How deep is China's quagmire of local debts?

How deep is China's quagmire of local debts?

Written by He Qinglian on June 17, 2011
(translated by krizcpec)

These days Beijing became really anxious, the heavy debts of local governments had worried them. After spending more than two years indulging itself in the imaginary title of the “Savior of the world's economy,” China has now to rescue its own banking system, which balance sheet revealed dire problems that had long been hidden. Just when the China Banking Regulatory Commission announced plans to strictly control the credit risk of local financing platform, people discovered that the debt-to-capital ratio of the Railways Ministry had reached the tolerance limits, posing huge potential risks.

How Massive is the Scale of Local Debts?

The so-called “local (government) financing platforms” are in fact institutions set up by all levels of local governments to borrow from banks. How many has been lent to local financing platforms in these two years?

According to the most authoritative report, the China Regional Financial Performance Report 2010 recently published in the central bank's website, there were altogether more than 10,000 financing platforms of local government (at provincial, city and county levels) by the end of 2010; the loans from banking system totaled 47.92 trillion yuan, of which 30% was loaned to local financing platform, that was about $ 14.4 trillion yuan. A third of this 14.4 trillion yuan was from China development bank, the remainder from state-owned commercial banks as well as city commercial banks. Now it has been confirmed that two to three trillion of these loans are at risk of default.

What Are the Characteristics of Local Debts?

FIRST–Extremely poor investment returns  
Based on findings, at most only 35% of local government investment projects had truly served their purposes. That means, of the nearly fifteen trillion debts, only 5.3 trillions might generate benefits, the rest of the loans were either invested in projects that utterly ineffective or lost in corruptions and waste. 

For instance, the Railways Ministry corruption case in which Railways Minister Liu Zhijun (刘志军) was the chief wrongdoer, Zhang Shuguang (张曙光), Secretary for Transport, the person responsible for distributing high speed rail projects, had himself alone 2.8 billion deposit in the United States and Switzerland. Zhang’s wife and daughter, settled in the United States long ago, have three mansions in Los Angeles to their names.

SECOND–Collateral for Project Loans was mostly Straw Bail
In general, the local government revenue used as collateral for project loans was but straw bail. Among the projects of local financing platforms, there has been massive amount of project loans which, without cash flow, was guaranteed and repaid only by local government revenue, which carrying capacity fell far short of the scale of local government credit.

Due to the “Division in Administrative Power and Tax CollectionSystem” (分税制) that has been in place, local governments have little power over their tax but have huge administrative duty. Having to pay the bill for excessive amount of public expenditure with the limited tax they collected, local governments have long been immersed in debts.

And this problem grew more serious following the Reform of the administrative divisions of the People's Republic of China, which require provincial governments to directly supervise those at county level, and take from governments of prefecture-level cities their administrative power as well as their allotted share of revenue, leaving the governments of prefecture-level cities financially unsupported. As a result, their revenue became unreliable straw bail for loans.

In the past decade or so, Land-transferring fees and tax revenue related to real property had become pillars of local finance. This year, as real property price slid, land became unsalable in many places. And as a series of recent statistical data revealed, after rising for years consecutively, China’s land price showed signs of falling.

Credit Suisse released China’s real property market survey data recently. It revealed that China’s national average price of land fell by 32% in April month-on-month (MOM), and was 51% lower than the beginning of this year. 

Figures announced by the Centaline China Property Research Center showed that in April, land price in China’s first tier cities dropped 18% MOM. With land prices declining too fast, the financial capacity of local governments and reimbursement capability of the local (government) financing platforms are greatly threatened. (Please see the report in Chinese)

THIRD—Institutional factors in default risk

There are institutional factors in Local Government Financing Platforms' risk of default.

To begin with, local People's bank (branches), the China Banking Regulatory Commission and commercial banks are all dependent on local resources to survive. The connection between them and local governments as well as corporations is intricate. To keep GDP rising, the government employ the tactic of covering up old bubbles with new ones, thus becoming the politics factor in the proliferation of Local Government Financing Platform.

And the way banks compete among themselves, as well as their profit model propel them all to offer loans to Local Government Financing Platform. China's banking system remains an industry that is very stringent in price and quantity control. The main source of profit for banks come from the carry of an ever expending credit scale.
Once the credit scale is loosened, banks inside China would do everything they could to enable their own credit scale to grow ever larger. At times when there is ample money supply, it is not how the corporations borrow from banks, but how banks would find targets and do everything in their ability to put out more loans. The Local Government Financing Platforms have therefore become the main target for banks to offer loans and expand their scale. An institutional condition like this is, in all likelihood, a factor in the rapid expansion of Local Government Financing Platforms.

What is Beijing Anxious About?

At present, the financial risks of Local Government Financing Platforms are not just serious shortage of cash flow in local governments and their weak capacity for repaying debts. All levels of governments rely directly on loans from state-owned banks to keep their investment projects and economy going. A credit model like this is in reality a return to planned economy system that was in place in the early stage of Chinese economic reform—local governments are spending money from state-owned banks, and when they cannot repay the loans themselves they have the central government to foot the bill.

What worries the central government is that this credit model would lead to the emergence of huge bad debts in banking system and eventually trigger a financial crisis.

How would China handle the financial risks created by local financing platforms? Based on new information I've found, there could be two possible outcomes—

Possibility One:

Local governments and interest groups try and persuade the central government to relax Macro-control and put an end to the policy of economic tightening, and allowing the real property market to skyrocket again.

Once the central government agree to loosen monetary supply again, inflation would become even more serious and entail grave social consequences that are hard to predict.

Possibility Two:

There could be whitening and transfer of local governments' debts. A few days back, there was a report from Reuters which quoted an informed source as saying that the China Banking Regulatory Commission, the Ministry of Finance, and the National Development and Reform Commission would between June and September clear up about two to three trillion yuan of local government debt that is at risk of default by transferring part of the debts into several newly established companies and lift the bond sale restrictions imposed on provincial and municipal governments.

It is is only a means of debt “whitening” to transfer debt into newly established companies and make the banks' balance sheet look “clean”. It won't solve any actual problem.

And to allow local government to issue bonds would be no difference from transferring the massive debts of local governments to the populace who purchase local government bonds. Because in order to satisfy the dire financial needs, local governments may very likely lure the people into buying their bonds with high yields.

This would only result in relocation of deposits from banks, which would end up in shortage of money supply. It does not truly resolve the massive financial risks posed by the Local Government Financing Platforms.

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After the news of Wenzhou tycoons fleeing from loan sharks came to light recently, I thought this article written in June might shed some more insight into China's financial problem. – Translator note.