By Terril Yue Jones and Aileen Wang
BEIJING (Reuters) - China pledged on Wednesday to take steps to clean up hundreds of billions of dollars in local government debt, seeking to defuse concerns that a wave of defaults could derail the world's No.2 economy and hobble its state-run banks.
Described by the cabinet and the head of China's No.2 bank as a big issue, the country's mountain of local government debt has long been seen as a major risk by investors. Ratings agency Moody's Investor Services this week said the problem could be bigger than estimated, threatening banks' ratings.
A meeting of the State Council led by Premier Wen Jiabao would establish a mechanism to rectify any bad loans and tackle financing vehicles run by local governments, according to the official Xinhua news agency. The council reiterated a ban on local authorities providing guarantees for debt.
"The size of local government debt being formed over the past several years is relatively big and some risks loom, as the some regions and industries are weak in repaying the debt," Xinhua said, citing a statement after the meeting. "Local governments must continue to clean up and standardize the financing vehicles in a timely manner," it said, adding that the cabinet is paying close attention to the debt issue.
China's state auditor has estimated that local Chinese governments have borrowed a total of 10.7 trillion yuan ($1.6 trillion) by the end of last year.
But ratings agency Moody's said this week that likely understated banks' holdings of local government debt by 3.5 trillion yuan, potentially putting banks on the hook for deeper losses that could threaten their credit rating.
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. A worst case envisaged non-performing loans could reach 12 percent, compared with 1.1 percent at the end of March.
SMALLER BANKS MORE EXPOSED
Guo Shuqing, chairman of China's largest mortgage lender China Construction Bank, called the problem a "big issue" but downplayed the risks from the debt for his bank.
"For my bank, I don't think it's a big problem," Guo told an academic forum in English.
"We just choose the good projects, good companies. We also have a lot of measures to control the risk. Also these projects usually have very good cash flows," Guo said.
Many smaller lenders, while still large on a global scale, have a higher proportion of problematic loans made to local government financing vehicles (LGFV), potentially threatening their survival if defaults spiral and Beijing doesn't step in.
Shenzhen Development Bank, for example, had more than 20 percent of its loans with LGFVs as at the start of the year.
That was worse than numbers reported by major lenders such as Industrial and Commercial Bank of China and Bank of China, which said their LGFV lending stood at 13 and 9 percent of total outstanding loans, respectively.
"Any default will likely hit smaller banks more than the big national lenders," said Sheng Nan, an analyst at UOB-Kay Hian in Shanghai.
"Many of these banks have their operations only in one single geographical area, which makes them more susceptible to pressure from local governments into extending loans for projects that national banks may not want to take on."
Many executives at mid-sized banks may also have relatives or friends in local governments, and may face undue influence when extending loans, Sheng added.
To get around investor fears over their high levels of local government debt, many banks have taken to re-categorizing loans as lending to a public or commercial entity rather than a financing vehicle.
For example, only about 5 percent of Shenzhen Development Bank's loans are now classified as being local government financing vehicle lending, a stunning turnaround from the 22 percent it had just a year ago.
"I don't believe this is going to be a major problem for our country or the industry," bank president Richard Jackson said. "I do think it's correct to keep reducing the exposure (to local government financing vehicles)."
China's banking regulator has been allowing loans backed by an underlying asset or cashflow to be re-classified as lending to commercial projects. Such projects are typically infrastructure projects such as highways or toll roads.
"These are the healthier LGFV loans, with cashflow in the underlying project adequate to repay to loan," said Sanjay Jain, an analyst with Credit Suisse in Singapore. "As usual, the key is how valid those cash flow assumptions are."
Already, local media reports say that a Chinese highway builder backed by the Yunnan government is struggling to repay almost $15.5 billion in loans, highlighting the risks of lending to infrastructure projects that were once seen as reliable.
If the government does step in, it would be the second time since the late 1990s, when Beijing transferred the banks' bad debts to asset management companies backed by sovereign bond issues in preparation for their eventual listings.
However, such a scenario is unlikely until the current administration steps down at the end of its term next year, said Stanley Li, an analyst at Mirae Asset Management in Hong Kong.
"I'm worried the leadership has no strong incentive to tackle the issue because it's like recognizing that their fiscal stimulus was wrong," he said. "They may push it to the next government. If we do not see a clear master plan this year, we won't be seeing one next year."
(Additional reporting by Kevin Yao and Koh Gui Qing; Writing by Kelvin Soh; Editing by Lincoln Feast)