Subordinated debt could be issued by the nation's big four State-owned commercial banks as soon as the first quarter of this year to increase their capital adequacy ratios, sources and analysts said.

However, the strict terms and requirements are likely to keep costs high.

According to a regulation published late last year by the China Banking Regulatory Commission (CBRC) that allowed banks to issue subordinated bonds, the four State-owned commercial banks could float up to almost 300 billion yuan (US$36 billion).

The Industrial and Commercial Bank of China (ICBC), the largest of the four, said it wanted to raise 100 billion yuan (US$12 billion) over a period of two to three years, bringing its capital adequacy ratio, which stood at 5.54 per cent at the end of 2002, over the 8 per cent minimum regulatory requirement.

"We have submitted both the total and the first issuance (to the CBRC)," said a senior ICBC manager, who declined to be named. "This is a critical year. Now that they have given permission, we should have some flexibility in how we go about it."

Most Chinese banks fall short of the 8 per cent capital adequacy requirement. The four State-owned ones -- the ICBC, the Bank of China (BOC), China Construction Bank (CCB) and the Agricultural Bank of China (ABC) -- have been filing applications annually in recent years to replenish their capital by debt issuance, but were not approved.

Last year's CBRC's regulation cleared the way, allowing commercial banks to calcuate proceeds from subordinated debt, which ranks behind other liabilities in terms of claims on bank assets, as non-core capital. The BOC and CCB have also reportedly submitted applications.

The Industrial Bank, a joint-stock commercial bank, became the first domestic bank to issue subordinated debt, floating 3 billion yuan (US$360 million) last December, but declined to reveal further details.

The Huaxia Bank, another joint-stock lender, said earlier this month that it plans to issue 4.25 billion yuan (US$512 million) in subordinated bonds to insurance firms this year.

The ICBC official said his bank hopes to float its first bonds "at the beginning" of this year, citing inflationary pressures that threaten to push interest rates up. "We'd rather do it sooner than later." he said.

"The risk is on the upside," said Chen Lihua, chief investment officer at China Southern Fund Management Co Ltd, which manages 20 billion yuan (US$2.4 billion). An interest rate hike may come in the latter half of this year or the first half of 2005, he added.

China's interest rates are at a long-time low, but growing inflationary indications, with the consumer price index registering a sharp 3 per cent rise in November, are fuelling expectations in the marketplace that an interest rate increase is imminent.

The would-be issuers have a tight schedule. The BOC said it has plans to issue shares next year, while the ICBC and CCB's initial public offerings are supposed to be no later than 2006.

Analysts say the issuers would have to offer high yields on their bonds as compensation for the high risk of subordinated bonds.

Such bonds, with maturities of no less than five years, are required to be guarantee-free and, most importantly, not allowed to be transferred -- a requirement imposed by the CBRC which has frustrated both potential issuers and investors.

"The yield has to be rather high,'' said Zhao Xinyu, an analyst at Huaxia Securities. "When there is no guarantee or liquidity, the only compensation is the yield."

Ten-year corporate bonds currently trading in the Chinese market typically carry coupons around 4.5 per cent, analysts say.

A key variable is whether the bonds will need credit ratings, and who will be giving the ratings that will heavily influence investor behaviour.

The CBRC's regulation provides the bonds are issued through "directed fund-raising," which analysts interpreted as either a private placement, which requires no credit rating, or a market with restricted access, like the interbank market, which would require the bonds be rated.

Eligible investors are non-bank corporate legal persons, sources say, and foreign institutions are not explicitly excluded.

Terry Chan, a Hong Kong-based director of Standard & Poor's, said his firm would give a rating that is two or three notches lower than the issuers' credit ratings depending on terms and conditions if any of the four State-owned banks floats subordinated debt.

"If the issuer is BB-plus, and the terms are not so strict, I would give BB-minus," he said. "But if strict, I may give B-plus."

Standard & Poor's currently assigns BB-plus to three of the Big Four except ABC, which has a BB rating. The ratings are all below investment grade.

The rating firm has said China's State-owned commercial banks need a further capital injection to get better ratings, but Terry said issuance of subordinated debt would probably not prompt immediate rating revisions, as his firm continues to wait for further moves such as government-sponsored recapitalization.

"This helps, but we are more looking for straight equity, because you still have to service the debt," he said.

But mainland-based credit rating companies give the Big Four ratings equivalent to China's sovereignty rating in their systems -- AAA, recognizing the State ownership of the banks.

He Minhua, vice-president of China Chengxin International Credit Rating Co Ltd, said specific ratings would depend on the terms of the bonds, but the problem of illiquidity would not be a major factor as it is unrelated to payment ability.

She said her company assigned AAA ratings to many corporate bonds guaranteed by the Big Four.

The status of being State-owned is likely to ensure a good level of demand from investors if pricing is appropriate. Some insurance companies and investment funds, frustrated by a sluggish stock market and a small corporate bond market, have expressed interest in the upcoming offers.

"We should be interested, as the risk is lower than many corporate bonds," said Southern Fund Management's Chen. "Although they have non-performing loans and capital adequacy problems, they have State backing."

Analysts say insurance companies, which currently hold one third of China's corporate bonds, are the biggest potential buyers.

Insurance firms had nearly 400 billion yuan (US$48 billion) in bank deposits at the end of October. A big part of the deposits are held in five-year upward deposit agreements that carry interest rates around 3.2 per cent, which analysts said are likely to be used to buy subordinated bonds if they promise higher yields.

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