China's audit missed $500 billion in local government loans, Moody's says, and about 75% will go bad

07/06/2011 2:54 pm EST


Jim Jubak

Founder and Editor,

China’s banks are in more trouble than investors thought. That’s the message in the warning from Moody’s Investors Service and the decision by Temasek, Singapore’s national investment fund, to sell shares in two of China’s biggest banks.

Yesterday, July 5, Moody’s warned that the recently completed government audit of loans by local government financing platforms might have missed a few loans. Last week China’s first audit of local governments found that provinces, cities, and counties owned about 10.7 trillion yuan. Moody’s calculates that the audit missed about 3.5 trillion yuan, or roughly $540 billion in loans. Most of these, according to Moody’s, weren’t included in the national audit because they weren’t properly underwritten and thus couldn’t be classified as government loans. As a result of that sloppy underwriting and other problems with the loans as many as 75% of them could go bad. That would push the bad debt ratio for China’s banks up to 8% to 12% of all loans instead of the 1% bad loan ratio now officially calculated.

Yesterday Temasek sold its shares in two of China’s biggest banks for an estimated $3.6 billion. Singapore’s sovereign investment fund sold $2.4 billion of shares in Bank of China and $1.2 billion in shares China Construction Bank. Temasek, which has played a role as a core institutional investor in the initial public offerings of China’s big banks, didn’t reference the Moody’s news, so investors don’t know if there’s any connection. In February Temasek completed an internal review of its holdings in China’s big government-owned banks. At the end of March 2010 Temasek had owned 4% of Bank of China and 6% of China Construction Bank.

Despite its findings Moody’s didn’t wasn’t urging investors to sell China. Moody’s did not anticipate a downgrade on China’s debt, Yvonne Zhang, one of the authors of the report, told the Financial Times. The banks appear to have started to get a handle on the debt problem, she said.

And Moody’s remains more optimistic than Fitch Ratings, which warned earlier this year that China’s bank could eventually see their bad loans reach 30% of their portfolios.

My own view is not so much optimistic or pessimistic as cynical. The big banks that have recently gone public were essentially bankrupt until Beijing began injecting capital and selling off their huge portfolios of non-performing loans to special entities set up for the single purpose of taking that debt off bank balance sheets.

What China has done once, China is certainly willing to do again.

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