The problems of Chinese banks’ portfolios of non performing loans (NPLs) are well known. Over the past six years the Asset Management Companies, companies set up to remove bad loans from the banks’ books, have exchanged bonds often at face value for NPLs worth $328 billion. According to the Chinese they have reduced bad loans from 30% down to 5% in less than two years. It took Sweden, Japan, India and most of Asia about 10 years to reduce bad debts of about 10% to around 3%. The US took at least five. Even after they were relieved of such huge amounts of bad loans, the four state banks still had enormous problems. To prepare the state banks for their recent IPOs, the Chinese government injected $55 billion dollars from its foreign reserve pile into the banks. Yet the problem are still there. Earnest and Young estimated earlier this year that the bad debts in the banks were about $358 billion and there was another $600 billion of NPLs in the financial system. What is disturbing is that this mountain of NPLs may be just the tip of the iceberg.

The rest of the problem may be inter company loans, which are not registered, not recorded, not supervised, not monitored and not reported. According to Chinese law, firms cannot lend directly to one another. A recent study by two economists, Ronald Schramm, of the Columbia University Graduate School of Business, and Lin Guijun, of the University of International Business and Economics in Beijing suggests that an enormous amount of the national savings does not go to the banks. Instead it is loaned between companies. In China loans, even until quite recently bank loans, have been made, because of relationships and not the ability to repay the loans. Often these are state owned companies owned by local governments, who are trying to achieve mandated growth objectives. So loans from other local companies would be quite predictable. Since they are illegal, they would not show up on anyone’s books especially if they went bad. China has only 140,000 certified accountants. If they had the same ratio as the UK they would have 5.3 million. So it is unlikely that the level of these loans are known to anyone.

The collapse of inter company lending in 1998 in Russia helped lead to a financial depression in that country. Bad loans in Japan led to decade long depression. Neither country had large amounts of foreign capital. This is certainly not true of China today. If this important source of liquidity for a large part of the Chinese economy disappears, so will its growth. This could lead to problems from the commodities markets to a repatriation of US treasuries by the Peoples Bank of China.

Recently problems with the subprime market in the US resulted in single bankruptcy of the 17th largest subprime lender, Ownit. In a housing down turn, a collapse of a subprime lender would hardly be news. Thanks to mortgage backed securities (MBS), this market has grown into to $625 billion since 2000 in the US. The margins on these loans and the securitization fees are quite profitable, so these subprime loans made up over 40% of the $1.02 trillion of MBSs issued in the first six months of this year. Like China, it is getting harder to quarantine a risky segment of the market from the rest of the global capital markets. The bankruptcy of Ownit caused a blip in the 65 trillion dollar interest rate swap market. The problem was equivalent to a 350 point drop on the Dow or a 40-point drop in the S&P 500.

It is near Christmas, which is bonus time on Wall Street. Much of the billion dollar bonuses now being handed out are due to successful IPOs in China. International investment banks have earned huge fees in further integrating the Chinese financial system into the rest of the world and acted as a conduit for international capital into China. The problem is that no one, even the Chinese government, have any idea what sort of problems lurk in their system. When the effects of these problems become visible, they will not be limited to China. Their effects on international capital markets may create a hangover that would surely be painful for everyone.