One of the largest Chinese banks, China Construction Bank (CCB), a primary component of the Global X China Financials ETF (AMEX:$CHIX), and the country’s second biggest bank in terms of assets posted impressive results for the second quarter of the current year, with quarterly profits increasing by 20%. Net income also rose to $8.6 billion for the quarter, beating analysts’ estimate of$7.8 billion thus making it the 11th straight quarter where their profit growth rate exceeded 10%. However, the bank has warned that it might not continue at the current pace as the country’s economy slows down, causing a flight of speculative capital from the sector while it struggles with the “disappearance” of borrowers and macro-economic headwinds.

On a semi-annual basis, the bank’s profits have risen by 15%, half of the 30% growth in the same period in 20111. A significant portion of profits has come from gains in interest and fee income, which are likely to decrease in the future as the People’s Bank of China (AMEX:$FXI) introduces more flexibility in interest rate policy, i.e. moving towards more market-based savings rates, so the arbitrage between lending and savings should be ground away over time. The PBoC’s lowering of both the reserve ratio and the benchmark lending rate was aimed at stabilizing the banking sector, while also allowing banks to exceed the deposit rate cap by 10%. 

It also ignited a run on the Yuan necessitating that ICBC, CCB and Agricultural Bank decreased foreign currency savings rates. This should make the Yuan relatively more attractive.  But the deposit rate on USD (AMEX:$UUP) is already nearly zero-bound.  The drop is from 0.1% to 0.05%, which is reflective of the USD money market rates.   It’s a minor move that cannot overcome other decisions to attract foreign investment made by the Chinese government this year.  Foreign currency deposits, mostly U.S. Dollars, have risen to $412.2 billion, 42% so far in 2012. 

Because of these issues and the bursting property bubble in China ‘the big four’ — ICBC, CCB, Agricultural Bank of China and Bank of China—are going to be in serious trouble going forward. They are all down versus the Hang Seng Index, dragging it down to a very modest 0.6% gain year to date. On the other hand, CHIX has gained 2.35% year to date, much lower than the SPDR S&P 500 ETF (AMEX:$SPY) at 12.67% in the same period. Like the Chinese banking industry, CHIX remains highly volatile. In the past six months, it has dropped by 15.0%, wiping out the rally from the 1st quarter of this year.

At this point the USD/CNY cross looks to have peaked, with the exchange rate back down to ¥6.35.  The region’s powerful exporters generally prefer to keep their savings in U.S. dollars in Chinese banks, instead of converting them to Yuan (AMEX:$DSUM) but as China has signed more than 30 bi-lateral trade agreements, most notably with their biggest partner Japan, in the past two years, demand for Yuan by exporters should be increasing. 

But all of that pales in the face of a potential meltdown in real estate and business loans brought on by two years of tight monetary policy to tame the property and construction bubbles.  The Chinese banking sector is troubled with the “disappearance” of 47 business clients, including 17 of CBC’s customers.  Bankruptcy has been an option for some, but going into hiding has been the choice of others.   The good news is that SHIBOR rates (Chinese money market) have dropped sharply this year meaning the PBoC’s easing measures have provided liquidity but have not fixed the underlying problem.  As we’re seeing in Vietnam right now, attempts to unwind a huge property bubble eventually runs aground and interbank rates can and do change quickly.  China’s GDP growth is still nominally strong above 7% but the question everyone should be asking at this point is how much of it will need to be liquidated later if things continue as they are.

Non-performing loan ratios still stand, officially, at around 1% but like U.S. banks stuffed with central bank cash and, like Bank of America (NYSE:$BAC) ,refusing to foreclose for months in fear of having to report the truth, the real number is likely a lot higher.  Unlike U.S. banks, however, the Chinese banks are not also using their deposits to fuel their trading bets, holding the entire world for ransom, like Goldman-Sachs (NYSE:$GS) has done with both the failure of Lehman Bros. in 2008 and Greece earlier in the year. 

The short term outlook for China’s banks is grim with food and energy inflation putting a limit on further easing by the PBoC to provide them with liquidity if hit by a wave of debt defaults. While this will be constructive for China’s economy over time, liquidating malinvested capital built up over the past decade, it will be difficult for the banks to deal with.