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China's Startling Local Debt Problem
China’s local governments went on a massive development binge starting in 2008 that has put them 10.78 trillion yuan (US$1.69 trillion) in debt, equivalent to 27 percent of the country’s entire GDP, according to a study of Chinese local government debt by the Seoul-based Samsung Economic Research Institute.
Although it isn’t news that China’s local governments have over-extended themselves, particularly in property development, the magnitude of the indebtedness is somewhat of a shock, along with the strain the development binge could put on China’s banks. Citing figures made available by China’s National Audit Office in June 2011, the report says the debt zoomed almost 10-fold from 1.7 trillion yuan in the first half of 2008 despite the fact that municipalities are barred from borrowing directly.
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.
So 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,” usually supported by some form of government assurances.
The local governments apparently got around the prohibition by establishing 6,576 “financing vehicles” by the end of 2010 to fund new roads, airports and other infrastructure. The SERI report, written by researcher Li Meng, says that 8.5 trillion yuan of the 10.7 trillion came from bank loans, more than half of which have to be repaid by 2013. In addition, Li Meng writes, a report issued by the National Audit Office in January questioned 530 billion 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,” SERI said. “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.
At the same time, between 2000 and 2010, China continued to urbanize “at a pace and scale never seen before in world history,” according to the US-based magazine New Geography, adding some 205 million urban residents over 10 years. “China's urban population expansion was 2.5 times the estimated increase in rapidly urbanizing India. In 2010, nearly 50 percent of the population lived in urban areas, compared to 37 percent in 2000. This increase is well above expectations. While the need for local infrastructure investment increased exponentially to take care of these legions of new urban dwellers, “”most local governments' disposable financial resources could not meet the huge demand for funds,” according to SERI.
Local government indebtedness was exacerbated by the 4-trillion-yuan (US$618-billion) stimulus package introduced to cope with the effects of the global financial crisis which struck in 2007. 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 local governments hit on the extra-governmental financing vehicles and what SERI calls hybrid government-private sector enterprises, which began to borrow on a massive scale.
At the same time, the national government flooded the market with credit, creating an opportunity for the local governments and their extra-governmental entities to obtain loans on an unprecedented scale. The credit structure and monetary policy of banks intensified the flow of capital to financing platforms.
“China adopted a moderately loose monetary policy in 2009, and the net interest margins of commercial banks declined substantially because of the asymmetric rate cut,” SERI said. “Commercial banks had to expand credit scales to maintain revenue growth. The reason why local government platforms could easily attain large bank credit funds in 2009 is that the expanding of banks' credit scale relied excessively on loan income, and the banks' regulators had driven the flow of credit funds to government platforms preferentially.”
The stage has thus been set for default risk on the part of local governments over the next two or three years. 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 China’s housing market has begun to fall, complicating the plans of cities and provinces that had anticipated clearing their debt through land sales.
That in turn is problematical. Property 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. At least two top developers, Country Garden and Greentown, have turned to their staff for purchases, with staff discounts allowed and employees offered sales commissions to try to move surplus property.
The downturn is thus expected to weigh on the cities and provinces that had planned to pay off debt by selling high-priced land.
The investment in infrastructure projects such as roads and bridges doesn’t generate returns fast enough to meet repayment terms, the SERI study says. 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. The investment returns of most local government projects were too low to be commercially viable. Accordingly, it will be very difficult for local governments to make interest and principal repayments.”
Even projects that were properly sanctioned are running into trouble, let alone poorly managed ones, with the national audit office finding many irregular activities as local governments using nonexistent or illegal collateral to secure loans, with some of the money they borrowed being funneled into the stock and property markets. Local governments have also overstated the value of collateral, which was often tied to land values.
It is estimated that as much as 2-3 trillion yuan of loans made to local governments have gone bad and that the scale of the problem may push up non-performing loan ratios in the banking industry to around 5 percent, from their current average of 1.1 percent, the report notes. For now, it doesn’t appear certain that the central government will bail out the municipalities. Instead, with 1.84 trillion yuan scheduled for repayment this year, accounting for 17.7 percent of the total local government debt, the most immediate solution seems to be to postpone repayment.
Extensions of local-government debt have already started last year, and will continue, the report notes. The China Banking Regulatory Commission is considering long-term extensions of bank loans (i.e. a debt rollover) to local governments, which could give the central government breathing room to deal with the huge debt load. It is expected that maturing debt might have to be extended for as much as four years.