Stimulus may trigger bank bailouts

China may be forced to bail out banks that made loans for local-government projects under the unprecedented stimulus programme unleashed in 2008, according to Citigroup and Northwestern University's Victor Shih.

In a "worst-case scenario", the non-performing loans of local-government investment vehicles could climb to 2.4 trillion yuan ($500 billion) by 2011, Shen Minggao, Citigroup's Hong Kong-based chief economist for greater China, said yesterday.

"The most likely case is that the Chinese government will engineer a massive financial bailout of the financial sector," said Shih, a professor who spent months researching borrowing by about 8000 local government entities.

Chinese officials pledged this week to limit the risks posed by the investment vehicles, which circumvent restrictions on local-government borrowing to channel money into stimulus projects. Yan Qingmin, head of the banking regulator's Shanghai branch, said on March 5 that China planed to nullify guarantees provided by local governments for some loans.

Citigroup's Shen said officials could keep monetary policy loose for longer than they should, boosting asset prices and building up overcapacity, to avoid the "squeeze" on investment vehicles that would trigger bad loans and bailouts. "The risk is that inflation or asset bubbles force the Government to withdraw their support to local governments much earlier than expected," he said.

In Shen's worst case, commercial banks, lending because of explicit or implicit government guarantees rather than the quality of projects, see 20 per cent of lending to the investment vehicles turn bad in 2011.

Premier Wen Jiabao is weighing when to exit crisis policies as property prices surge, inflation climbs and exports rebound, highlighting the risk of overheating in the world's fastest-growing major economy, awash with cash from unprecedented lending in 2009.

Shih was more pessimistic than Shen in an interview in Hong Kong yesterday. He said that if the central government stopped lending to the entities now, the cost of a bailout could already be "in the neighbourhood" of three trillion yuan.

The academic said that "the only credible action by the central government now is to allow a handful of these entities to go bankrupt - so that the banks know that the central government means business when it says it's withdrawing guarantees.

In contrast, Jia Kang, the head of the research institute of China's Ministry of Finance, said March on 10 that the risks "may not be so serious as some people have claimed".

Industrial & Commercial Bank of China president Yang Kaisheng said on March 7 that the lender had inspected loans it extended to the financing vehicles in 2008 and 2009 and "so far didn't find many big problems".

Su Ning, a deputy governor at China's central bank, said on March 8 that a "fairly high proportion" of lending last year went to the funding vehicles. Chinese banks extended a record 9.59 trillion yuan of loans in 2009. Su saw "a big risk" from local-government guarantees for money borrowed to fund infrastructure projects that may not generate returns, he said.

The investment entities have played a key role in channelling money to stimulus projects, often for urban development, Citigroup's Shen said.

Central bank Governor Zhou Xiaochuan said March 6 that while "many" of the financing entities have the ability to repay debt, two types cause concern.

One uses land as collateral, while the other can't fully repay, meaning local governments may be liable, leading to "fiscal risks," he said.

Regulators believe a few cities and counties may struggle with repayments because of debt ratios exceeding 400 per cent, a person with knowledge of the matter said in January. The ratio is of year-end outstanding debt to annual disposable fiscal income.

Chinese banks had 497 billion yuan of non-performing loans as of December 31, accounting for 1.58 per cent of advances, according to the banking regulator.

- BLOOMBERG