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China Banks Said to Underestimate Local Government Risks

China Banks Said to Underestimate Local Government Lending Risk
The China Banking Regulatory Commission (CBRC) seal is seen outside their offices in Beijing. Photographer: Nelson Ching/Bloomberg

Chinese banks misclassified about 20 percent of their outstanding loans to local governments, understating the risk that slowing revenue will cut borrowers’ ability to repay, a person with knowledge of the matter said.

The China Banking Regulatory Commission told lenders last month that they had incorrectly placed about 1.8 trillion yuan ($286 billion) of loans to local government financing vehicles in the safest category of lending, the person said, declining to be named because the matter is private. The banks erred in calculations and underestimated risks when they decided the loans were fully covered by cash flows from the projects, the person said.

Reclassifying the debts may force banks to set aside greater loan-loss provisions and seek more collateral from regional authorities, whose revenue growth has slumped as the world’s second-biggest economy slows. Agricultural Bank of China Ltd., the nation’s third-largest lender, March 22 unexpectedly posted its first drop in quarterly profit since its 2010 listing after creating more provisions than analysts had estimated.

“The impact of a reclassification would not be huge for the entire industry but it can be much bigger for a few banks if the problems are concentrated in them,” said Yvonne Zhang, a Beijing-based vice president and senior analyst at Moody’s Investors Service. “In our stress tests, we assumed that between 20 percent and 33 percent of those loans will eventually turn sour without government assistance.”

Local Projects

Local governments in China, prohibited from directly taking out bank loans or selling bonds, have set up more than 6,000 financing companies to raise funds for projects such as stadiums, roads and bridges, the National Audit Office said in a June report.

Regulators and investors have expressed concern that if local-government loans aren’t repaid they could lead to China’s third banking bailout in less than two decades. While the regulator’s warning doesn’t order banks to categorize the loans as non-performing, it suggests that the risks may be greater than lenders have estimated.

Cash Flows

About 8.2 trillion yuan of a total 9 trillion yuan of loans to the financing vehicles were classified as fully covered by cash flows as of Dec. 31, and some lenders had wrongly included items such as government subsidies in their calculations, the person said. It’s unclear what the regulator will tell banks to do with the misclassified debt, the person said.

The CBRC’s press office responded to a query by referring to a March 1 statement in which the regulator urged lenders to “completely and objectively” recognize risks and problems including maturing of loans to local governments, restructuring of such debt and fluctuation in the value of collateral.

Local government loans that are fully covered by forecast cash flows from the projects they finance should be given a 100 percent risk weighting when banks calculate their capital adequacy ratios, according to a CBRC regulation released in December 2010. The weighting otherwise would be at least 140 percent and could be as high as 300 percent.

Banks need to hold more capital to cover assets with higher risk weightings.

Assuming an average 50 percentage-point increase in risk weighting for the 1.8 trillion yuan of loans after reclassification, commercial banks may see roughly a 15 basis-point drop in their core capital adequacy ratios, Zhang said. The average ratio stood at 10.2 percent as of Dec. 31, according to the CBRC. A basis point is 0.01 percentage points.

Slowing Economy

Local-government revenue grew 15 percent in the first two months of this year to 1 trillion yuan, compared with a 36 percent jump a year earlier, according to government data. China’s economy expanded at the slowest pace in 10 quarters in the last three months of 2011 as export demand moderated and a prolonged campaign against consumer-price inflation and property gains cooled growth.

The government’s scrapping of tolls on some roads has made it harder to repay loans in certain regions, and new requirements that local governments set aside more funds from land-sale proceeds for education and irrigation further strain their ability to pay off debts, the person said. More than 450 billion yuan of local government loans went to the roads affected by the toll cancellation, the person said.


Regional authorities are also finding it harder to replace improperly registered collateral and government guarantees the regulator has banned, after having injected about 280 billion yuan of new capital and more than 800 billion yuan of assets into the financial vehicles’ books, the person said.

In addition, banks were told they could refinance loans for completed projects that aren’t yet generating income if estimated future cash flows can cover borrowings, there’s adequate collateral and repayment terms meet regulatory requirements, the person said. The amount of money provided for such refinancing may not exceed the amount of the original loan, the person said.

If debt matures before a projects is completed, banks may reset the duration of the loan if the project meets the same requirements, the person said.

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