Much has been said about China’s savings glut leading to an equally unbalanced amount of debt in the US financial system, but comparatively little has yet emerged on China’s own dodgy debt problems.

While China has been seen by many as a beacon of prudence and thrift, its banking system is at best opaque and at worst defective.

As recently as 2003, Chinese banks had on the books an amazing $US271 billion in non-performing loans (NPLs), equivalent to 16.5% of that year’s gross domestic profit, or 20.4% of total loans on issue, according to intelligence service Stratfor.

While that figure has been reduced to a relatively manageable 2.81% of GDP in 2008, Stratfor notes that bad loans were merely wiped from balance sheets and dumped into the Chinese equivalent of structured investment vehicles. And what of loans that have not yet been classed as non-performing?

A recent Fitch Ratings report outlines that while NPLs may be significantly lower than six years ago, the accounting of these could pose a problem. It is thought that a large number of “special-mention”, or second-tier loans could actually be non-performing.

“Core capital of Chinese banks already is somewhat thin, particularly when potential losses on special–mention loans are taken into account,” Fitch wrote.

A recent increase in lending could also prompt further worries.

Logan Wright, a China-based analyst at Medley Global Advisors, told Business Spectator that the problem of bad debts in China is nothing new.

“The real question is what proportion of the loans that have been extended in recent years are going to turn bad? Even if you take fairly pessimistic projections of how bad these loans are going to be, there’s still arguments to say that they’re in a fairly controllable range of debt to GDP.”

Not everyone shares this view — the problem is not what the data says, but what it doesn’t say, according to many China watchers.

“History shows even the worst banking systems can appear decent during periods of robust GDP growth,” said Fitch analyst Charlene Chu in a separate report.

Aberdeen Asset Management also wrote in a recent note that there is a risk that Chinese banks are rolling-over bad loans to avoid declaring them as non-performing. Aberdeen said that there is a potential for NPLs to rise in absolute numbers, if not in percentage terms.

Since Beijing’s most recent stimulus package was announced, the potential for bad lending has grown. In the month of January, Chinese banks lent approximately $US237 billion, double on the corresponding monthly figure a year before and double on the amount lent in December 2008.

A lowering of interest rates has led to this surge, but more worryingly, China has relaxed credit and risk regulations. The risk is that China’s bad debts could return to around the 20% mark, as they were in 2003 before the system’s so-called clean-up.

The US has been justly criticised for overseeing a financial system that created subprime lending and then repackaged those loans into structured assets with AAA credit ratings. Yet China, with a restricted press and a largely government-owned banking sector, has overseen politically-directed lending with the same faulty logic as subprime mortgages. And what’s worse, nobody really knows the scale of such lending, or the parts which are non-performing.

Unlike the US government, which must politically pass measures to bail out Wall Street, Beijing can almost unilaterally intervene in Chinese banks, recapitalise them and “erase” bad debts into special vehicles.

Sounds perfect. The problem, however, is just how China will fund this process amid growing unemployment in its export centres, a massive drought in its northern provinces and signs of cracks appearing in demand for sovereign debt. Foreign currency reserves won’t be able to plug holes made with yuan without ramifications for currency policy and higher taxes won’t be the answer.

China’s system of politically-directed lending and opaque decision making will need to be reformed if it to avoid inflicting unnecessary damage on its own economy and, of course, on trading partners such as Australia.