China’s banks are facing serious default risks on more than one-fifth of the Rmb7,700bn ($1,135bn) they have lent to local governments across the country, according to senior Chinese officials.

In a preliminary self-assessment carried out at the request of the country’s regulator, China’s commercial banks have identified about Rmb1,550bn in questionable loans to local government financing vehicles – which are mostly used to fund regional infrastructure projects.

A senior official from the China Banking Regulatory Commission told the Financial Times these loans would not necessarily all go bad but that the country’s non-performing loan ratio would almost certainly “increase slightly” at the end of the year.

Local governments had, until recently, been on a construction spree on orders from Beijing to prop up the economy in the face of the financial crisis. However, since the start of this year, top Chinese bankers and regulators have been warning that many of the loans used to fund infrastructure spending and a property boom could go bad.

Rating agency Standard & Poor’s estimates that if 30 per cent of loans to local government vehicles become irrecoverable, it would add 4-6 percentage points to overall non-performing loan ratios at the banks. “The pain will be uneven across the sector; the major banks should be able to keep the impact to a manageable level because of their stronger credit risk controls but smaller institutions could struggle due to their proportionally heavier exposure to local government vehicles and lower profitability,” said Liao Qiang, an analyst with S&P.

Chinese banks lent a record Rmb9,600bn last year – more than double the new loans issued in 2008. But stern warnings by regulators for the banks to slow down lending appear to be having an effect on the economy.

Headline growth in China slowed to 10.3 per cent in the second quarter from 11.9 per cent in the first quarter, and loans to property developers dropped 62 per cent from the first quarter to Rmb121.6bn in the second quarter, according to figures from the central bank.

But analysts say the apparent success of the clampdown on lending disguises a worrying new trend that involves banks co-operating with lightly regulated trust companies to keep loans off their books.

The regulator ordered a stop to this type of lending at the start of the month.

China’s banking system had a non-performing loan ratio of more than 50 per cent a decade ago. Today the country is a breeding ground for the world’s largest and most profitable banks with an average NPL ratio of just 1.3 per cent as of the end of last month.

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