BEIJING China's local government debt may be 3.5 trillion yuan (337 billion pounds) larger than auditors estimated, potentially putting banks on the hook for deeper losses that could threaten their credit ratings, Moody's said on Tuesday.
Moody's reviewed a report released by China's state auditor last week, which found that local governments had chalked up 10.7 trillion yuan of debt. Moody's said it identified more loans funded by banks after accounting for discrepancies in figures given by various Chinese authorities.
Moody's warning weighed on Chinese bank shares, which were the biggest drag on the Hang Seng index in midday trading. However, the share declines were relatively modest. Analysts said that was because Moody's figures were close to other estimates from Beijing on China's debt mess.
Investors worry the pile of loans, about half of which were racked up during a 2008 stimulus spending binge, could destabilise the Chinese economy in the long run. If banks have to absorb heavy losses, it could restrict lending.
"We assume that the majority of loans to local governments are of good quality, but based on our assessment of the loan classifications and risk characteristics...we conclude that banks' exposure to local government borrowers is greater than we anticipated," says Yvonne Zhang, a Moody's analyst.
The ratings agency said a jump in local government loan defaults could push the non-performing loan ratio for Chinese banks as high as 12 percent, well above its base-case scenario that envisions losses in the range of 5 percent to 8 percent.
Unless China comes up with a "clear master plan" to clean up the problem, the credit outlook for Chinese banks could turn negative, Moody's said.
The agency said it expects Beijing to "implement gradual discipline" over the stock of government debt, and that would involve the Chinese government leaving banks to manage a part of problem loans on their own.
Many investors have long eyed China's mountain of local government debt as a major risk. The worry is that slower growth in the world's second-biggest economy could set off a wave of loan defaults and hobble its banking system.
About half of the debt dates back to the 2008 financial crisis when Beijing unveiled a 4 trillion yuan fiscal stimulus package that compelled local authorities to spend their way back to economic health.
But the legacy of the massive spending is now catching up with China as maturity dates for the loans, many of which are due in 2013, draw closer.
While most loans were used to build roads and other infrastructure that some analysts argue China needs, it has also generated some wasteful spending.
For the most part, investors have assumed that cash-rich Beijing would step in to soak up losses if needed, but some analysts are starting to flag the chance of banks paying for a part, or even all, of the losses.
"There is political risk here and concern of a tail-risk event. While the likelihood is very slim, the risk here is that the central government steps away from these loans," said Mike Werner, a bank analyst at Bernstein Research in Hong Kong.
Some analysts said local governments still have options available for ensuring the debts don't go bad, such as selling assets or extending loan maturity dates.
China's five-year credit default swap widened after the Moody's report to around 84 basis points from an opening level of around 80 bps, underperforming a steady iTraxx IG index.
Bank stocks were trading down modestly. Analysts said their cheap valuations, which are near troughs seen during the 2008 financial crisis, could pave the way for a rebound later this year.
In a bid to assuage investor worries, different Chinese authorities including the state auditor, the bank regulator and the central bank have tried to assess the local government debt situation.
But all three agencies have used different definitions and accounting methods to review the debt, resulting in a hodgepodge of official forecasts.
Moody's said it derived the additional 3.5 trillion yuan of debt after comparing the estimate of China's state auditor with that of the bank regulator.
The ratings agency said the Chinese state auditor likely omitted the 3.5 trillion yuan of debt from its assessment because they were not considered real claims on local governments.
"This indicates that these loans are most likely poorly documented and may pose the greatest risk of delinquency," said Yvonne Zhang, a Moody's analyst.
(Reporting by Koh Gui Qing; Additional reporting by Kim Coghill in Singapore, Vikram Suhedar in Hong Kong, and Kit Yin Boey in IFR Markets; Editing by Jacqueline Wong)