China's Local Government Debt Problem May Have Doubled

In August, China's National Audit Office embarked on a comprehensive attempt to determine how much money is owed by the country's local governments as the result of a massive borrowing binge that began in 2008. While no official report has been released, it appears that the figure may be twice as big as it was thought to be just two years ago - 19 trillion yuan, or US$3.1 trillion, more than a third of the country's annual gross domestic product.

The 19 trillion yuan figure was printed in domestic Chinese-language newspapers, citing leaks from the national audit office. Other unofficial estimates by western observers range anywhere from 15 trillion yuan to 25 trillion although some of the increase may be due to the way the debt is calculated. Nonetheless, local officials, still driven by the need to measure their performance by GDP growth despite a decade of warnings by Beijing not to do so, have continued to debt-driven projects to polish their resumes.

Top officials in Beijing have repeatedly said the local government debt problem is manageable.

The attempt to discover the dimensions of the problem was kicked off by Li Keqiang, who took over as premier earlier this year. It comes amid rising concerns over the governments' ability to pay and the murky schemes they used to borrow in the first place. A large portion of the money may have disappeared overseas, one economist told Asia Sentinel.

China's local governments started their mammoth development spree in 2008 as part of a national effort to roll back the recession that was gripping western economies and threatening China's as well. Beijing poured 4 trillion yuan into development at the onset of the global financial crisis, with the local governments required to do their part to match national goals.

However, 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. China's national budget law stipulates that local governments can't do deficit financing and are prohibited from issuing bonds without the approval of the State Council, although China, with its new leadership in place, is now experimenting in some areas with allowing local governments to issue bonds.

Trapped by their need to obtain development funds, the local governments turned to what are known universally as LGFVs - local government financing vehicles - that could borrow to fund new roads, airports and other infrastructure, often without considering their ability to repay the loans. A 2012 report by the Samsung Economic Research Institute estimated at the time that at least 8.5 trillion yuan came from bank loans, more than half of which were to be repaid this year.

The National Audit Office in January questioned 530 billion yuan as "having irregularities" in local government debt. Even projects that were properly sanctioned are running into trouble, let alone poorly managed ones as local governments used nonexistent or illegal collateral to secure loans, with some of the borrowed money being funneled into the stock and property markets. There are also widespread suspicions that at least some of that money disappeared overseas as corrupt officials siphoned off funds from the borrowing binge. Capital flight has been a major problem in China for decades, with an astonishing US$3.97 trillion being sneaked out of the country between 2000 and 2011, according to a report by the Washington, DC-based Global Financial Integrity, a research and advocacy group - as much as 10 percent of China's annual GDP.

Although it was estimated earlier this year that as much as 2-3 trillion yuan in the local government loans had gone bad by early 2012, that doesn't mean the local and national governments face the loss of the entire 19 - or 15 or 25 - trillion yuan, depending on who is doing the estimating.

Beginning in 2008, the money was poured into 10 programs including low-income housing, rural infrastructure, water, electricity, transportation, the environment, technological innovation, and reconstruction from several disasters. The central government provided 1.2 trillion yuan in stimulus, with the rest expected to come from local governments - which, given the shift in tax revenues to Beijing -- didn't have the money to fulfill their part of the bargain. Thus the local governments hit on the LGFVs to borrow on a huge scale. Ultimately more than 5,500 of the funding schemes came into being.

At the same time, the national government flooded the market with credit, creating an opportunity for the local governments and the LGFVs obtain loans on an unprecedented scale. The credit structure and monetary policy of banks intensified the flow of capital to financing platforms.

To meet their commitments, the local governments have hoped to generate income through land sales - already a major source of income. For instance, Guangzhou obtained 48 percent of its income in 2010 through land sales. But while some areas of China's housing market are red hot, in other areas it has begun to fall as banks tighten credit. Suicides have been reported in Wenzhou as homeowners have gone underwater.

The local governments and developers are under considerable pressure as home inventories continue to climb and debt levels escalate. By one industry account, the total inventory of the top 500 property developers is up by 50.3 percent year-on-year, reaching almost 5 billion yuan. The downturn is thus expected to weigh on the cities and provinces that had planned to pay off debt by selling high-priced land.

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, creating additional pressures.

For now, it doesn't appear certain that the central government will bail out the municipalities. Nobody knows at this point just how big the problem is although reports of fraudulent operations have continued to leak out. Extensions of local-government debt started last year, and are expected to continue. IN some cases, banks have been accused of hiding non-performing loans by transferring them from one enterprise to another.