China's leading State-owned banks could be adding to their non-performing loans (NPLs), instead of resolving them.

"Short-term strategies to reduce the NPL levels may actually increase them in the long run," said Jack Rodman, a partner with Ernst & Young's Transaction Advisory Services.

China's four State-owned banks - China Construction Bank, Bank of China, the Industrial and Commercial Bank of China and the Agricultural Bank of China - succeeded in the first half of 2003 in reducing their NPLs from about 26 per cent of their outstanding loans to about 22 per cent.

The central People's Bank of China and the China Banking Regulatory Commission have set a goal of reducing the banks' NPLs to 15 per cent of outstanding loans by 2005.

One strategy to meet the goal is to "grow" their way out of the problem. Banks have embarked on an aggressive programme to increase the total loans on their balance sheets and thereby reduce the percentage of NPLs, Rodman said.

Their loan volume increased an estimated 25 per cent in the first nine months of this year as China's booming economy fuelled demand for real estate loans, mortgages and automobile loans.

"While banks' NPLs appear to be declining, this is more a function of mathematics than asset resolutions," Rodman said. "If China's economy should unexpectedly slow, there is a risk that the rapid increase in new loans could expose banks to greater loan write-offs in the future."

Another question is whether the banks are providing sufficient reserves for loan losses on their growing portfolios, said another partner Peter Chan with Ernst & Young.

Reserves have not been set aside for these new loans because banking regulations first require that their default rates be determined, a process that can only occur over time.

"At some point banks will have to provide sufficient reserves for future loan write-offs to satisfy the capital adequacy rules of the Bank of International Settlements and International Accounting Standards," Chan said.

The good news is that some banks are trying to pioneer new transaction structures to reduce their NPLs through co-operation agreements with global investment banks, Rodman said.

China Construction Bank and Morgan Stanley, as well as the Industrial and Commercial Bank of China and Goldman Sachs, are seeking government approval to enter into strategic relationships to work out NPLs.

"The market for foreign investment in China's NPL portfolios appears to be opening up," Rodman said.

With only one or two transactions in the market to date and several in the pipeline, investors have the chance to get an early start in perhaps the largest asset game remaining in Asia, he added.

Asset management companies were also active in reporting record NPL resolutions through the end of last year and for the first six months of this year.

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