Estimates of the amount of Chinese bank lending total nearly $7.5 trillion. Of that total about 30%, or $2.2 trillion, has been lent through a central government program that puts enormous amounts of money into local government hands. These are called local government financing programs (LGFPs) or local government financing vehicles (LGFVs), and they are starting to get the attention they deserve.

A recent article from Bloomberg highlights the central issue.  And that is, many of these loans are “backed by collateral that is overvalued, may be hard to sell and, in some cases, doesn’t exist.” If this sounds familiar, think “Lehman” back in 2008.  Virtually all of China’s major banks are holding this paper, and many US ETFs and funds hold stock in these banks. One analyst cited by Bloomberg assumes that as much as $900 billion or so will not be repaid.

We’ve taken a look at some ETFs and mutual funds that hold shares in major Chinese banks. These funds include iShares FTSE China 25 Index Fund (NYSE: FXI), SPDR S&P China ETF (NYSE: GXC), PowerShares Golden Dragon Halter USX China ETF (NYSE: PGJ), Matthews China Investor (MCHFX), Fidelity Advisor China Region A (FHKAX), and Templeton China World A (TCWAX). All data on the funds is taken from Morningstar.

The iShares FTSE China 25 Index Fund (NYSE: FXI) holds 100% of its $6.7 billion in assets in Chinese equities. Just over 50% of the fund’s holdings are in financials, with more than half that invested in China Construction Bank, Industrial and Commercial Bank of China, Bank of China, Ltd., and Ping An Insurance Group, all Hong Kong-traded equities. The fund holds no real estate stocks. The ETF gets a 2-star rating from Morningstar.

The SPDR S&P China ETF (NYSE: GXC) holds more than 99% of its $772 million in assets in Chinese equities, and about 27% in financials. Its investments. Two-thirds of these holdings are in the same three banks, with China Life Insurance Co. Ltd. replacing Ping An. The fund holds about 3.8% of assets in real estate stocks. The ETF holds a 3-star rating from Morningstar.

The PowerShares Golden Dragon Halter USX China ETF (NYSE: PGJ) holds about 97% of total assets of $370 million in Chinese equities, but only about 5% in financials. Only China Life is included in its top ten holdings at 4.4% of assets. The fund holds less than 1% of assets in real estate stocks. The ETF holds a 2-star rating from Morningstar.

The Matthews China Investor (MCHFX) tracks the MSCI China Index and holds 100% of its $2.8 billion total assets in Chinese equities. About 18% are invested in financials, approximately half the exposure to the financial sector as the Index itself. Only Ping An is included in the fund’s top ten holdings. The fund’s largest investment sector is the consumer discretionary sector, at nearly 27% of assets, more than 4 times the Index holdings. Real estate holdings total about 4.75% of assets. The fund holds a 5-star rating from Morningstar.

The Fidelity Advisor China Region A (FHKAX) holds nearly 98% of its $2 billion total assets in Chinese equities. Financials make up about 30% of the holdings, with the three large banks accounting for almost 10% of holdings. The fund holds about 7.5% of its assets in real estate stocks. The fund holds a 3-star rating from Morningstar.

The Templeton China World A (TCWAX) holds about 99% of its total assets of $1.2 billion in Chinese equities. About 12.5% of holdings are financials and about 3.7% are real estate stocks. About 6.4% of holdings are shares in Bank of China and China Construction Bank. The fund holds a 5-star rating from Morningstar.

The three ETFs we’ve noted have done no better than stay flat since the beginning of the year. Of the mutual funds only TCWAX is showing a gain for the year.

Accounting issues and bad loans are not new to China. In 2003, when China Life issued shares on the NYSE, the company admitted accounting irregularities totaling $650 million. In the same year China’s biggest banks held an estimated $500 billion in bad loans, most of which the government covered in a massive recapitalization program. Even then the big problem was soaring real estate prices.

The difference was the real estate in question. In 2003, the boom in property was occurring in Shanghai and Beijing. Now, it has moved out to the sticks into cities few people outside of China have ever heard of.

It is pretty unlikely that the Chinese government will let its biggest banks fail. But to rescue them could put the brakes on China’s economic growth. The country’s financial, consumer, and real estate sectors could all suffer significant damage, with the effects rippling through the entire economy.

What happened in the US following the Lehman implosion is on the brink of happening in China. When (not if) it does, the best the country can hope for is that the government has taken the proper steps to ensure a soft landing. So far, there’s not a lot of evidence for that.

Paul Ausick

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