Are risks of a Chinese credit crisis growing?

By Wei Gu

HONG KONG (Reuters) - China's banks seem to have dodged a bullet in the still-unraveling U.S. subprime mortgage crisis.

Chinese lenders accumulated large amounts of that bad debt. But bankers have assured investors they are within manageable levels that won't greatly affect their profits, fattened by a domestic economy that is growing at double-digit rates.

But that doesn't mean China will be able to avert a credit crunch of its own making. In fact, risks are growing for a credit crisis with Chinese characteristics.

A crisis like that could rock global markets, because China has been one of the few bright spots in the world economy.

With memories still fresh of Beijing having injected more than $260 billion into its banks while shifting bad loans off their books, another huge bailout may become necessary if loose lending practices aren't halted.

What could trigger such a turnaround in China's credit market? A sudden sharp slowing of the Chinese economy.

That's not as far-fetched as it might seem. Weaker overseas demand and the bursting of an asset bubble in China could force small exporters and property developers to default in droves.

Sudden deflation of a bubble can lead to fast deteriorating asset quality, cascading in a chain reaction through the financial system, as has been seen in the United States.

Warning lights are already flashing. The non-performing loan ratio for major Chinese commercial banks rose for the first time in two years, to 6.72 percent in the fourth quarter from 6.63 percent in the previous quarter. That is dwarfed by the 20-50 percent NPL ratios six years ago, but the trend is worrisome.

Listed banks' special mention loans, 10 percent of which usually migrate to non-performing loans, are "disconcertingly" large, and, for some banks, growing, said Fitch Ratings.

"History shows even the worst banking systems can appear decent during periods of robust GDP growth," said Charlene Chu, a Fitch senior director. "Fitch remains concerned Chinese banks could well be under-estimating potential future credit losses."

Chinese banks have benefited from a foreign investment wave and an explosion of credit. Robust lending growth has boosted profits but also kept bad debt ratios artificially low by inflating the denominator - overall loans.

As U.S. financial institutions discovered the hard way, a rapidly growing loan base can suddenly explode if no one is paying attention to the quality of the loans.

The World Bank expects China to grow this year at its slowest pace since 2002. And with inflation hitting 11-year highs, the central bank needs to clamp down on lending.

"It is worth watching whether Chinese banks can pass this test," said Mingchun Sun, Lehman's China economist. "It is impossible that when the economy and earnings go down, bad debt will not go up -- even better managed U.S. banks failed at that." While reckless lending to home buyers brought some U.S. banks to their knees, loans to exporters and property developers are threatening to do the same to Chinese banks.