IMF report shows $1.3 trn of risky loans

China may have $1.3 trillion loans extended to borrowers that don't have sufficient income to cover interest payments, with potential losses equivalent to seven per cent of the country's gross domestic product (GDP), according to the International Monetary Fund (IMF).

Loans "potentially at risk" would amount to 15.5 per cent of total commercial lending, the IMF said in its latest Global Financial Stability Report. That compares with the 5.5 per cent problem loan ratio reported by China's banking regulator after including non-performing and special-mention loans.

The true amount of bad debt sitting on the books of China's banks is at the center of a debate about whether the country will continue as a locomotive of global growth, or sink into decades of stagnation like Japan after its credit bubble burst. Hayman Capital Management's Kyle Bass in January flagged a $3.5 trillion potential loan loss for China banks, though analysts from China International Capital Corp and Macquarie Securities Ltd have said that estimate overstates the real situation.

The IMF said loans potentially at risk aren't the same as non-performing loans reported by banks and supervisors. Borrowers can sell assets to meet interest payments and banks can take steps to recover collateral and seize assets to avoid losses, it said.

Assuming a 60 per cent loss ratio, potential bank losses on such risky loans may amount to $756 billion, the IMF estimated. That's manageable because the estimate is equivalent to 1.9 years of the banking system's estimated pretax profits for 2015, the IMF said, also noting that Chinese banks hold $1.7 trillion of Tier 1 capital.

Still, the organisation urged "prompt action" to address rising corporate sector vulnerabilities. Chinese firms are generating operating profits equivalent to only two times their interest expenses, down from almost six times in 2010, according to data compiled by Bloomberg on non-financial companies traded in Shanghai and Shenzhen.

Risks are concentrated in sectors such as real estate, manufacturing, retail and wholesale, mining and steel, the IMF said. Those industries have both high leverage and a high proportion of loss-making firms, the organisation said.

China's government has indicated it's drawing up plans to address high corporate leverage and non-performing loans.

Premier Li Keqiang said the country may use debt-to-equity swaps to cut excess borrowings by Chinese firms. China's cabinet has discussed lowering bad-loan coverage ratios, according to people familiar with the matter. Regulators will allow domestic banks to issue up to 50 billion yuan ($7.7 billion) of bad loan-backed securities to remove soured credit from their books, other people said.