By: Our Correspondent

Although the financial news focus has been on the so-called
stress-testing of European banks – tests which have been too easy for
comfort — the bigger news is surely the admission by China of the loan
loss potential of its banks.

The China Banking Regulatory
Commission said that as much as 20 percent of 7.7 trillion yuan loans to
regional government entities could become non-performing. These were
mostly for infrastructure and building projects many of dubious
commercial value and comprised the lion's share of new lending last year
of 9.6 trillion yuan.

These alone could mean losses of 5 percent
of the loan portfolio. At present nonperforming loans are just 1.3
percent and banks have appeared to be good investments on the back of
strong margins and rapid asset growth. They trade on an average of 13
times earnings.

In the face of now-confirmed worries about bank
financing of local government-owned entities, Chinese bank shares have
been relatively steady. Although they have been raising capital to
reflect expanding loans, they have been extremely profitable – more than
twice the global average and so able to build capital without too much
resort to shareholders.

The listing of Agricultural Bank of
China in mid-July may have been lackluster but to get such a gigantic
issue away at this time demonstrated that belief in the China story is
still strong among foreigners starved of good news from elsewhere.
Meanwhile global liquidity and low interest rates almost everywhere are
pushing sovereign wealth funds into equities like ABC even if they have
to close their eyes as they do so.

It is hard to imagine that
after such a prodigious state-directed rise in lending last year, losses
on loans to entities other than regional government enterprises will
not also increase. In sum, it is quite likely that unless the data is
fudged and more money or easier terms are provided to borrowers there
will be a huge increase in NPLs which would wipe out a chunk of the
banks' core capital. That ratio currently stands at a seemingly
comfortable 8-9 percent of risks assets for the major Chinese banks. But
5 percent losses would require shareholders to dig deep into their
pockets to restore the capital bases and enable loan growth to continue.

Of
course, such disasters for shareholders may not happen. As before, the
central government may take many of the bad loans off the bank books and
onto special purpose vehicles. The government budget, not the
shareholders would take the hit. Or regional governments may be called
upon by the central government to use local revenues to bail out their
defaulting corporate entities. This would be fair as these vehicles were
created to get around controls on borrowing by local governments but
politically might be very difficult.

One way or another there is a
large price yet to be paid for the lending spree which sustained
China's growth during the global slump but led to much non-productive
investment that was financed by interest-bearing loans. Indeed, there is
now a clear struggle going on between the People's Bank of China, the
central bank, which wants to rein in these loans in the name of
responsible banking and those in the central government who fear it will
lead to a sharp fall in gross domestic product growth, and those in
regional governments who still have big projects under construction that
have been financed by banks through corporate vehicles.

A major
problem of some sort is in the works but how long it takes to
materialize will depend on the PBoC's success. Sharply reining in credit
now, at the cost of a similar growth slowdown, should enable the system
to absorb NPLs without too much agony. But let the situation drag on,
pretending that the problem is an illusion – as happened in Thailand and
elsewhere in the 1994-97 era – is storing up a crisis of the Asian
magnitude in perhaps two to three years. As the banks are mostly
state-owned they will not face the same problems as Thailand's but they
will be immensely costly to the government and accompanied by both a
sharp rise in government debt and a halt to new lending. In other words,
a prolonged period of slow growth.

For the PBoC, the state of
bank lending is not its only worry. With US$2.5 trillion in foreign
exchange reserves it may have to prepare to take enormous losses on its
US dollar holdings if China is eventually forced into a major
revaluation. Such losses are not simply balance sheet items. They are
actual yuan liabilities to local depositors. The loss is a loss to the
nation and will ultimately be another drag on growth. An artificially
weak yuan has boosted exports and China's prestige but at a cost both
today, in terms of real incomes, and tomorrow in terms of capital losses

The US is not the only major country where politics has meant more benefits today to be paid for later.