Infrastructure lemons could squeeze China banks

Reuters | Wed Jun 2, 2010 | 3:29pm IST

Chinese banks could be headed for a crisis Chinese banks could be headed for a crisis similar in some ways to what their Wall Street counterparts faced two years ago, as a chunk of the $1 trillion they made in dubious infrastructure loans to local governments looks set to sour. And though the banks have lined up tens of billions of dollars in new capital-raising, they could be forced to raise billions more if China’s property market sees a sharp downturn. Lending on a wide range of projects — from high speed railways to airports and bridges — mushroomed in China last year as Beijing launched a 4 trillion yuan ($586 billion) stimulus package to keep the economy humming during the global downturn. But as Beijing moves to cool it’s now racing economy, including a red-hot real estate market, fears are mounting that local governments that depend on land sales for up to 45 percent of their revenues may be unable to pay back their massive loans.

Chinese banks may have as much as 7 trillion yuan in loans to local government infrastructure projects on their books, with 30-50 percent of that likely to go sour, estimated Stephen Green, China economist at Standard Chartered Bank. "It’s like a time-bomb," said Fan Kunxiang, analyst at Haitong Securities. "No one knows exactly how big the problem is or when it is going to explode. If one or two infrastructure projects fail, that would cause panic in the market." The sheer scale and nature of the problem is unclear due to opaque borrowing practices by local governments. To better understand it, China’s banking regulator has launched an industry-wide investigation slated for completion by the end of this month. The regulator has already ordered a drastic slowdown in infrastructure lending, and is the main force driving banks to raise billions of dollars in new capital to bolster their balance sheets against potential future losses. All of China’s major lenders have announced various capital raising plans, hitting shares of top lenders like ICBC, Bank of China and China Construction Bank, even as all three reported record quarterly profits. "The government is auditing local governments’ infrastructure projects, so I think the concern there is that regulators will force the banks to increase their provisions," said CLSA equity strategist Christopher Wood.  


China’s cash-strapped local governments have devised a system of financial smoke and mirrors to facilitate their infrastructure spending binge, often using special vehicles backed by land as collateral to finance projects with little chance of success. Some 8,000 such vehicles now exist in China, half of them created over the past 18 months alone, according to Credit Suisse economist Dong Tao. But many of the projects being built through such vehicles hardly look commercially viable. In one exemplary case, Jiamusi, a small city in northeastern Heilongjiang province, plans to build a high-tech maglev train, even as a similar project in Shanghai, China’s commercial hub continues to struggle years after starting operation.

Another case in Shanghai demonstrates how funds lent to such vehicles can often be abused for spending that has nothing to do with infrastructure. That saw a Shanghai district borrow 2 billion yuan in the name of a high-speed rail project, only to spend 1.3 billion on non-related matters like resettlement compensation, according to a state audit. "No one really understands how much revenue-generating capability these projects have, how much land sales can help local governments repay, or how much these projects will add to growth," Standard Chartered’s Green said. "In other countries, these projects began with a budget, while in China, it’s all done off government balance sheets."

Credit Suisse’s Tao warned that many such vehicles look alarmingly similar to those used by Wall Street banks that set off the global crisis, in terms of their high leverage, land-based valuations and lack of asset liquidity and transparency. He said a crisis could blow up as soon as in 2011, triggered by a property market downturn as Beijing takes harsh steps to curb real estate speculation. Such a crisis would not only affect major lenders, but also thousands of smaller institutions such as city commercial banks and rural credit co-operatives that typically have close ties with local governments, said Green. Green added that one of the most basic problems lies in the current ban on local governments issuing bonds directly, a common practice in other countries. "Fundamentally you need local government fiscal reform … and that implies local governments are held accountable for their debts and that’s very, very hard to do in this system," he said.


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