About 26 percent of all loans to Chinese local government financing vehicles are at serious risk of default, regulators concluded after a probe into what some analysts see as a liability for the economy.
The estimate that 2 trillion yuan ($300 billion) of local debt could turn sour is slightly higher than an earlier assessment by the Chinese banking regulator that 23 percent, or 1.76 trillion yuan, was in trouble.
The results of the latest investigation, published on the front page of the official China Securities Journal on Thursday, are a first step in what the government has promised will be a thorough effort to clean up the mess left by a surge of stimulus spending to counter the global financial crisis last year.
Local governments, which are officially barred from borrowing, launched thousands of hybrid government-company bodies as financing vehicles to get around the restrictions and fund their expenditures, much of which went to infrastructure.
According to the investigation, 24 percent of the debt incurred by the local financing vehicles is fully backed by revenues from the projects that they have funded.
A second batch of loans, about 50 percent of the total, will not be recoverable directly from the projects that they have funded, but will be covered by secondary sources, such as government revenues.
The third batch is the 26 percent in serious trouble.
"With the third kind of loans, projects did not conform to regulations, fiscal guarantees did not conform to regulations and there will be serious risks in paying them back. For example, the loans have been embezzled or used as investment capital," the China Securities Journal reported.
The investigation, which covered the state of local finances up to the end of June, also looked at the sources of the funds.
Large state-owned banks provided about 40 percent of the loans to the financing vehicles, while smaller banks accounted for 26 percent and government-controlled policy banks the remaining 30 percent.
The report added that banks were carrying out regulators' instructions to carefully review their loan books and begin the work of writing off bad debts.
Banks have been told to stop lending to local financing vehicles if their projects will rely on government revenues to pay off debts, it said.
It also said that many banks had set aside provisions of more than 200 percent of local government non-performing loans.
Moody's Investors Service last week put the Chinese government's bond rating on review for a possible upgrade, saying that the boom in lending by state banks during the financial crisis was on solid ground.
It said that banks would be able to absorb the bulk of credit losses themselves, either from capital or from future earnings.
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