China's banks on the hook for $260 billion in local-government bad loans

07/29/2010 10:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

That’s one huge bad loan problem.

23% of the $1.1 trillion that Chinese banks have lent to infrastructure projects backed by local governments are likely to go bad, an unnamed source with access to government data has told Bloomberg.

The works out to about $260 billion in potential bad loans or about five times the $50 billion that China’s five biggest banks plan to raise this year in new capital.

About half of the projects can’t generate sufficient revenue to cover their debt service. The interest on these loans will have to be paid by other sources including the local governments that guaranteed the loans.

The problem isn’t likely to show up all at once. Many of the loans to the investment vehicles set up by local governments (since China’s local governments aren’t allowed to borrow themselves) are long-term debt. Borrowers will probably manage to scrape up interest payments for the next year or two in the hope that something will happen to bail them out before running out of cash. That means that loan problems will start to show up in large numbers in two or three years.

But show up they will. This same insider said that government data show that only 27% of the loans to local government-affiliated investment vehicles will generate enough cash to repay their loans.

The central government is ultimately on the hook for this bad debt—well at least as much on the hook as Beijing can be given its history of simply burying bad debt in special purpose vehicles.

But still Beijing has recently moved to limit the problem as much as it can at this late date. In June Beijing ordered local governments to concentrate on completing projects already underway rather than starting new work. Financing vehicles that rely only on the income of local governments to repay debt should stop spending. And local governments have been barred from guaranteeing the loans of local investment vehicles.

Not all of China’s big banks are equally exposed to these loans. China Citic Bank (CHBJF.PK) faces the biggest exposure, wrote Sanford C. Bernstein analyst Michael Werner in a recent report. China Merchants Bank (CIHHF.PK) faces the least exposure.

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