Analyst warns Chinese banks on risk from rising local government debt

China’s banking system has experienced rapid credit growth in recent years with much of the expansion of bank lending associated with state-directed credit to fund projects that facilitate the country’s economic growth. Bank loans, for e.g., rose from 97% of GDP in 2008 to around 120% in 2010.

The excessive credit expansion has led to concerns about potential deterioration in banks’ asset quality, particularly non-performing loans related to real-estate and local government financing vehicles.

As China seeks to transform its economy away from over-reliance on investment and exports, there is also concern that growth may moderate in the near- and medium-term, thus hurting the earnings sustainability and performances of Chinese banks.

Weaknesses in corporate governance and information- disclosure among some Chinese companies and banks also mean any potential banking sector risk may be much bigger than reported.

Official data showed that Chinese banks’ lending to the property sector amounted to 25%, i.e. RMB2.02 tn, of the total new loans issued in 2010 and 19% in 1H11. These do not include off-balance-sheet items which some estimated may constitute about 25% of total banking assets in 2010.

While the NPL ratio of the Chinese banking system has improved markedly from over 20% in the early 2000s to less than 1.5% currently, the improvements mainly came from government clean-up and rapid economic growth.

Although the latest stress tests by China’s banking regulatory authority suggest that Chinese banks can withstand a 50% decline in property prices, we think the banks’ balance sheets could look ugly as other sectors dependent on the property market would also be affected apart from possibly higher mortgage default rate. Moreover, the economy would likely experience a sharp slowdown in this worse case scenario, potentially hurting the profitability of corporates and banks.

According to the National Audit Office, China’s local government debt amounted to RMB10.7 tn at the end of 2010, or about 27% of GDP, with 79% being bank loans. A total of 46.4% or RMB4.97 tn was held by LGFVs.

While the NAO does not provide detailed breakdown of the bank lending, we estimate that policy banks could have the biggest exposures to local government debt, amounting to perhaps 40% of their total loans, given their important role as policy-lenders. Their earnings and capital base could be adversely affected if the local government finances soured.

However, we do not expect the local government debt risk to result in widespread bank failures in the Chinese banking system as the central government would probably provide support for any troubled policy banks and bigger state-owned banks if needed. Nevertheless, smaller banks could potentially be at risk of failing if the property sector and local government debt risks went out of control as China is reportedly resuming the drafting of bankruptcy law for banks.