Off-balance sheet loans jump 110%

Since last October, China has raised interest rates four times and lifted the reserve requirement ratio nine times.

While global financial regulators are requiring more transparency and the People's Bank of China restricts credit to cool inflation, lenders have increased the off-balance sheet loans by 110 percent, central bank data show. Credit-default swaps on Bank of China Ltd are on course for their biggest monthly rise in a year and are the most expensive since September, according to data compiled by Bloomberg.

The so-called entrusted loans are kept off balance sheets as in theory the bank is a middleman and bears no direct credit risk. When a company borrows and lends the funds on to firms for a profit, the financial institution could still face liabilities. Companies are charging firms interest of as much as 21 percent, more than three times higher than the benchmark one-year lending rate of 6.31 percent, stock exchange filings show.

"Some of the borrowers with low credit quality, which can never or should never get bank credit, get levered through entrusted loans, which increases the overall leverage of the economy," said Winnie Wu, an analyst at Bank of America Merrill Lynch in Hong Kong. "If there is a credit downturn or liquidity crunch those things could easily go bust, and the effect will come back to haunt the banking system."

More than 40 percent of borrowers on entrusted loan deals announced since January 2010 have been property developers facing lending curbs intended to control inflation, according to Bank of America Merrill Lynch research. The banks receive a fee for acting as an intermediary.

Money market rates have surged as the Chinese central bank raised benchmark rates four times since September to 6.31 percent and ordered the largest banks this month to set aside 21.5 percent of their deposits as reserves. The seven-day repurchase rate, which measures interbank funding availability, rose 23 basis points, or 0.23 percentage point, to 9.04 percent on Thursday, the highest level since October 2007. New loans in the first five months, excluding unofficial lending, totaled 3.55 trillion yuan, 12 percent lower than a year earlier, central bank data show.

Entrusted loans made up 7.9 percent of last year's 14.27 trillion yuan of social financing, the term used for all funds raised in the economy, central bank data show. That compares with 0.9 percent in 2002.

Fitch Ratings estimates off-balance sheet liabilities for 16 Chinese banks are about US$3.5 trillion to US$4 trillion, or 25 percent of total assets, including entrusted loans, credit commitments, guarantees, letters of credit and acceptances.

"There has been a rise in off-balance sheet and other hidden activity which is leading to understated credit growth and credit exposure," Charlene Chu, senior director of financial institutions at Fitch in Beijing, said at a conference in Singapore on June 21. "We foresee a fair amount of contingent liabilities in the banking sector."

Total credit in China, including non-bank lending, is at worrying levels, according to Vincent Chan, the Hong Kong-based head of China research at Credit Suisse Group AG. The amount of loans reached 26.7 trillion yuan in 2009 to 2010, a 71 percent increase from the end of 2008, he wrote in a June 20 report. The ratio of credit to gross domestic product reached 166 percent in March.

What if something goes wrong?

China's banks could be saddled with more non-performing loans as economic growth in the nation slows, according to Credit Suisse, which cut its forecast for expansion in 2012 to 8.5 percent from 8.9 percent on June 20.

"The problem is, if anything goes wrong, whether the banks will get away unharmed," Chan said. "In theory the banks have no need to pay at all, but they end up paying a lot out of their own pocket."

On April 30, Ningbo Bird Co, a maker of cellular phones, said in a stock exchange filing it had lent 50 million yuan through an entrusted loan at a rate of 18 percent to a property company based in Huai'an City, Jiangsu Province.

Sunny Loan Top Co lent 55 million yuan to Nan Tong Fragrant Cereals Food Processing Co through a one-year entrusted loan using Bank of China at 21.6 percent, the company said in a June 7 stock exchange notice.

Five-year credit-default swaps on Bank of China, the nation's third largest, surged 39 basis points this month to 160, the highest level since September, according to data provider CMA, which is owned by CME Group Inc and compiles prices quoted by dealers in the privately negotiated market.

The average cost for 32 Asian banks, including South Korea's Kookmin Bank and Japan's Nomura Holdings Inc, rose 14 basis points to 143.6 in the month. The 16 basis-point gap is the widest since September. China's sovereign bond risk climbed three basis points to 90 on Thursday and is up from 72 on May 31. The default swaps protect investors from losses when a company or government fails to pay its debt. Traders use them to speculate on credit quality.

The extra yield investors demand to own Industrial & Commercial Bank of China Asia Ltd's US$500 million of 5.125 percent bonds due November 2020 instead of similar-maturity Treasuries widened 26 basis points this month to a record 241 basis points on Thursday, ING Groep NV prices show. Spreads on Bank of China Hong Kong Ltd's US$2.5 billion of 5.55 percent, February 2020 bonds widened 32 basis points to 271, the highest level since July 2010, according to ING prices.

Turning sour

The yield on China's 2.77 percent May 2012 bond gained 62 basis points to 3.64 percent in June, according to the National Interbank Funding Center. The yuan strengthened 0.1 percent last Friday to 6.4676 per US dollar and has risen 2.1 percent this year.

China's banks already face the risk of losses on loans to more than 10,000 investment companies set up by local governments to get around regulations prohibiting direct borrowing. As much as 30 percent of those loans are expected to turn sour, Standard & Poor's said last month. Moody's Investors Service estimates the total outstanding loans to local government financing vehicles at about 10 trillion yuan.

China's banking regulator required systemically important banks to have a minimum capital adequacy ratio of 11.5 percent by the end of 2013 in its own version of the Basel Committee on Banking Supervision rules, it said on May 3.

The total cost of bailing out the Chinese banking system from 1998 to 2005 was about 5 trillion yuan, or 20 percent of China's GDP at the time, according to a June 3 Barclays Capital report.

The China Banking Regulatory Commission required lenders in January to transfer 1.66 trillion yuan of off-balance sheet loans to trust firms back onto their books by the end of 2011 to ensure financial safety. Banks make the so-called trust loans using proceeds from the sale of wealth management products to their individual and corporate customers.

"It's important to have some policy to discipline banks' behavior because so far for entrusted loans and trust loans banks have no transaction cost," Bank of America Merrill Lynch's Wu said. "They don't have much incentive to control the risk or be more selective in managing the process."