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Slowing growth in local government incomes could exacerbate liquidity shortages among Chinese banks, experts said.
"Chinese banks are like a cashbox for local governments; therefore, they are not exempt from the difficulties of local governments' financial situation," said Zhao Quanhou, head of financial research at the Institute of Fiscal Sciences at the Ministry of Finance.
According to the ministry, government revenues grew 6.6 percent in the first five months, 6.1 percentage points slower than a year earlier. The growth target for 2013 is 8.5 percent.
The deceleration was attributed to the slowing economy, weakening industrial activity and structural tax cuts, the ministry said in an online statement.
Last week, the People's Bank of China kept the domestic money market short of funds during a period of seasonal tightness. As a result, the average interbank offered rate among 18 Chinese commercial banks rose to a record high of 13.4 percent on Thursday.
Although Zhao said there was no direct link between the two situations, as last week's liquidity shortage was mostly a seasonal phenomenon, "the fact that local governments' borrowings have taken a considerable share in the banks' loan balances poses a threat in case of similar conditions in the future."
Against the backdrop of central bank statistics showing rapid first-half credit growth, Moody's Investors Service said it is prudent for China to curb its credit growth to more sustainable levels to avert excessive leverage.
Bank loans account for more than 80 percent of local governments' financing, while local governments are responsible for 20 percent of Chinese banks' loan balances, according to Zhao.
Local governments account for an even larger share of financing via wealth management products issued by banks, at a level between 30 and 40 percent, Zhao said.
"Local governments have taken up massive credit resources, and slowing revenue growth will threaten their loan repayment capacity," Zhao said.
Zhao said most of the loans have been invested in public projects that generate little revenue, so repayments depend mostly on local governments' fiscal revenue.
"In the long term, if local governments continue such massive investment, it will lead to a rise in non-performing loans at commercial banks."
Tobias Moerschen, vice-president and senior research analyst with Moody's, said exposure to local government financing vehicles that are used by many of China's local governments to raise funding represents a key risk for Chinese banks.
"Only 53 percent of 388 surveyed companies now have sufficient cash resources to cover estimated debt and interest payments in 2013 without resorting to refinancing," Moerschen wrote in a report.
Banks' non-performing loans remain low at 0.5 percent or less of their total loans to local government financing vehicles, but Moerschen said this was a result of the local governments' support, not because of any intrinsic financial strength.
The extent of losses to the banks would depend on the degree to which local governments and regulators support the financing vehicles, but Moody's noted that several developments may challenge their ability to provide assistance in the future.
"For example, slower revenue growth at some local governments will constrain their capacity to provide support, while regulators are also limiting local governments' ability to inject land reserves into their financing vehicles."
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