Chinese banks finished 2010 in a stronger position than they started, chipping away at their bad debt holdings and beefing up provisions in case their asset quality deteriorates, a new set of official data shows.

But after steadily improving in recent years, Chinese banks' balance sheets could face mild erosion in 2011 with some of the vast body of loans that they gave to local governments since the outbreak of the global financial crisis likely to sour.

The non-performing loan ratio at Chinese commercial banks averaged 1.14 percent at the end of 2010, down from 1.58 percent at the start of the year, according to data published this week by the China Banking Regulatory Commission (CBRC).

The total industry-wide volume of bad loans fell to 429.3 billion yuan ($65.2 billion) from 497.3 billion yuan during that time.

In a series of tables on its website, the CBRC also said that banks' provisions for loan losses were equal to 218.3 percent of the bad debt on their books at the end of 2010, up from 155.0 percent coverage at the start of the year.

But the various measures of the strength of Chinese banks' balance sheets will confront headwinds this year.

Liu Mingkang, chairman of the China Banking Regulator, warned in December that the bad loan ratio might rise to 2 percent after factoring in local government debt, especially as the government's property tightening campaign bites.

With banks still lending at a rapid clip, their capital cushion is thin. Analysts expect more fundraising this year to ensure that they keep ahead of the regulatory requirement of an 11.5 percent capital adequacy ratio (CAR).

A series of successful fundraising efforts nudged up the sector's average CAR to 11.6 percent at the end of the third quarter from 11.4 percent at the start of the year. The CBRC did not disclose the end-year CAR in its latest data.

Agricultural Bank of China (1288.HK)(601288.SS), the last of the country's major state-owned banks to be reformed along commercial lines, led the way in fundraising with a $22 billion IPO in August.

All other major lenders, including Industrial and Commercial Bank of China (1398.HK)(601398.SS), the world's biggest bank, conducted rights issues to rebuild their depleted balance sheets after uncorking a record loan surge in 2009 to shake off the global financial crisis. ($1=6.580 Yuan)

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