The root of municipal government debt
Mismanagement of liquidity has played a key role in almost all financial crises in history. In the financial crisis of 2008, some experts have attributed the cause of the crisis to loose monetary policy which in turn fueled high levels of household and government debt, as well as drive up asset bubbles. Ultimately, a correction took take place and the cost is undoubtedly a deep and painful one. China has similarly witnessed a huge spike in liquidity in recent years. The M2/GDP ratio has risen from 60% in 1985 to 160% today.1
Much of this liquidity has found its way into local municipal government debt in the form of Local Government Financing Vehicle (LGFV), property speculation, the stock market and other investment schemes like high interest loans in Wenzhou (温州民间借贷). Of which, the biggest concern lies with the local municipal government debt in the form of LGFVs, due to the size of the market and its potential impact on the real economy.
Introduction to local government financing vehicle (地方政府融资机制)
LGFVs are essentially government-backed enterprises established to raise capital and finance infrastructure investment for local government. They are typically 100% owned by local SASAC (State owned Asset Supervision and Administration Commission). Local governments support LGFV by injecting assets such as land and fiscal revenue to strengthen the balance sheet.
Reason for LGFV
China local government shares a small pie in the national tax income but assume major responsibility in China’s infrastructure build-out and social economic development. For example, the urban fixed asset investment by local government in 2009 is RMB 17tn, 9 times the size of investment by central government. However, local government only account for 50% of budget expenditure. While local government faces severe shortage in funding, they are legally prohibited from running budget deficit, borrow from banks or issue bonds (unless specially approved). This leaves local government will little choice but to raise capital via LGFV in order to finance infrastructure investment. The financial crisis of 2008 led to China’s RMB 4tn stimulus package which played a key role in driving the LFGV market. In March 2009, PBOC (People’s Bank of China) and CBRC (Central Banking Regulatory Committee) jointly issued a guideline to encourage local government to set up LGFV, motivate banks to increase credit and expand the financial channels through issuance of enterprise bonds (linked to LGFV) and medium term notes.
Size of LGFV
The real answer is nobody knows the exact figure. In late 2009, CBRC, PBOC and NDRC (National Development and Reform Commission) reported that the LGFV loan is around RMB 7tn. However, some analysts commented that the real amount is much more as the figure is based on a narrow definition of just infrastructure loans. More recently, NAO (National Audit Office) revealed that LGFV debt is RMB 10.7tn.2
Risk underlying LGFV
LGFV returns could be overstated
As LGFVs are mainly focused on long term infrastructure projects, many of them do not generate cash flows in the short term. Also, infrastructure projects tend to have lower returns (ROE <5%). Nevertheless, issuers have to “boost” these returns in order to qualify for bond issuance. According to regulation, the issuers’ average net profits over the past three years have to exceed the annual interest expense of the bonds. This motivated local governments to provide one-off subsidies to “dress up” LGFV’s profitability before bond issuance. Also, local government can inject assets such as land or property companies. Given the increase in property prices, the profitability of LGFV investments have historically been good. However, the risk is when property prices fall, the value of LGFV will fall sharply.
Low transparency of LGFV borrowings
When LGFV raises debt capital, loan pricing was based on perceived local government’s credit worthiness due to expectations that the local government will bail out the loans. It is common for multiple LGFVs under the same administration to guarantee one another’s loans and bonds in order to increase credit worthiness and reduce financing cost. This type of cross-guarantees can give rise to significant systemic risk. If one LGFV faces financial distress, this can result in contagion effects on other LGFVs, triggering the local government to bail out not just one but multiple LGFVs. Given that local governments are already running a tight budget, they may not be in a position to deal with this problem. This can be made worse should property price falls, thereby reducing revenue from government land sales (a key revenue generator for local governments).
Financial system: Land, LGFV, Banks & Property market
The major risk in a property market slowdown lies in its role within the financial system. As mentioned, land finance is a crucial credit guarantee for local government’s debt. For example, in Liaoning province, 54% of its liabilities are to be repaid with income from land grant while the figure for Hainan province is even higher at 84%. When local governments discover the value of land resources in obtaining loans, there is an incentive to “push up” the property market which results in land price appreciation and in turn provide more revenue from land sales. In addition, banks play a critical role in financing the LGFVs and the property market. As of September 2011, loans to both real estate and LGFVs are estimated to account for 40% of total outstanding bank loans 3. Clearly, the risks of LGFVs are now linked with the property market and the banking system. As long as infrastructure projects return the projected cash flow and land prices remain high, there is no substantial risk of default. However, should economic growth slows, the impact could be widespread.
Defaults on LGFVs can result in a hard landing economic slowdown
The widely feared scenario could be something like this: Property prices decline, resulting in property developers unable to obtain projected sales target and therefore defaulting on loans. In addition, as land prices fall, LGFVs value will decline as land is used as collateral. In addition, investment returns may fall as cash flows from infrastructure and construction projects decline with the market. This may result in defaults by some less creditworthy LGFVs. Given that many LGFVs have cross guarantees on one another, default could be widespread. By that time, local governments will face difficulties bailing out the LGFVs as budget revenue declines due to lower land grant (land prices decline) and tax revenue (profits of major enterprises decline). Banks will ultimately face major NPLs write-downs from LGFV and 3 Li Mingliang, “China’s Public Debt: Sustainability and influences”, Haitong Research, Pg 12 property loans default. In order to strengthen balance sheet, banks will preserve capital and reduce lending. This would severely restrict capital to other key parts of the economy such as small medium enterprises (SMEs). Ultimately, the impact could be widespread and could result in a “hard landing” economic slowdown.
China central government holds the solution key
The bear case scenario rests on the key assumption that the central government will allow local government to default on the loans. This may not be happen as the central government has the ability to shift RMB 2-3tn in local debt to federal books.4 Given the focus on maintaining macroeconomic stability, it is unlikely that the central government will allow local governments to fail. Another assumption is that the government will not recapitalize the banks. Historically, recapitalization took place from 1998 – 2005 where bank NPLs are swapped with special government bonds issued by Asset Management Companies (资产管理公司).
Given China’s high domestic savings rate and more than US$3tn of foreign reserves, it is likely that the wealthy central government have the ability to prevent a catastrophic outcome by bailing out local governments, recapitalizing banks and stabilizing the economy. That said, this solution is short term and does not solve the fundamental problem. If Chinese government decides to bail out, it will then have to deal with the issue of moral hazard. Should markets “get used” to the idea that the central government will always step in during times of crisis, assets prices will have a tendency to become a bubble and there may come a day when the central government would no longer be able to contain a catastrophic economic meltdown.
From a broader perspective, local municipal government debt problem is a reflection of structural weakness in China’s economic and financial system. Since economic reforms began in the 1970s, China has witnessed both the failure of free market capitalism in 2008 as well as the imperfections of a centrally-planned system. Going forward, the fundamental solution lies in finding the appropriate economic development model uniquely suited for China.4
1. Barry, E. The Economist. The yuan: This house believes that the yuan will be the world's main reserve currency within ten years. Retrieved January 30, 2012 from http://www.economist.com/debate/days/view/756
2. 小林正宏、中林伸一(2011) 從貨幣看懂世界經濟. 台灣: 大雁文化出版
3. The US-China business council. US-China Trade Statistics and China's World Trade Statistics Retrieved January 29, 2012 from https://www.uschina.org/statistics/tradetable.html
4. Trading economics. China Interest Rate. Retrieved January 29, 2012 from http://www.tradingeconomics.com/china/interest-rate
5. 韋冬澤 吳成良(2011). 人民日報. Retrieved January 29, 2012 from http://big5.qstheory.cn/gj/gjgc/201109/t20110907_108751.htm
6. Investopedia. Definition of Dim-Sum bond. Retrieved February 4, 2012 from http://www.investopedia.com/terms/d/dim-sum-bond.asp
7. NAKED CAPITALISM.MONDAY, NOVEMBER 16, 2009. China Lambastes Dollar “Carry Trade,” Diverting Attention from Its Currency Manipulation Retrieved January 29, 2012 from http://www.nakedcapitalism.com/2009/11/china-lambastes-us-for-fueling-gl... 8. Alex, F. (26/10/2009). Yuan's Fall Annoys the Neighbors Link to Dollar Pulls Down China's Currency; Other Countries Scramble. WSJ .
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