China8217;s bad debt risks expose systemic shortcomings

Banks say less than 1 per cent of the loans are in trouble,a number some investors say is too low to be real as lending unleashed to spur economic growth at its weakest point implies a rising risk of bad debt as the economy slows again.

I talk to so many people and they say the same thing: they do not trust the data coming from Chinese banks,said James Antos,a bank analyst at Mizuho Securities Asia in Hong Kong.

China8217;s state audit office said earlier this month it had uncovered 530 billion yuan worth of irregularities with local government debt,leaving investors wondering how much clean-up work remains to be done.

Lacking information,investors are jumping to conclusions. Some think all local government loans are bad. More sober guesstimates assume 2-3 trillion are sour and banks8217; non-performing ratios may quadruple to 5 per cent,from an average 1.1 per cent.

Investors8217; worst fears are a cover-up that threatens financial stability in the world8217;s No. 2 economy.

This is especially so if Beijing orders banks to lend aggressively this year to support the economy and counter Europe8217;s slowdown,fuelling a vicious cycle of state-directed lending with poor credit judgment that leads to bad loans.

More immediately,the risk is that rising loan losses hit banks8217; net profits and capital bases,forcing another government-led bailout like that a decade ago when Beijing spent billions on capital injections to shore up state-backed lenders.

For a Factbox on China8217;s banks,click

OPTIMISTS EYE REPAYMENT

Optimists say Beijing will pay the debt,or let local governments sell bonds to repay loans used mainly for building infrastructure. Investors like the former option as it is clean and fast,but Beijing is non-committal.

Markets hate that uncertainty,which is one reason why Chinese bank shares have underperformed.

Their average price-to-book ratio of 1.3 is half that of Indonesian banks,according to Reuters data,after the Shanghai financial index plunged some 37 per cent in the last two years.

Certainly a good number of loans made in the last three years will go bad,said David Madden,a managing partner at DAC Financial Management,a 425 million private equity firm in Hong Kong focused on trading Chinese bad debt.

They weren8217;t necessarily made with the highest levels of credit analysis.

China8217;s cumulative loan growth is the second fastest in the world8217;s emerging economies at around 55 per cent,after Belarus,and a third faster than India8217;s 40 per cent,Fitch Ratings said.

Yet Chinese banks insist bad loans are falling,not rising.

Their weighted-average non-performing loan ratio dipped 0.1 per cent in the third quarter from the previous three months,Citi data showed. In contrast,Indian banks8217; weighted-average ratio rose 7.5 per cent,hurt in part by a falling rupee.

Non-performing loans are those where borrowers have not made payments for at least 90 days and are in or close to default.

Investors suspect banks are concealing bad loans by adamently refusing to label them as non-performing when cash-strapped governments cannot repay.

Instead,analysts say banks have 8212; or will 8212; quietly restructure loans by extending maturities,violating best practice where loans are marked non-performing before being restructured. China8217;s top state-owned banks declined to comment.

CONSTRAINED BY ACCOUNTING RULES

The market does not like the fact that you are trying to hide loans which do not meet current terms,said an analyst at a foreign bank in Hong Kong who declined to be identified.

That Chinese banks are concealing bad debt would be even more apparent if they continue to report enviably low non-performing loans in their 2011 results in March,analysts said,since a fifth of all local government loans matured last year.

In banks8217; defence,they could argue their provision coverage of 190 per cent is among the highest in Asia,meaning they have put aside 1.9 yuan for every yuan of dud loan 8212; although this ratio looks good when banks recognise lower levels of bad debt.

Margarita Ho at PricewaterhouseCoopers in Beijing said banks are also constrained by China8217;s accounting rules.

The accounting rules do not permit banks to provide reserves for losses based on future events,regardless of how probable they are,she said.

But some investors argue the economic reality is that China has more bad loans than it is admitting to,especially with its economy now slowing,and so its financial stability is at stake if Beijing does not act more forcefully.

You kind of let the bad news ride until you are forced to accept it,said Madden from DAC. But I don8217;t think kicking the can down the road is,ultimately,a smart thing to do. 1 = 6.3095 Chinese yuan

CHINA-ECONOMY/BANKS FACTBOX

China8217;s giant state-owned banks may be the biggest in the world by stock market value but they wield little clout in reality as the government controls the reins of their operations.

For an accompanying story on how bad debt risks highlight the systemic short comings of China8217;s state-directed banking system,click on

Below are key facts about the banks.

Chinese banks were restructured in one of the world8217;s largest bank bailouts in the early- to mid-2000s that culminated in the public listing of the biggest state lenders. The exercise sheared banks of their bad debt and recapitalised them.

Analysts say the restructuring cost about 4 trillion yuan 633.36 billion,or 22 per cent of China8217;s 2005 gross domestic product. In contrast,Washington has so far spent 428 billion rescuing US financial institutions from the 2008 crisis.

Chinese banks had an average non-performing loan ratio of 26 per cent in 2002 before they were restructured,analysts said. The ratio has since dropped to 1.1 per cent,according to the regulator.

The cost of the bailout underscores the government8217;s reluctance to ease its grip on banks,which have no say over how much they lend,at what price,or how much to pay for deposits.

Beijing controls total bank lending by setting an annual loan target. Banks that overshoot their target may be punished either with forced purchases of central bank bills that give low returns,or be slapped with higher reserve requirements.

Beijing stopped announcing its lending target last year after banks overshot the 2010 target of 7.5 trillion yuan by 400 billion yuan. Sources said the 2012 target is 8 trillion yuan,up from 20118217;s estimated 7.5 trillion yuan.

Banks are also required to lend no more than 75 per cent of their deposits. Beijing runs checks at the end of each quarter so banks compete harder for deposits then.

To support banks8217; profitability,Beijing sets a ceiling on deposit rates and a floor on loan rates,giving banks a guaranteed net income margin of 300 basis points right now.

China8217;s 3,769 bank institutions owned 95.3 trillion yuan 15.1 trillion worth of assets in 2010,equivalent to 2.4 times that of China8217;s GDP,the China Banking Regulatory Commission said.

The top five banks control 49 per cent of total banking assets.

The banks are Industrial and Commercial Bank of China ,China Construction Bank ,Bank of China ,Agricultural Bank of China ,and the Bank of Communications .

8212; Bank loans accounted for 58 per cent of total funding in the third quarter,which critics say is too high for lending to be efficient,especially with heavy state intervention and banks8217; propensity to lend to other large state firms.