China's local government debt may be 3.5 trillion yuan ($540 billion) larger than auditors estimated, potentially putting banks on the hook for deeper losses that could threaten their credit ratings, Moody's said on Tuesday.
China's mountain of local government debt has long been seen as a major risk by investors. The worry is that slower growth in the world's second-biggest economy could set off a wave of loan defaults and hobble its banking system.
"Banks' exposure to local government borrowers is greater than we anticipated," Yvonne Zhang, a Moody's analyst, said in a statement.
Unless China comes up with a "clear master plan" to clean up the problem, the credit outlook for Chinese banks could turn negative, Moody's said.
Moody's debt tally is near the midpoint of various estimates from Chinese authorities, which used different definitions and accounting methods to compute their debt totals. The varying figures have led to confusion about just how serious the problem could become if heavily indebted local governments default, saddling banks with large loan losses.
Moody's said it was hard to judge which banks had taken on the most local government debt, but Bank of China and China Citic Bank were among those that had lent more aggressively than their peers during China's bank lending spree in 2009.
China's state auditor reported last week that local governments had chalked up 10.7 trillion yuan of debt, about half of it amassed during a stimulus spending binge as Beijing sought to cushion the blow of a global recession.
Moody's said the auditor's report excluded some bank-funded loans because they were not deemed to be "real claims" on local governments. But the ratings agency said those loans posed the greatest risk of delinquency, and banks may face losses.
The warning weighed on Chinese bank shares, which were the biggest drag on the Hang Seng index on Tuesday. However, the share declines were modest and analysts expressed confidence that banks could withstand loan losses.
"Even if the worst-case scenario happened, it's not going to be fatal," said Victor Feng, an equity strategist at Everbright Securities in Shanghai.
"Profits may drop but banks will not go bankrupt."
The ratings agency said a jump in local government loan defaults could push the non-performing loan (NPL) ratio for Chinese banks as high as 12 percent, well above its base-case scenario that envisions losses in the range of 5 percent to 8 percent.
Government figures show the average NPL was 1.1 percent at the end of March.
Moody's outlined three scenarios for resolving the debt problem. Most likely, Beijing would work on a case-by-case basis, helping local governments to get funding. China may ask banks to absorb losses on loans for which local governments are not liable. Moody's said this scenario would probably involve a fair amount of debt restructuring by banks.
In the worst-case scenario, Beijing would leave banks and local governments to thrash out the issue on their own. This could hurt investor confidence in China as there would be no clarity around China's debt problems and loan disputes could drag on, thereby worsening losses.
The best case would involve Beijing stepping in to supply local governments with funding or take on some of their debt, although Moody's acknowledged that this would raise "moral hazard" issues of banks assuming excessive risk knowing the government would always come to their rescue.
Reuters reported on May 31 that China's regulators planned to shift 2 trillion to 3 trillion yuan of debt off of local governments to try to ease the default threat.
INSTRUMENTS OF THE STATE
Many investors have long eyed China's mountain of local government debt as a major risk. The worry is that slower growth in the world's second-biggest economy could set off a wave of loan defaults and hobble its banking system.
About half of the debt dates back to the 2008 financial crisis when Beijing unveiled a 4 trillion yuan fiscal stimulus package that compelled local authorities to spend their way back to economic health.
But the legacy of the massive spending is now catching up with China as maturity dates for the loans, many of which are due in 2013, draw closer.
While most loans were used to build roads and other infrastructure that some analysts argue China needs, it has also generated some wasteful spending.
Peter Elston, a strategist with Aberdeen Asset Management Asia, said the episode served as a reminder that Chinese banks can be used as instruments of the state, making them less attractive as investment options.
"It is very sad because it is going to take a very long time for them to convince investors that they are run for the benefit of shareholders and not for the benefit of the broader economy," Elston told Reuters in an interview in Singapore.
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