“One might avoid paying one’s debts on the first of the month, but not on the fifteenth.”
In light of this warning – another age-old Chinese proverb – China’s local governments could be forgiven for reaching for their calendars, and checking the date.
The scale of the investment binge launched by thousands of local government financing platforms over the last two years is slowly becoming apparent.
But as repayment schedules loom, is help now at hand? A report issued last week by the central bank has sparked speculation that a major clean-up effort may be on the horizon, much of it financed from central government coffers.
Below, WiC looks at the key issues.
Why the latest headlines?
They’re in response to a report last week from the People’s Bank of China (PBoC) warning that China’s local governments have now run up Rmb14 trillion of debt. This was quickly followed by media rumours that Rmb2-3 trillion (i.e. up to $463 billion) of that may be bailed out by the central government.
The debt – most of it borrowed from state banks and spent on infrastructure projects – increased by half in 2009, the peak period for the credit binge linked to Beijing’s wider economic stimulus plan.
But it also grew by another fifth last year, even as policymakers tried to rein in lending. Most of the debt was raised by financing platforms guaranteed by local authorities.
WiC first wrote about the local government financing vehicles in February last year (in issue 48 – in fact, WiC was almost certainly the first English language media where these platforms were cited as a looming problem). Now the PBoC report has brought them sharply back into focus, with estimates of the debt incurred continuing to rise. Last year the China Banking Regulatory Commission (the CBRC) suggested a much lower Rmb4 trillion figure from its own investigation. It also thought that at least a quarter could go bad.
Could the figures be revised upwards again? Victor Shih, a professor at Northwestern University in Illinois predicted that as much as Rmb24 trillion might have been lent out to local governments, and that default levels are likely to be higher than officials think.
Shih’s forecast – made around the middle of last year – came in for criticism, and remains significantly above the PBoC’s. But the ballpark figures do seem to be moving in his direction, and they might rise further if the economy slows and interest rates increase…
Why can’t they get to a final figure?
One problem, says Caixin magazine, is that government departments disagree on how the debt should be quantified. In March this year the Ministry of Finance (MoF) was reported to be challenging the CBRC’s previous tally as too high, and now at least four government entities are involved in looking at the financing platform issue (the PBoC, the National Development and Reform Commission, the MoF and the CBRC).
Each has its own agenda and there doesn’t seem to be a lead agency with coordinating responsibility for the work.
The speculation is also that the PBoC issued its report last Tuesday because it wants to see more urgent action. It may also have briefed journalists informally on some of the potential policy responses. But two days later, the MoF issued its own statement, insisting that the PBoC’s report was limited to scoping the amount of debt, and that there was no agreement on the policy outcomes. Specifically, it quashed any idea that a bailout had already been decided upon.
How might a bailout work?
A number of options seem to be on the table, according to unattributed PBoC sources quoted by Reuters.
The central government could choose to take on a portion of the liabilities itself. Additionally, it might try to switch some of the loans into centrally managed asset management companies, with longer-term repayment schedules. Nominally, the debt would then be sold to private investors (more likely: the worst loans get swept under the administrative carpet). Something similar happened at the state banks in 1999, to clean up their own loan books in advance of stock market listings.
The banks themselves may not get off completely unscathed, as they may have to take haircuts on some of the poorer performing loans. Even so, their share prices might get a lift from a restructuring, writes Tom Holland in the South China Morning Post, as it would clear some of the uncertainty blotting their balance sheets.
Another, more contentious suggestion is to let the local governments issue municipal bonds as part of the refinancing effort. Currently, local treasurers have little freedom to go to the capital markets themselves (a key factor in why they grabbed the opportunity to load up via the ‘off-balance sheet’ financing platforms).
But a new bond regime would seem to fall within the Ministry of Finance’s bailiwick (which is perhaps why its bureaucrats responded rather sharply last week to the PBoC briefings). And according to reports on a similar review started earlier this year (again, from Caixin), the provinces would still only be allowed to issue bonds after the central government has set “amounts, rates and time periods”.
That doesn’t sound like much of a loosening of central control. Nor is it clear why investors would rush to buy provincial paper, given the current uncertainty surrounding local finances.
How serious is the financial mess?
Official measures of central government debt – about 19% of national GDP in 2010 – are not a concern, says The Economist magazine.
But a rosier picture obscures plenty of other liabilities that might end up on Beijing’s plate (massive pension-related commitments or reams of non-commercial loans made by the policy banks, as just two examples).
Patrick Chovanec, a professor at Tsinghua University’s School of Economics and Management, says that the state banks are also exposed to plenty of risky credit aside from local government lending. Borrowing by real estate firms, emergency financing for struggling exporters, bonds for burgeoning railway investment, and loans to clients who have punted on stock and property are all widespread.
Despite this, and even if total debt is much higher than admitted, the State Council has ways of handling the burden. Most of it is denominated in local currency, so it is easier to roll over. There are state assets that could be auctioned off to raise cash, and the leading state-owned enterprises could be squeezed for a bigger contribution of their dividends into state coffers (although they would resist fiercely).
Another pressing issue is the payback period on many of the loans made through the financing platforms (most are of five to 10 years tenor). This looks far too ambitious, with the majority of infrastructure projects unlikely to be generating enough cashflow over the same timeframe.
Hence Qu Hongbin at HSBC argues that one of the better remedies for the government is to issue construction bonds, and then to extend repayment schedules.
But talk of a banking crisis is still unwarranted, Qu believes, as most of the infrastructure projects will end up in the black. One example: China accounts for a quarter of global freight volume but has a rail network equivalent to just 6% of the worldwide total, implying that its return on rail investment will be much higher than the international average.
But who is ultimately on the hook?
Others warn that the current debate is still focused more on refinancing rather than repaying – and that there is an inevitable reckoning ahead.
China may not be headed for a debt crisis in the style of Greece, Portugal and Ireland. But if the loans do start to go bad, in the end someone will have to pay the price, writes Michael Pettis, a finance professor at Peking University’s Guanghua School of Management.
Ultimately Pettis expects that this will force a further round of land sales, plus more privatisations of state assets. Another possibility is tax increases. But this would undercut efforts to shift more of the momentum for economic growth towards household consumption and the private sector.
All of these bailouts add up too, points out Tsinghua’s Chovanec. He agrees that Beijing has the means to clean up the local government mess, and perhaps to bail out the Railway Ministry as well, if its own expansion plans run into trouble. But what about the loans that have been made to state firms who have been speculating in real estate? And what of the bill for the affordable housing initiatives being championed by the State Council?
Whether Beijing can push ahead with all of these efforts at the same time is much more debatable, Chovanec concludes.
One key consequence of the local government debacle: it will likely shape thinking on reforms to China’s currency regime. One of the inherent advantages of the current structure: the authorities can shift liabilities around the ‘walled-off’ financial system without fear of capital flight. That makes it easier for Beijing to clean-up the more toxic debts of local government.
So the status of the current debt problem – i.e. whether it worsens – will thus have an impact on Beijing’s thinking for when (or even, if) the yuan should become fully convertible.
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