Chinese banks gave more loans over the last few years than previously reported

By TOM ORLIK

How bad can things get for China's banks? Temasek Holdings isn't waiting around to find out.
The Singapore state investment fund, manager of a $133 billion portfolio and the biggest foreign investor in China's banking sector, has sold 49% of its shares in Bank of China and 8% of its China Construction Bank holdings for a total of US$3.6 billion. The timing of that move and the involvement of long-term strategic investor Temasek ring alarm bells about the outlook for the mainland's banking sector.
Last week, China's National Audit Office announced that the banking sector is exposed to some $1.3 trillion in local-government debt. In the days that followed, press reports said that local-government financing vehicles in Shanghai and Yunnan could default on their debts.
Those debts are an insignificant fraction of the total owed across the sector, but investors are concerned they represent the tip of a default iceberg. Concern about the overhang of bad debts, and the absence of a clear resolution plan from the government, mean bank valuations have taken a hit. Bank of China is down 13% since the beginning of June, and China Construction Bank is off 14%.
Temasek has yet to comment on its divestment. A longer-term desire to diversify its assets may have played a role. But it's also possible it is trying to get ahead of the curve, with rumors that Bank of America—the second-largest investor in China Construction Bank—plans to sell down a portion of its holdings.
Sales into a weak market, even if Temasek has come out US$1.2 billion up on its initial investment according to WSJ calculations, also suggest a certain nervousness. Markets seem to have drawn the conclusion that major investors are concerned about hidden risks in the banks. And the negative signal couldn't have come from a more significant stakeholder.
Temasek has been the largest single institutional investor in Bank of China— holding 12.5% of the stock before Wednesday's sale—and the third-largest in China Construction Bank. When Royal Bank of Scotland, Bank of America and UBS sold down their holdings in China's banks during the financial crisis, Temasek won political points with Chinese officials by actually increasing its exposure.
Bank of China fell 3.6% in Hong Kong on Wednesday amid heavy trading following the Temasek news, and China Construction Bank wasn't far behind.
The bigger question, however, is what lies ahead. Two factors loom large: the extent of bad debts in the system, and the banks' scope to grow through the problems. The signs aren't encouraging on either front.
A report by Moody's estimates that nonperforming loans in the banking system could rise to 8%-12% from the current 1.1%. At the same time, a two-year lending bonanza has seen China's loan-to-GDP ratio soar to 127% in 2010 from 101% in 2008. Bad debts will add to the banks' costs. Past excesses mean that even when the government eases its credit controls, the scope to grow through the problem by pushing more loans out the door is limited.
Whether nonperforming loans actually rise to the feared levels remains unclear, given how little is known about asset quality at China's banks. But Temasek's sales suggest not everyone is giving them the benefit of the doubt.
Write to Tom Orlik at Thomas.orlik@wsj.com