China Bails Out Local Governments

China's State Council has acted to bail out to local governments which have racked up at least 10.7 trillion yuan (US$1.69 trillion) in debt steered through covert "financing vehicles" to finance a wave of development spending on empty housing complexes and over-developed infrastructure.

In the 2013 budget, the State Council granted 350 billion yuan in local government loans to be issued by the Ministry of Finance to cover local government deficits for the year. It is the highest amount of debt relief since 2008.

Some observers believe the debt levels could be as much as 13 trillion yuan, amassed against prohibitions by Beijing and creating a problem as big as the so-called triangular debt problem that nearly capsized major state-owned enterprises in the 1990s. The 10.7 trillion yuan figure comes from the National Audit Office.

It is difficult to know just how big the local government debt problem is, since debt isn't recorded officially. The local governments financed most of it through off-budget vehicles that then borrowed through banks. There are indications, however, that many local governments are having serious problems meeting debt obligations, hearkening back to the 1990s triangular debt problem on the part of the state-owned enterprises, in which SOEs purchased materials from upstream suppliers but failed to pay. Because A couldn't collect payment from a downstream SOE, it couldn't afford to pay its upstream suppliers. As a result, firm A owes firm B, firm B owes firm C and firm C owes firm and nobody can collect. Eventually the national government had to bail out the SOEs to the tune of hundreds of billions of yuan.

In an indication that the government recognizes the seriousness of the problem, outgoing Prime Minister Wen Jiabao specifically said in his work report that China must do everything it can to prevent a systemic shake-out.

The debt bulge started as the Chinese government poured 4 trillion yuan into development with the onset of the global financial crisis, with the local governments required to do their part to match national goals. The local governments, handicapped by the fact that Beijing was taking the lion's share of tax revenues, had to find new sources of financing.

Thus, despite the fact that China's national budget law stipulates that local governments must balance their budgets and are prohibited from issuing bonds without approval of the State Council, the local governments set up companies to borrow money, "in some cases without considering their ability to repay the loans," according to a 2012 report by the Samsung Economic Research Institute, "usually supported by some form of government assurances."

The local governments apparently got around the prohibition by establishing 6,576 of these "financing vehicles" by the end of 2010 to fund new roads, airports and other infrastructure, according to the SERI report. The report, written by researcher Li Meng, said that 8.5 trillion yuan of the 10.7 trillion came from bank loans, more than half of which were due by 2013 and are creating a big problem for the banking industry.

In addition, Li wrote, a report issued by the National Audit Office in January questioned 530 billion yuan as having "irregularities" in local government debt. It appears that 46.5 billion yuan were issued in "irregular credit guarantees;" 73.2 billion yuan worth of loans were secured against irregular collateral; 35.1 billion yuan was spent on stocks, housing, and polluting plants; and 132 billion yuan worth of expenditures were not made by the approved deadline.

Fraudulent underpayment of registered capital in financing vehicles amounted to 244.15 billion yuan.

"The local governments in question have been ordered to correct these irregularities, but such efforts remain less than half finished in some areas," according to Li's report.

"Of the 46.5 billion yuan of problematic guarantees, only 22 billion yuan had been corrected by the end of October, while just 23 billion yuan of the 73.2 billion yuan linked to irregular collateral had been resolved through renegotiating terms with banks."

The problem has been exacerbated by the fact that the majority of tax revenues flow into central government coffers, leaving local governments in difficulty to finance their activities. Tax reforms enacted in 1994 raised the income share for the central fiscal authorities from 22 percent to 55 percent, thus strengthening the central government's financial power while emasculating that of the local governments.

While the need for local infrastructure investment increased exponentially to take care of hundreds of millions of people moving into China's cities in what has been called the biggest urbanization wave in human history, most local governments were simply unable to meet the demands for funds.

The investment in infrastructure projects such as roads and bridges is not generating returns fast enough to meet repayment terms. Over the past couple of years, more than half of China's GDP has been generated by investment in fixed assets, which may make economic sense but are not necessarily commercially viable.

SERI estimated that as much as 2-3 trillion yuan of loans made to local governments had gone bad by early 2012.