Since the end of June, shares in HSBC (LSE: HSBA) have charged higher. Shares in the bank are up by more than a third over the past four months as investors bet that the group will benefit from a weak pound. 

However, HSBC’s underlying business performance has become disconnected with the market’s view of the bank. Indeed, for the first half, the company reported a 29% fall in pre-tax profits. A “turbulent period” was the reason given for the profit decline. What’s more, management went on to warn investors in the results release that the bank was facing “considerable uncertainty” that’s “likely to continue for some time.” 

But aside from the uncertainty facing HSBC, I believe there is another big issue that management isn’t addressing: China. 

The China problem 

China’s economic outlook, and more importantly, debt outlook is probably one of the biggest issues facing the financial world today. By some estimates, corporate China sits on $18trn in debt, equivalent to about 169% of gross domestic product. According to Fitch, the credit ratings agency, as a proportion of China’s total loan pool, non-performing loans could be as high as 15% to 21%. The official data from China’s policy makers was 1.8% at the end of June. 

The problem is that Fitch estimates that to solve China’s bad loan problem it would cost CNY7.4trn to CNY13.6trn, or $1.1trn to $2.1trn, equivalent to around 11% to 20% of China’s economy. Such a massive capital readjustment would undoubtedly send shock waves through the global financial system. As a China-focused Western bank, HSBC is likely to suffer more than most if China’s banking system collapses. 

Significant impact 

According to research published by analysts at JP Morgan earlier this year, at the end of 2015 HSBC had $273bn of direct lending exposure to Greater China, with some of the riskiest debts in wider Asia including $74bn lent to commercial real estate and $95bn of mortgages. Of these loans, JP Morgan believes $5.4bn will turn bad this year and if things really start to go pear-shaped, $15.3bn of HSBC’s Asian loans could be written off.

With a Tier 1 capital ratio of 12.1% at the end of the first half, HSBC can stomach these losses, but it will take some time for the bank to recover afterwards. The bank’s net income for the first half amounted to $6.9bn, or $13.8bn annualised, so worst case scenario losses would wipe out one year of losses for HSBC and could threaten the dividend. At the time of writing shares in HSBC support a dividend yield of 6.7%. 

So overall, China’s debt mountain is a huge threat to HSBC’s future. If Chinese policy makers can’t get the country’s corporate debt under control, the whole of Asia will suffer, and there’s almost no way HSBC will be able to avoid the fallout. 

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.