Non-performing loans (NPLs), the inevitable aftermath of China's unprecedented credit boom in 2009, will increase gradually in the coming years, and the country's less creditworthy local government financing vehicles are expected to suffer the most damage, says Standard & Poor's.

But that damage will strain rather than cripple China's banking system. Good profitability, strong liquidity and adequate capitalisation will enable the country's major lenders to absorb unexpected credit losses in reasonably distressed scenarios. However, smaller banks may run into difficulty should economic conditions drastically deteriorate, the ratings agency argues.

"We believe China's banking sector will have a higher NPL ratio, with lending to the local government financing vehicles bringing the most risk; 30% to 35% of new loans over the past 18 months went to these local government entities," Liao Qiang, a banking analyst at the agency said in a telephone conference yesterday. The local government vehicles represent about 18% to 20% of total loans in the banking system, he added.

Most China watchers agree the local government financing vehicles are the big headache for the Chinese banking authority. While taking up a significant portion of total lending, their solvency is generally weak and they typically have high debt or operational leverage. Selling land and fiscal transfers from local governments are their main debt repayment resort.

These entities have been around for decades. Since Beijing bans provincial and municipal governments from raising capital via bond sales or bank loans, they circumvent the restrictions and set up wholly owned subsidiaries through which they can get loans and obtain funds to ensure much-emphasised economic growth in local areas.

"Their lack of disciplined financial policies makes it uncertain whether they will stick to any capital expenditure and funding plans. Moreover, these vehicles often generate inadequate cashflow from operations," Liao said.

BNP Paribas has estimated that about Rmb3 trillion ($442 billion) worth of new credit went to the local government vehicles last year.

Defaults among property developers are also very likely after the government has introduced tightening measures to cool property prices. Domestic exporters have also become less capable of paying off their bank loans due to increasing wages and renminbi appreciation, S&P said.

Nevertheless, the agency expects China's overall NPL ratio to stay flat at 3% to 4% until the end of this year and below 10% until the end of 2012 because of the current resilient economic conditions and the relatively long tenor of loans to government vehicles.

"Despite the credit risk pressure, China's major banks are capable of absorbing the potential losses. They have good operating profitability due to a regulated interest rate regime [and] their growing momentum in fee income will remain strong in the next several years," Liao said.

The major banks' pre-provisioning profitability ratio was about 1.8% in 2009, compared with actual credit costs of 0.28%, according to S&P.

The agency's view is shared by CLSA, although the brokerage reaches this conclusion through a different calculation.  

According to Francis Cheung, head of China and Hong Kong strategy at CLSA, if 25% of new loans issued to local government vehicles turn bad, it would add 200 to 250 basis points to the NPL ratio. This would see the NPL ratio rise to 3.58% which remains manageable for most Chinese banks.

Cheung thinks the market is so worried about the Chinese banks' questionable loans that some banking stocks have become very attractive because they are now trading at relatively cheap valuations. Bank of China trades at 1.4 times forward book value, while Agricultural Bank of China, which listed last week, trades at 1.6 times book for 2011, even though Bank of China has better asset quality than the latter, Cheung told reporters in Hong Kong yesterday.

However, the earnings capacity among Chinese banks varies significantly. Banks in the county and rural areas are the least profitable, and rising credit costs could prove severe for the small lenders that are heavily exposed to local government vehicles, S&P's Liao said.

It won't lead to a crisis in the banking system, but does point to further banking industry consolidation during which small lenders will be taken over by their bigger competitors or be forced to close down, he argued. The Chinese banking sector is already in the midst of consolidation. There are currently just over 4,000 domestic banks, compared with 20,000 banking institutions three years ago.

S&P believes the ongoing capital-raising exercises by the major Chinese banks have reinforced their liquidity and capitalisation, and the banks' structural strength will continue to shield the sector from any foreseeable crisis.  

CLSA's Cheung predicts China's monetary tightening measures will be completed in 2011. And after a decline of 37% year-on-year in the first half of this year, loan growth will turn positive at about 30% year-on-year in the second half with a significant portion of the lending going to state-owned enterprises.

Beijing is targeting 18% credit growth this year, but analysts believe the actual growth will exceed that level. Last year, a state-directed credit spree aimed at preventing an economic recession saw banks issue Rmb9.6 trillion of loans.