Over the last week, several commentators have noted some trickery at the centre of efforts to recapitalise China's banking sector. But the sleight of hand is even more subtle than most of those sceptics seem to suspect. China's banks may have sailed unscathed through the 2008 international financial crisis, but they still need to raise fresh capital. Last year's government-mandated lending binge, which saw the official value of China's outstanding bank loans shoot up by 33 per cent (see the first chart below), left mainland banks' capital bases looking uncomfortably thin relative to their assets. Core capital ratios at the big four state-controlled commercial banks dropped from well over 10 per cent before the spree to a little over 9per cent at the end of last year. Ratios at second tier commercial banks, which had been considerably weaker to begin with, were even more heavily eroded (see the second chart below). And that doesn't even factor in the strenuous efforts the banks have made over recent months to disguise the true extent of their lending by repackaging loans and selling them on to unsuspecting wealth management clients. Working out how many loans have been hidden in this way is tricky, but analysts at Fitch Ratings estimate that Chinese banks may have shifted as much as 2.3 trillion yuan-worth (HK$2.63 trillion) of new lending off their balance sheets. Count those loans back in as assets and capital adequacy ratios would sink even more. Understandably concerned, the regulators have ordered China's banks to tap investors for fresh capital by issuing new shares. In response, Industrial & Commercial Bank of China, China Construction Bank and Bank of China have announced plans to raise more than 200 billion yuan in new equity. But these plans pose a problem for the authorities. At the moment the central government owns controlling stakes in the country's biggest banks though its holding vehicle, Central Huijin Investment. If the government doesn't want to see its stakes in the banks diluted then Central Huijin will have to buy into the proposed share offerings. That in turn means Central Huijin will have to raise the cash it needs to fund its purchases. The holding company made a start last week by issuing 54 billion yuan of debt in China's domestic bond market. Over the coming months, it plans to issue a further 134 billion yuan-worth of bonds. Now, as a number of commentators have noted, the only feasible buyers for the majority of those bonds are the commercial banks themselves, who own 63 per cent of China's entire domestic bond market. This peculiar shuffle in which the banks pay for their own recapitalisation has provoked a lot of muttering about conjuring tricks and giving with one hand while taking away with the other. But as Yi Zhang at Moody's in Beijing points out, there is more to this circular deal than simple accounting trickery. Let's suppose China's banks buy up all Central Huijin's 188 billion yuan of bonds. Because those bonds are issued by the central government, they are considered zero-weighted for risk, which means the banks don't have to hold any capital against them on their balance sheets. Now in return for buying the bonds, the banks receive an injection of 188 billion yuan in equity capital from the government - capital which they can hold against new loans to Chinese companies. At a capital to asset ratio of 11.5 per cent, that means they will be free to rush out and make 1.6 trillion yuan worth of new loans. In short, what looks like a game of pass the parcel is actually a neat way of allowing the banking system to increase its leverage and continue lending while appearing to stay sound. That should be worrying, because China's banks are notoriously poor at making commercial lending decisions, overwhelmingly preferring to lend to state sector companies even though returns on capital among state companies are consistently lower than in the private sector. As a result, what looks like a recapitalisation is simply a licence for Chinese state banks to carry on with the same old bad behaviour. As Zhang at Moody's explains: 'These announcements suggest the new capital likely won't last long and the banks' business model won't change fundamentally in the near term. But pain lies ahead if China's economic growth slows and the banking business model cannot adjust accordingly in time.'