Moving the deckchairs

What do the following places have in common: Zhenjiang in Jiangsu province, Xiangtan in Hunan and Shaoxing in Zhejiang? The answer: they hold the dubious distinction of being China’s most indebted cities.

Earlier this month, an HSBC research report concluded that all three have debt levels that outstrip local government income by more than 400%, well above the central government’s mandatory 150% upper limit. In Zhenjiang’s case, the figure stands at a colossal 530%.

Others rank poorly if the debt-to-GDP ratio is applied. For instance, Guizhou – one of China’s poorest provinces – scores badly. Its capital city Guiyang tops the national list on a 133% ratio (double the government’s 60% ceiling), with debt to fiscal income standing at 446%.

Overall, HSBC discovered that 41 out of the 297 cities it surveyed had surpassed a 60% debt-to-GDP ratio and 137 had overshot 150% debt to local government income. The figures suggest that bond investors should steer well clear of some of China’s most overleveraged provinces and cities right now. More importantly, the data is also reviving concerns about the wider global impact should this well-flagged debt mountain finally come crashing down.

China’s decade-long credit binge has been a key factor underpinning global growth. In 2017, China contributed 30% to global growth, according to the National Bureau of Statistics. A hard landing because of a debt blow-up would inevitably undermine the world economy.

And HSBC, for one, believes the real level of local government debt could be as high as Rmb30 trillion ($4.31 trillion). ‘Official’ debt in municipal bond format accounts for just Rmb17.2 trillion.

Last week, the issue pushed its way front-and-centre once again after S&P Global Ratings estimated an even higher Rmb40 trillion total. The global rating agency described this debt as an “iceberg with titanic credit risks”.

It was not supposed to be like this. In 2015, the government started issuing provinces and cities with a quota so they could swap the unofficial debt they had accumulated off balance sheet (via local government financing vehicles, or LGFVs) into lower-yielding and longer-dated municipal papers. The LGFVs – first mentioned by this publication in February 2010, when we referred to these debt platforms as ‘city construction investment companies’ (see WiC48), one of the original term coined for them by local media – were supposed to be transformed into standalone, state-owned entities, cutting their links with local government.

Instead, this hidden debt, as S&P describes it, has just continued to grow. HSBC believes the central government is not keen to publicly admit just how bad the problem is. Fixed income analyst Helen Huang, noted in her report: “The market is already concerned about China’s high corporate debt and fast growing household debt, so China is understandably eager to show healthy government debt levels as evidence of its debt sustainability.”

HSBC advocates an increase of local governments’ municipal bond quotas to more “convincing” levels to dissuade the latter from heading off balance sheet. It believes a default is likely “sooner rather than later”. And when it comes, S&P does not think LGFVs will get bailed out as they were when the issue last came to a head in 2015.

Both institutions believe this is partly because financial markets have more tolerance for defaults this time round and partly because the government is determined to continue deleveraging the economy even in the face of softer growth. The theory was almost tested in late September when Qinghai Provincial Investment Group came very close to defaulting on a $300 million maturing bond.

However, some financial analysts are far from sanguine about the market’s ability to absorb more bad news at a time when sentiment remains febrile at best. More and more economists are starting to describe China’s debt vulnerabilities as the biggest risk to the global economy, far above trade wars and rising US interest rates.

As WiC and plenty of other commentators have long pointed out, China’s massive Rmb4 trillion fiscal stimulus package, which helped to bail out the world economy after the Global Financial Crisis in 2008, may have, inadvertently, sown the seeds of the next one. Institute of International Finance (IIF) figures show that China’s gross debt to GDP has risen from 171% to 299% over the past decade, much of it thanks to surging corporate debt.

Local government and household debt are the second and third legs of an increasingly wobbly stool. Sitting upon it is a government which faces an increasingly tricky balancing act: how to meet its growth targets (a doubling of real consumer incomes between 2010 and 2020) while rolling back debt from past excesses.

According to Fitch’s global chief economist, Brian Coulton, the Chinese government would need to maintain growth of 6.25% for the next three years to hit this target. He says the government only navigated this conflicting agenda in 2017 thanks to strong export growth.

“Exports have always been a free source of growth that someone else funds,” he told WiC. “Last year, this meant that China hit 6.9% GDP growth while slowing new credit formation, reassuring financial markets.”

The Sino-US trade war is putting an end to this. China’s rate of growth is slowing and on October 7, the People’s Bank of China (PBoC) eased monetary policy by cutting banks’ reserve requirement ratio by 100 basis points, twice consensus expectations.

Coulton believes that more negative news on growth is coming. “I’m not sure the market fully recognises the time lag between when the government starts to ease and when it starts showing up in the growth figures,” he commented.

PBoC Governor Yi Gang has also indicated that the central bank’s main focus will be the domestic economy as it tries to engineer a soft landing. It is the kind of statement which worries China’s neighbours and the wider financial markets. Will China try to backstop its own growth by letting the renminbi fall harder and faster than expectations?

A big fall would have a correspondingly painful impact for emerging market countries. The last thing any of them need is a weakening of export competitiveness at a time they are being forced to fight harder for credit as central banks across developed markets raise rates, reducing global liquidity.

However, Fitch’s Coulton does not believe a large devaluation is on the cards. The agency’s base case is for a 5% to 6% drop from its current 6.91 level to the US dollar to 7.3 by the end of next year. For one thing, China does not want to rile the rest of Asia at a time when it is in a fight for their economic loyalties against a resurgent US.

Over the short-term, US exceptionalism may also counterbalance Chinese weakness in the global context. The world’s largest economy registered 4.2% second quarter GDP growth, taking up some of the slack from China.

However, Coulton and others believe that China’s debt levels will constrain its ability and willingness to ease conditions too much to offset slower growth. The government is still saying that its new asset management rules will come into effect in 2020, for instance.

So far this year, it has managed to slow the rate of credit growth as a result of its clampdown on the shadow-banking sector. Coulton estimates that this factor alone accounted for the year-on-year drop in credit growth from 15.5% in July to 11.5% in September.

The government is also trying to improve credit differentiation between different borrowers. Analysts hope this will slowly lead to a more efficient market where the weakest borrowers are forced out through defaults, without the government having to continually step in with its famous ‘Beijing Put’ (the implicit government guarantee which creditors have so long relied on).

Meanwhile while the numbers remain scary, there is one point of solace: experts have been predicting a Chinese financial crisis for almost the entire decade that WiC has been publishing.

Predicting when China will follow the standard laws of economics has never been easy – and thanks to capital controls Beijing has more scope than most to keep the proverbial plates spinning.

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