most profitable wireless communications company, with 540 million subscribers and 65% market share. But two points are key to the present discussion.

  1. China Mobile is cash-rich, with more than $38 billion on its balance sheet.
  2. China Mobile is 75% owned by the Chinese government.

What is this massive mobile phone provider doing taking a 20% stake in a Shanghai bank? Although the company has told the media, analysts, and investors that the deal enables strategic cooperation in the field of mobile banking, am I too cynical in thinking the Chinese government might be leveraging China Mobile's balance sheet to bail out a troubled bank?

Why Shanghai Pudong Development Bank might be in trouble
Although most Chinese banks are opaque, China Mobile released SPDB's financials in a circular to shareholders and in a 6-K filed with the SEC. There's at least one startling fact contained within that 202-page document. As SPDB's loan portfolio grew 33% overall in 2009, and as its mortgage portfolio was up 46%, reserves for loan losses increased just 12%. That discrepancy is troubling even if we didn't already know that Chinese lending standards relaxed in 2009.

Should those loans start to move against the bank, odds are it would be left with a gaping hole in its capital -- a hole that China Mobile now appears to have filled.

Are you outraged? Should you be?
Pettis wrote in his article that because Chinese banks and SOEs now have foreign shareholders, the Chinese government would be less likely to pull this recapitalization lever. In fact, I believe the fact that foreign shareholders now own significant chunks of cash-rich and cash-generating state-owned enterprises (SOEs) such as China Mobile, PetroChina (NYSE: PTR), and CNOOC (NYSE: CEO) makes them more likely to be used as a source of recapitalization funds. If there's anything we've heard over and over again during our extensive travels in China for Motley Fool Global Gains, it's that no American should expect to get too rich there. Yes, China wants foreign capital, but it also wants to keep most of the fruits of those investments to itself. This is a sobering thought, and one we should remember if we continue to see SOEs take equity stakes in troubled Chinese banks.

If there's a comforting aspect to this ordeal, it's that China Mobile spent just $6 billion on SPDB. That suggests that while the Chinese government may be willing to take advantage of SOE shareholders, it's not willing to outright abuse them. Depending on your perspective on China, that's either very troubling or very reassuring.

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