Chinaâ€™s Big Banks Look More Like Paper Tigers After spending time combing through the financial reports of Chinaâ€™s biggest publicly traded, state- owned banks, I now understand what Jim Chanos, the famous short- seller, means when he keeps saying they are â€œbuilt on quicksand.â€ Heâ€™s definitely on to something. Start with Industrial & Commercial Bank of China Ltd., the worldâ€™s most valuable bank, at least on paper, with a $238 billion market capitalization. Much of its capital consists of the remnants of bad loans dating to the 1990s, which ICBC now calls receivables. One such receivable represented about a third of ICBCâ€™s shareholder equity, as of Dec. 31. It was scheduled to start coming due in 2010 but wasnâ€™t repaid, and still sits on ICBCâ€™s books at its original value. At the same time, ICBC has been reporting torrid, almost cartoonish, growth since going public in 2006. Total assets, about half of which are loans, rose 15 percent last year to 15.5 trillion yuan ($2.5 trillion). Earnings (1398) jumped 26 percent to 208.4 billion yuan. It has been quite a transformation. At the end of 2004, before its most recent restructuring by the Chinese government, Beijing-based ICBC said about 21 percent of its loans were nonperforming. Today the same bank, which is 71 percent state- owned, classifies less than 1 percent of its loans that way. New Skills You can choose to believe that latest figure if you like. Either the Chinese government has become extremely skilled at lending in a very short time, and Chinese borrowers have become even better at repaying. Or the numbers are too good to be true, in which case the quality of the bankâ€™s capital matters a great deal, as a gauge of its ability to absorb losses. If nothing else, a look at the receivables at ICBC and other large Chinese banks provides insights into what passes for normal in the countryâ€™s banking system. Everything is a big circle. The largest receivable at ICBC is a 313 billion-yuan asset called â€œHuarong bonds.â€ The footnotes to ICBCâ€™s latest annual report say they were issued to ICBC starting in 2000 by China Huarong Asset Management Corp., an asset-management company established by Chinaâ€™s finance ministry. The bondsâ€™ book value hasnâ€™t changed over the years. After ICBC bought the bonds, Huarong used the cash to buy nonperforming loans from ICBC at full face value, cleansing ICBCâ€™s books. In short, ICBC swapped bad loans for bonds backed by the loansâ€™ new owner. The old loans didnâ€™t really go away. Perhaps not surprisingly, ICBC wasnâ€™t repaid its principal when the Huarong bonds began to come due 10 years later in 2010. Instead, ICBC received a notice from the finance ministry saying the maturity dates had been extended by another 10 years. ICBC has said the ministry â€œwill provide support for the repaymentâ€ if Huarong canâ€™t make good, citing a separate 2005 notice. Such a notice isnâ€™t the same as a guarantee, however, which is a point that Carl Walter and Fraser Howie made in their acclaimed 2011 book, â€œRed Capitalism,â€ about the frailty of Chinaâ€™s banking system. The bonds are non-transferable, meaning they canâ€™t be sold. Maybe ICBC will get paid eventually, maybe not. The finance ministry owns 35 percent of ICBCâ€™s shares. A state-owned investment company holds another 35 percent. At Beijing-based Agricultural Bank of China Ltd., a receivable from the finance ministry represented 474.1 billion yuan, or 73 percent, of shareholder equity, as of Dec. 31. A 2008 notice from the ministry said the amount would be â€œsettled annually over a period of 15 years.â€ At least there, the ministry has been paying the bankâ€™s receivable down. A year earlier, Ag Bank showed the same asset at 568.4 billion yuan, which was 5 percent more than its equity then. It got the receivable as part of its last restructuring, in 2008, in exchange for transferring bad assets to the finance ministry. Cleaning Up As recently as 2007, Ag Bank classified about 24 percent of its loans as nonperforming, compared with 1.4 percent last quarter. After cleaning up its books, the company went public in 2010, raising $22.1 billion in the largest IPO ever. The bank, which is 83 percent state-owned, now has a $141 billion market cap. Last quarter alone, Ag Bankâ€™s total assets rose 7.6 percent from their Dec. 31 level to 12.6 trillion yuan. Similar receivables reside at Chinaâ€™s other Big Four banks, Bank of China Ltd. and China Construction Bank Corp. (939), though the amounts there arenâ€™t as large. Before their restructurings almost a decade ago, Bank of China and China Construction classified about 16 percent and 17 percent of their loans as nonperforming, respectively. Now both show about 1 percent. The warning signs about Chinaâ€™s construction boom and state-owned banks have been evident for years. News reports of local-government financing vehicles that canâ€™t repay their loans are so abundant, they are hardly surprising anymore. The Big Four banks each have set up loan-loss reserves ranging from about two to three times the size of their nonperforming loans, which probably are understated to begin with. Those reserves wouldnâ€™t be enough should loan losses return to historical norms. Charlene Chu, a Beijing-based analyst for Fitch Ratings, wrote in a Dec. 2 report on Chinese banks that â€œFitch expects the authorities to continue a selective policy of forbearance and liquidity support for borrowers, including loan rollovers and restructurings, new loans, and bond issuance.â€ As a result, â€œasset quality issues may not fully appear in NPL (nonperforming loan) ratios until well into a deterioration, if at all.â€ By the time any big problems show up in the banksâ€™ numbers, the jig will be up. The hard part is figuring out the timing. Foreign shareholders would suffer the brunt of any losses should the government need to inject capital or restructure the banks again. The banks would survive, though. The Chinese government is like Wall Street in that it always pays itself first. In a Bloomberg Television interview last week, Chanos said â€œthe Chinese banks ought to be sending a thank-you note to Greece and Spain every month for keeping them out of the limelight.â€ Itâ€™s anyoneâ€™s guess how long they will stay this way. (Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.) Read more online from Bloomberg View: Today's highlights: the View editors on solving Europe's employment woes and the futures of Fannie Mae and Freddie Mac; Stephen L. Carter on the overuse of the word "emergency"; Virginia Postrel on Amazon's move into high fashion; Jonathan Alter on human capital and venture capital; Tom Valasek on Ukrainian politics and soccer; Gerald M. Rafshoon on Mitt Romney and Jimmy Carter.