Li Keqiang’s Dilemma

During last week’s National People’s Congress meeting in Beijing, Wang Juguang, a Chongqing municipal official, warned that Beijing faces a seemingly insoluble dilemma over the government’s need to keep the economy moving to meet 7.5 percent GDP growth at the same time its main vehicle for doing that – local government investment – is in crisis.

As has been widely publicized, China’s local governments have accumulated as much as US$3.4 trillion in debt via so-called “local government financing vehicles” or LGFVs that borrowed from banks off government balance sheets.

As Wang pointed out during the conference, Prime Minister Li Keqiang’s goal of urbanization – moving as many as 250 million people to the cities, or building cities to house them – means local governments must bear the brunt of construction. Beijing needs local government investment in low-income housing, rural infrastructure, water, electricity, transportation, cleaning up the environment, technological innovation, health clinics and all the appurtenances of urbanization.

But Wang warned that “borrowing is still a major channel” and that Beijing “needs great wisdom and must exercise great caution” in figuring out how to solve the problem.

China is publicly wedded to 7.5 percent growth because of a vow to double personal incomes by 2020.

“This is the fundamental dilemma for China – urbanization, infrastructure, etc., are the heavily polluting elements in the China growth story,” said Dr Jim Walker, managing director of the Hong Kong-based financial analysis firm Asianomics. “No surprise it is a provincial government guy saying Beijing needs the provinces to keep growing but the bigger question is, can it really afford to have them growing so irresponsibly? The answer is no, which means much slower growth.”

Li downplayed the problem at a press conference yesterday, saying the government’s total debt to GDP ratio is still below internationally-agreed standards and that the government has begun to address the issue.

Nonetheless, despite the fact that warnings began to sound on local government debt as early as April of 2012, the National Audit Office recently disclosed that China’s various governments had direct debt of RMB20.7 trillion (US$3.4 trillion) at end June 2013, up 8.6 percent over the end of 2012. Economists are growing concerned that the mounting debt is a danger to the country’s fiscal stability.

The local debt first blew up when local governments went on a development spree in 2008 in a national effort to counteract the recession that hit western economies. Beijing poured RMB4 trillion into development and demanded local governments to do their part to match national goals.

But the local governments were trapped by the fact that Beijing was taking the lion’s share of tax revenues. Because they couldn’t borrow legally and were prohibited from issuing bonds, they turned to creating separate entities through which they could borrow from the banks off the books. Those entities, unsupervised, ballooned into vast debt, at least some of which disappeared overseas into illicit bank accounts in the British Virgin Islands and other banking havens.

Li said during his Thursday press conference, that Beijing would “establish a standard financing mechanism for local governments to issue bonds and place local government debt under budgetary management."

That means bonds, which require disclosure and spread the risk of default across a wide array of investors. China launched local government bond pilots plans in 2011 Shanghai and Shenzhen, and Zhejiang and Guangdong provinces in 2011and has since expanded the trial to Shandong and Jiangsu provinces. But the market is in its infancy. China doesn’t have major reliable credit rating institutions to evaluate risk. The country needs a credit rating system, information disclosure and regulatory coordination. All of those things appear to be far in the future

But if Beijing is asking local governments to pull extra weight in transforming the landscape from agrarian to urban at a 7.5 percent annual pace, that means not only raising the funds to do it but working out how to pay the banks back the RMB20 trillion they owe.

The government is also actively studying allowing local governments to levy property taxes. However, recently it was reported that despite the fact that property tax pilot plans are in place in Shanghai and Chongqing, inadequate planning and laws mean the pilots probably won’t be expanded to other cities any time soon.

This is all complicated by the fact that nobody really seems to know where the Chinese macro economy is going. Economists are sharply divided, split between bulls and bears. Richard Haass, the president of the Council on Foreign Relations, told Bloomberg’s Tom Keene earlier this week that China’s GDP figures were fake and that economic troubles would lead to political instability. World trade hasn’t grown for the past two years, a blow for China’s export-oriented sector.

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. At least one bond default has already occurred, although analysts haven’t been overly concerned about a cascade of failures.

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.

So in all, Li Keqiang and the plan to urbanize may be caught in Wang Juguang’s trap. In order to keep the economy moving at the 7.5 percent pace that the government feels is crucial, it will require local governments to continue to pour on the investment. But debt-strapped local governments have to figure out how to do that in a way that they haven’t discovered yet.