MAOPING, People’s Republic of China – I’m often asked if there are investment risks in China.

My answer: Absolutely… there are investment risks everywhere.

But it’s how you evaluate and manage those risks that will ultimately determine how well you do in this highly promising market.
Needless to say, not all risks are the same.

As an example, let’s take a look at China’s surge in lending – and the potential for that country to have a credit crisis of its own. This year, the Bank of China Ltd. is expected to issue as much as $1.32 trillion (9 trillion yuan) in stimulus loans. That’s in addition to the $670 billion (4.58 trillion yuan) that the Bank of China had already lent during this year’s first quarter, and is almost as much as the state-run commercial bank lent during all of 2008.

China, of course, is legendary for its lack of financial transparency, and has actually brought financial misappropriation to an art form.

“Most companies have two, maybe even three sets of books, so when investors evaluate them, they have to know where the cash really moves … now more than ever,” Johnson Chien, managing director of Global Consultants and Services (Shanghai) Ltd., said recently.

While the numbers vary, estimates suggest that some 20% to 30% of all loans extended have actually been diverted for re-deposit or for “stir-frying” purposes.
Re-depositing is the practice of obtaining loans at extremely low interest rates and depositing them in the issuing bank to earn a profit in higher-yielding bank accounts.

“Stir frying” is the Chinese slang term for putting the money into Chinese markets in an attempt to manipulate share prices and profit. But most of the money has come back and remains “performing” at least to date.

In a related wrinkle, a hugely disproportionate amount of money (at least, by Western standards) is loaned out on a long-term basis, only to be paid back a month later. While this creates havoc with asset matching, this helps the borrowing company look more financially active than they are and presumably appear sounder at the same time. Asset matching, in case you are not familiar with the concept, refers to the practice of having long-term loans extended against long-term assets, and short-term loans extended against short-term assets.

When long-term funds are lent against short-term assets, or vice versa, there is a “mismatch.” I can recall a case in Japan – during that nation’s “Go-Go” era – where a major corporation used 90-day revolving debt to finance its new $45 million regional headquarters building. [Never mind that this was in complete violation of General Agreements on Tariffs and Trade treaties, because the 90-day loans were passed from bank to bank ... that's another story for another time.]

This kind of short-term/long-term mismatch is actually surprisingly common in many Asian markets – including China – because it’s a strategy that can help a company obtain still more funding, especially during times of high growth. The rough equivalent in U.S. terms would be a person who borrows money even though he or she may not need it and then pays it back in an attempt to boost his or her personal credit rating.

The lending crisis in the United States was the result of two things:

• Derivatives contracts that were unmonitored.
• And improperly categorized risks unseen by both management and regulators alike.

Here in China, however, the real danger stems from lending driven by guanxi, or “connections.” [Although the West defines guanxi as "connections," that's actually something of an oversimplification; some sociologists have actually likened it to "social capital." But even that doesn't capture all of the nuances that make the Asian culture so fascinating to watch and study.]

Because the social concept of "face” is so important in Asian cultures, there has historically been a tendency to lend money on a preferential basis to favored clients based on nothing more than the connection between lender and borrower – regardless of actual credit worthiness.

China’s bankers are learning quickly, however. Beijing is keenly aware that many banks may not have been properly checking the creditworthiness of their borrowers, so the government has taken steps to implement stricter lending requirements even as it has increased the amounts of lendable cash available.

While many Western executives claim to have been surprised by the credit crisis, I find it interesting that many of China’s bankers seem to be anticipating a credit crunch of their own. Indeed, a recent survey by China Orient Asset Management Corp. of 333 banking officials – including 89 risk-management officers – found that more than half the respondents expected their bad loans to rise in 2009. Additionally, nearly 40% of the respondents expected sharp increases in non-performing loans within the first half of the year.

Yet, few bankers expect Beijing to turn off the lending spigots anytime soon. Many of my contacts here in China concur. While Beijing could certainly do so, it wouldn’t be in its interest to cut back on new loans, or to change the rules when it comes to stimulus-driven-lending programs – at least not for the time being. After all, there’s just too much riding on China’s ability to maintain a high rate of economic growth.

Beijing remains optimistic it can hit its growth targets, although “caution” is becoming the watchword around here. And as long as the growth imperative remains in effect, consumers and businesses here can have every expectation that the money will continue to flow from the banking faucet – even if an increasing percentage of that credit is destined to turn into “bad.”

But that’s okay: Confidence is what Beijing wants right now.

News and Related Story Links:

• Money Morning Market Analysis (Part I of II):
  The Lost Decade: How the U.S. Financial Crisis Resembles Japan’s Ten Years of Misery – And How to Play it.
• Bank of China:
  Official Global Web Site.
• Wikipedia:
  Bank of China Ltd.
• Wikipedia:
  Face.
• BusinessDictionary.com:
  Asset matching.
• Wikipedia:
  General Agreement on Tariffs and Trade.
• FindArticles.com:
  China Orient Asset Management Corporation Selects Sagent to Boost Business Efficiency.
• Wikinvest: 
  Metric: Non-performing Loans to Total Loans (U.S. Banks).
• Money Morning View From China Series:
  China/Taiwan Investment Accords Will Lead to Profit Plays for Investors.
• Money Morning View From China Series:
  Three Gorges Dam Project Demonstrates China’s Domestic Growth Ambitions.