China's bad debt risks expose systemic shortcomings

Bad debts in China's banks painfully expose the shortcomings of an archaic financial system geared to lend to the beck and call of government economic policy, rather than when it is profitable.

The crux of the problem is rising distrust of official appraisals of China's 10.7 trillion yuan local government loans, which surged on the orders of government as it rolled out a 4 trillion yuan economic stimulus programme at the end of 2008.

Banks say less than 1% of the loans are in trouble, a number some investors say is too low to be real as lending unleashed to spur economic growth at its weakest point implies a rising risk of bad debt as the economy slows again.

"I talk to so many people and they say the same thing: they do not trust the data coming from Chinese banks," said James Antos, a bank analyst at Mizuho Securities Asia in Hong Kong.

China's state audit office said earlier this month it had uncovered 530 billion yuan worth of irregularities with local government debt, leaving investors wondering how much clean-up work remains to be done.

Lacking information, investors are jumping to conclusions. Some think all local government loans are bad. More sober guesstimates assume 2-3 trillion are sour and banks' non-performing ratios may quadruple to 5%, from an average 1.1%.

Investors' worst fears are a cover-up that threatens financial stability in the world's No. 2 economy.

This is especially so if Beijing orders banks to lend aggressively this year to support the economy and counter Europe's slowdown, fuelling a vicious cycle of state-directed lending with poor credit judgment that leads to bad loans.

More immediately, the risk is that rising loan losses hit banks' net profits and capital bases, forcing another government-led bailout like that a decade ago when Beijing spent billions on capital injections to shore up state-backed lenders.