HONG KONG (Reuters) - Rising debt levels will worsen the credit profiles of China’s top 200 companies this year, requiring the country’s banks to raise as much as $1.7 trillion in capital to cover a likely surge in bad loans, S&P Global said in reports on Tuesday.

A labourer works at a construction site in Beijing's central business district, China, July 15, 2016. REUTERS/Jason Lee

The study sees little scope for improvement in 2017 amid worsening leverage and excess capacity in almost all sectors.

Debt has emerged as one of China’s biggest challenges, with the country’s debt load rising to 250 percent of gross domestic product (GDP). Excessive credit growth is signaling an increasing risk of a banking crisis in the next three years, the Bank of International Settlements (BIS) warned recently.

Seventy percent of the companies in the S&P survey were state owned, and they accounted for $2.8 trillion or 90 percent of the total respondents’ debt.

S&P estimated the problem credit ratio at Chinese banks was already at 5.6 percent at end-2015. In a downside scenario of unabated credit growth, that could worsen to 11-17 percent.

In such a situation, banks would need as much as $1.7 trillion in recapitalization by 2020, S&P estimated. Even under a base case scenario, they would require $500 billion.

That compares with China’s last big bank debt cleanup some two decades ago, when an estimated 4 trillion yuan ($600 billion) was spent on restructuring as of late 2005, according to a report for French economics thinktank CEPII.

S&P expects Beijing will continue to allow rapid credit growth over the next 12-18 months before attempting to rein it in, implying risks would heighten in one to two years.

The IMF has warned China its credit growth is unsustainable, with companies sitting on $18 trillion in debt, equivalent to about 169 percent of GDP.

Chinese banks’ non-performing loans are already at nearly 2 percent, the highest since the global financial crisis in 2009, according to the China Banking Regulatory Commission (CBRC).

But some analysts believe the ratio could be as high as between 15 and 35 percent, as many banks are slow to recognize problem loans or park them off balance sheet, and as lenders come under political pressure from local governments to roll over bad loans to prevent job losses and defaults.

WILL NEW DEBT GUIDELINES WORK?

On Monday, Beijing announced a series of guidelines aimed at cutting company debt levels. The measures include encouraging mergers and acquisitions, bankruptcies, debt-to-equity swaps and debt securitization to improve credit allocation and stop wasteful spending in the economy.

Moody’s Investors Service said on Tuesday that such moves would redistribute the debt load, but that economy-wide leverage would not be directly reduced.

“The actual implementation of such measures will reveal what role the government may play in mitigating some of the negative consequences of deleveraging in terms of job losses” or capital requirements for asset management companies which are needed for debt restructuring, Moody’s said.

Analysts say such measures are necessary to give struggling companies a lifeline as the economy expands at its slowest rate in a quarter of a century.

“The debt-to-equity swap would give both banks and borrowers a chance, a chance for struggling businesses to breathe and make blood again,” said Wu Kan, Shanghai-based head of equity trading at investment firm Shanshan Finance.

“If no action is taken, and the loans are left to rot, then banks have to write up bad loans and there would be huge capital shortfalls.”

Estimates about the size of such shortfalls vary greatly depending on assumptions used, such as how many poorly performing loans will eventually go bad.

“In my estimation, banks would need to fill gap of 1.4 trillion yuan in the worst case scenario,” said ANZ economist Raymond Yeung.

“A simple tax waiver from the government would take care of this gap and so this is unlikely to cause financial instability.”

David Marshall of independent research firm CreditSights says he expects China to deal with its bad debts over time, rather than in another ‘Big Bang” that necessitates an immediate and huge capital injection.

Complicating efforts to clean up debt and bury “zombie” companies, Beijing is increasingly reliant on state firms to generate economic growth, despite their inefficiency, as private investment cools to record lows.

“We expect further deterioration in the credit strength of state owned enterprises as they continue with their debt-funded expansion,” S&P Global’s report said.

“High leverage in corporates will likely constrain investments and aggregate demand.”

A recent Reuters survey showed profits at roughly a quarter of Chinese companies were too low in the first half of this year to cover their debt servicing obligations, as earnings languished and loan burdens increased.

($1 = 6.6685 Chinese yuan renminbi)