Is local government debt a serious threat to the Chinese state?

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Zung Sung Chuo's picture

The period of growth after the Asian Financial Crisis was characterized by fiscal prudence and conservatism, especially in East and South East Asian states. This, among other reasons, resulted in a global capital imbalance (Wolf, 2010) with Asian thrift symmetrically resulting in large deficit spending in the US. When the subprime crisis developed into a financial contagion, Asia found herself in a more fiscally prepared position. While there were no symptoms of economic decoupling due to the heavy dependencies of the trade-based economies of Asia, judicious spending in the past afforded the flexibility of policy response that was well-coordinated and sufficiently large. Leading the recovery among economically significant states was China, which posted a recovery in growth figures by early 2009.

However, concerns on the nature of China’s recovery have recently surfaced. Critics have noted the onslaught of a credit campaign to sustain public investment expenditure. Taking centre-stage in this recently uncovered debt concern are the 6576 financing platforms created by municipalities throughout China. Article 28 of China’s Budget Law (1994) prohibits local governments from issuing bonds, resulting in an implied balanced budget requirement. However, the central government has tacitly allowed the formation of financing vehicles to aid municipalities in securing credit from banks. Moody’s estimates of current local government debt stand at approximately RMB 10.7 trillion with a potential RMB 3.5 trillion that state auditors may not have disclosed (Moody’s, 2011). Federal funding which was supposed to have sustained local construction booms was acutely constrained during the global financial crisis, forcing local governments to increase borrowings – up to half of presently accumulated municipal debt were amassed after Beijing announced RMB 4 trillion worth of stimulus spending and eased lending policies in 2008.

A recent announcement by the Ministry of Finance which approved pilot bond issuance (Xinhua, 2011) in four municipalities signals very strongly that concerns over the fiscal sustainability at the local government levels are coming from even within the state’s communist ruling organ.1 Fundamental determinants of fiscal sustainability which inadvertently serve as proxies for sovereign debt risk include the tax base, changing population demographics, reserves and sources of GDP growth. There are, expectedly, other auxiliary determinants and risk factors unique to different states depending on specific economic conditions or fiscal and financial infrastructures. This essay will address each in turn, drawing upon cross-sectional comparisons.

From the perspective of the government, two key reasons form the basis of sovereign debt. In the first instance, debt allows the government control over monetary policy which plays some role in economic policy. 2 Secondly, debt allows the government to reduce shocks experienced during business cycles. 3 Opinions are polarized along the levels of debt that government should maintain. Regardless, debt proportions can generally be sustained if the economy is growing at a pace that exceeds maturing obligations. 4 Stresses to fiscal sustainability usually present themselves in the form of shifting population demographics, business cycle shocks and the consequences of cumulative unproductive borrowing. These stresses cause tax receipts to fall, risking a default on obligations. Governments can choose to issue more debt to temporarily mask the problem or enter into technical default, in which case, the government does not fulfil its obligations in a timely manner – otherwise known as a sovereign default or government insolvency. 5 The consequences of insolvency have been historically catastrophic for the economy and often lead to a protracted impairment of the state’s reputation as a credible borrower – in which case, any recovery will come at a very high cost. 6

The European Union and Greece, in particular, serve as useful cases in point. Average federal debt levels stood at approximately 66% prior to the GFC. 7 This is in addition to the fact that Italy and Greece circumvented the Maastricht Treaty by concealing debt through the use of complex currency and credit derivatives. 8 The loss of monetary independence to the European Central Bank also meant that EU member states were not able to simply “print” money to meet obligations. International exposure to debt was no less a problem, except for a minority of member states including Germany, Netherlands and Belgium which recorded a trade surplus. While Greek GDP growth rates were consistently high in the early 2000s, debt levels were similarly high. 9 Structural deficit were accumulated over time as the government increased transfer payments through social security programs and added and increasing number of public sector jobs. Political drag and a failure in coordinated response in the Eurozone coupled with multiple downgrades of Greek debt consequently resulted in a distressed economy with debt expected to remain unsustainable for at least until end-2012.

The Chinese debt situation presents somewhat contrasting circumstances; yet unique threats to the system need to be recognized. Federal debt levels in China stood at 20% of GDP (CFSR, 2011). Even if local government debt is included, taking into account claims of undisclosed sour loans, total public debt at the federal and municipal level would amount to 55% of GDP, substantially lower than average levels recorded across the EU prior to the GFC. More importantly, in 2009, the Chinese Banking Regulatory Commission (CRBC) re-instituted lending quotas and stringent capital and reserve requirements. During a time when Basel II still considered hybrid capital and subordinated debt as Tier 2 capital, the CRBC announced that these would be excluded in Chinese capital requirements. Reserve ratios for Chinese banks were 10 times higher than those required of EU banks. While public spending in Greece and most of the EU were driven by expenses incurred by deeply entrenched social security systems and transfer payments, Chinese local government debt were channelled almost entirely towards infrastructure investments. 10 There is even much less concern if we were to consider the population demographics of China – the state is experiencing a massive rural-urban migration as coastal economies like Shenzhen and Guangzhou continue to flourish. This comfortably justifies the massive infrastructural investments that local governments are making.

Nevertheless, several unique yet potentially detrimental stresses pose as apparent threats to Chinese economic and fiscal sustainability. Macro concerns are largely found in the Chinese property and informal lending markets – likely precursors to larger problems. Concerns directly related to municipalities include asset-liability mismatches, fiscal and credit misalignments, and serious data discrepancies (Bloomberg, 2011). Aggressive infrastructural spending has led to a construction boom which has had an (unintended) effect of fuelling the precipitous rise in real estate prices. Much of this has contributed to the deterioration of asset quality used as collateral by municipal financing companies. 11 Whether or not a burst bubble will have hard-hitting repercussions on debt obligations and the economy in general depends on the effectiveness of stringent down-payment policies that have been re-instituted. 12 In short, Chinese households are less leveraged (Lardy, 2010). 13 The informal lending market is of even greater concern, and the related data discrepancies hint at a potential credit situation. Tight lending policies have resulted in a shortage of loanable funds, resulting in a curb market providing debt at significantly higher costs (Tao, 2011). Much of these are unaccounted for, present significantly unregulated risks to credit markets and may potentially hinder swift government policy response to a default situation. Of immediate concern to municipal financing companies is the mismatch of assets and liabilities – asymptomatic of financial mismanagement. 14 A moral hazard problem also arises since municipal governments that are accorded fiscal autonomy also enjoy the credit worthiness of the central government. Such a situation encourages irresponsible and unproductive borrowing, though this is difficult to assess empirically.

The Chinese government has taken several necessary steps in the right direction – though we will see why this may prove insufficient. The state auditor has ordered municipal governments to immediately correct fraudulent and underpayment of registered capital. The late-2010 announcement of the scale of local government debt by the Chinese Ministry of Finance has also provided some reassurance of a transparent government. Nonetheless, claims of undisclosed debt need to be addressed urgently, to eliminate uncertainty in credit markets. Needless to say, infrastructural investments need to be scaled back while adopting more stringent investment appraisal approaches.15 The central government has also directed banks to recapitalize to avoid any slowdowns triggered by financial institutions. A delicate balance needs to be maintained to avoid tightening too quickly. 16 The pilot bond issue in four municipalities should be restricted to short-term bonds with revenue dependent coupons – these must be issued based on the credit-worthiness of local governments rather than the Ministry of Finance if municipalities were to maintain fiscal autonomy. 17

The arguments presented in this essay point in the direction of a Chinese local government debt problem that is unlikely to cause any severe contraction (if at all) in the Chinese economy – China’s foreign reserves total some RMB 20 trillion. 18 However, fiscal mismanagement very often leads to structural problems that develop exponentially and irreversibly. Fiscal sustainability requires extraordinary political will; constitutional safeguards do not provide this in the long run. 19 Full disclosure provides more of an assurance of prudent spending since markets will be able to respond accordingly. Bearing in mind the vulnerabilities of a one-party state, the independence of institutions needs to be preserved.

References: 
  1.  Debt proportion is measured by Debt:GDP Ratio in this case.
  2. Increased borrowing to fulfill maturing obligations may only be available at increased costs as investors begin to worry over increasing debt levels.
  3. The cycle is vicious.
  4. The EU has a unique fiscal and monetary infrastructure in relation to the fiscal sustainability question. See Beetsma, Roel M W J, “The Optimality of a Monetary Union Without a Fiscal Union”.
  5. The Maastricht Treaty requires government debt levels capped at 60% of GDP.
  6. Greek GDP growth averaged 4.2% from 2000 – 2007. See: http://www.gfmag.com/gdp-data-country-reports/266-greece-gdp-country-rep...
  7. This is contrary to popular belief that investment expenditures are on productive capacity (in the steel industry for example).
  8. This is due to the inflated prices of land, for example.
  9. Policies are a far cry different in the US and EU prior to the GFC: as little as 0% down payment in the US. See: http://www.usatoday.com/money/perfi/housing/2006-01-17-real-estate-usat_...
  10. Only 18% of Chinese household debts are mortgage-related, compared to 120% in the UK. See: http://www.oecd.org/document/43/0,3746,en_21571361_44315115_45333099_1_1...
  11. These include future revenue streams from highway toll concessions, for example.
  12. This might well be easier to accomplish than austerity measures in the EU.
  13. Japan made this costly mistake and lost two decades. See Shiratsuka, Shigenori, “Asset Price Bubble in Japan in the 1980s.” Institute for Monetary and Economic Studies.
  14. Inter-generational borrowing should be left to the federal government.
  15. This seems to be the only certain-difference between China versus the EU and US.
  16. An example would include a debt ceiling as in the US Constitution (Article I, Section 8). The 2011 US Debt Ceiling Crisis resulted in a political downgrade by Standard and Poor’s; the threat of unlikely political consensus was cited. See: http://www.ft.com/cms/af2c4fac-bfc2-11e0-90d5-00144feabdc0.pdf
  17. Wolf, Martin (2010). Fixing Global Finance. Baltimore: The Johns Hopkins University Press, 2nd Edition.
  18. Moody’s (2011). Global Credit Research Announcement, 05 July 2011.
  19. Xinhua (2011). MoF: China local debt risks controllable. http://news.xinhuanet.com/english2010/video/2011-08/16/c_131052469.htm Accessed: 10 February 2011.
  20. Pilot bond issues have been approved for Shanghai, Shenzhen, Zhejiang and Guandong.
  21. The role of monetary policies has varying extents across different schools of economic thought.
  22. Debt is raised to finance fiscal stabilizers, transfer payments and stimulus spending.
  23. CFSR (2011). China Financial Stability Report 2011. Financial Stability Analysis Group, PBoC.
  24. Bloomberg (2011). China Debt Dwarfs Official Data with Too-Big-to-Finish Alarm. http://www.bloomberg.com/news/2011-12-18/china-debts-dwarf-official-data... Accessed: 10 February 2011.
  25. Lardy, Nichols R. (2010). The Sustainability of China’s Recovery from the Global Recession. Policy Brief, Peterson Institute for International Economics.
  26. Tao, Dong (2011). China: An Informal Lending ‘time bomb’? Credit Suisse Economics Research.
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