Chinese municipalities have accumulated an unprecedented mountain of debt in the wake of the 2008 financial crisis. Official estimates put the debt burden of its municipalities at 10.7 trillion Yuan ($1.65 trillion) in 2010, or 27 per cent of the country’s gross domestic product in that year.1 However, some independent estimates, including Moody’s, suggest that China’s municipal debt figure could be as high as 20,100 billion Yuan.2 Although the situation may be “overall safe and controllable” in economic terms, as Chinese Premier Wen Jiabao stated in a January, 2012, speech,3 high levels of municipal debt are a manifestation of the dangerous problem underlying the political system, not the fiscal problem itself.
Local authorities borrowed heavily during the global financial crisis, as part of China’s massive fiscal stimulus effort. However, they will unlikely be able to repay this debt any day soon, because of poor cash flow and declining revenue from land sales, on which they rely heavily for much of their income. Local authorities shoulder most of China’s infrastructural spending, and have had to continue to borrow in order to complete projects to generate the cash flow needed to repay debt. Yet, there is a serious mismatch between asset and liability maturity. It takes several years to build a railroad or highway before a revenue stream is created. Exacerbating the financial asymmetry of costs incurred and revenue raised is local government’s heavy reliance on raising revenue from land sales. In recent times, the introduction of central government measures to take the heat out of the housing market, has inevitably led to declining property prices, undermining borrowing potential, and, in turn, local government’s capacity to raise finance.
In tackling this problem, Beijing has of late allowed a limited number of local authorities to directly issue bonds, for the first time since 1994.4 Although analysts reacted positively to this policy initiative, arguing that it would oblige local government to be more transparent about the nature of financing vehicles, the big question is whether anyone will buy these municipal bonds, given the revealed riskiness of this investment. Indeed, such fears have already been realized. During 2011, China’s Ministry of Finance, on behalf of the local authorities, struggled to sell tranches of these bonds.5
Averse market sentiment will, of course, continue, until such a time as when fiscal discipline is restored.
The Chinese economy is robust enough to ensure that its financial system avoids a severe economic slump. However, it is sobering to recall the early 1990’s near financial catastrophe, when China’s local authorities established a plethora of trust funds and other financial mechanisms, with the resulting financial expansion leading to an explosion in non-performing loans, reaching the equivalent of one fourth of China’s GDP by the end of 1990s.6 Nevertheless, thanks to financial reform and China’s admission to the World Trade Organization, the Chinese economy did not collapse. ‘What goes around, comes around’, and the danger today is that the volume of non-performing loans will accelerate to a value, in both absolute and relative terms, that is greater than was reached in the 1990s. The reasons for this fear are straightforward: the Chinese economy has expanded exponentially, due to rapid economic growth, low interest rates, and massive public sector investment. The somber and inescapable conclusion is that China in the years ahead faces a high probability of suffering a hugely destabilizing debt crisis, mirroring that ongoing in Europe at this time. The world awaits…
Increasing Political Instability from the Masses
Although the red ink may be shrouded by the red flag of the world’s second largest economy, the problem lies elsewhere. Worryingly, China’s ordinary citizens are inextricably enmeshed into this looming debt crisis, thus increasing political vulnerability. There are three reasons behind this growing threat to political instability:
Firstly, since the Central Bank of China has explicitly stated it would move to bail out all distressed financial institutions,7 a crisis similar to the bankruptcy of Lehman Brothers in the U.S. will not happen. However, even a ‘constrained’ crisis will hurt the majority of Chinese people. This follows because if the government bails out a bank, the financing will have to come via reallocation of public spending, such as from education or health- care, from borrowing, or, in the final analysis, through the printing of new money; the latter two financing modes carry the risk of creating a significant inflationary shock. All these bailout methods will bring economic pain to China’s citizens, raising the specter of political instability.
Secondly, a sharp reduction in local public investment would inevitably lead to a rise in unemployment and poverty, particularly in China’s impoverished areas. The tightening of lending through increases in interest rates and/or direct quantitative shrinkage of loans to reduce high inflation will disproportionately hurt private-sector small- and medium-sized firms. Bankruptcy, and civil unrest will likely follow. Such a scenario is far from unrealistic, given that the riots last June by hundreds of migrant workers in Chaozhou, Guangdong Province, arose because of a single firm’s shortage of funds to pay its workers wages.8 Reports abound of many other Chinese firms teetering on the edge of bankruptcy.
Thirdly, behind the massive local government borrowing are the huge numbers of people evicted from their homes to make way for never-ending urbanization projects in which the debts incurred are continuously ‘rolled-over.’ For instance, in building Yujiapu, the Tianjin municipality incurred at least half a trillion Yuan of loans, equivalent to half the annual per capita income of the city’s 13 million people. The project began in 2008, and more than 5,000 people were moved out of the area to make way for the project,9 representing a microcosm of forced relocation of low income citizens across China.
Financial Turf Wars Within the Chinese government
Significantly, behind China’s emerging debt crisis simmering turf wars exist, both within the highest levels of the Chinese government and between central and municipal levels of government. Tensions exist between Beijing’s top leaders on the degree of local debt disclosure. On the one hand, the current leaders, who will step down later this year, want to leave office without revealing the true extent of China’s debt. On the other, the incoming leaders are keen to raise the transparency of the debt problem, desperate to ensure they are not blamed for the potential economic Armageddon, if and when it occurs. As Professor Victor Shih, Northwestern University, noted, the resolution of the problem will have to wait at least until the younger leaders take over.10
Additional tensions exist between central and local government, because of their historical division of power, and here fiscal control is a fundamental instrument. In 1997 when central power and control were much weaker than that of the local authorities, the then Chinese Premier, Zhu Rongji, implemented profound reforms of state-owned enterprises and also taxation. The principal thrust of these reforms was held to be a hardening of budgetary constraints at the local level, representing an attack on where the real power lies, rather than any desire to increase competition or attract foreign direct investment. Is history repeating itself, in the sense of the center deferring to local government? Before 2008, central government was able to restructure or repay local debts, but the need grew more urgent in the wake of the 2008 financial crisis. The resolution to this burgeoning liquidity crisis depended on the balance of financial power between the center and local authority periphery. Beijing’s recent announcement of a pilot program for cities to directly issue bonds seemingly indicates the enduring weakness of central power versus local administration. Moreover, if Beijing decides to bail out China’s local authorities in the event of default, then, as central funding becomes scarcer, negotiations over transfer payments to local governments will in parallel become increasingly fierce.
China’s local debt crisis is serious, but hopefully manageable in economic terms. Simply put, the world’s second-largest economy has sufficient economic strength and fiscal management expertise to control its debt problem. However, it will be the political consequences of the debt crisis that pose the real question, and this is precisely where less certainty exists over the outcome.
1. Orlik, Tom. “China Tallies Local Debt”. The Wall Street Journal [updated 2011 Jun 28; cited 2012 Feb 12]. Available from http://online.wsj.com/article/SB1000142405270230444780457641101357522110...
2. Orlik, Tom. “China Tallies Local Debt”. The Wall Street Journal [updated 2011 Jun 28; cited 2012 Feb 12]. Available from http://online.wsj.com/article/SB1000142405270230444780457641101357522110...
3. Wei, Tian. “Govt Debt ‘Safe, Controllable’, Premier Says”. People’s Daily Online [updated 2012 Jan 31; cited 2012 Feb 12]. Available from http://english.people.com.cn/90785/7715295.html
4. Anderlini, Jamil. “China Municipalities to Issue Bonds”. Financial Times [updated 2011 Oct 20; cited 2012 Feb 12]. Available from http://www.ft.com/intl/cms/s/0/0640aaf2-fb20-11e0-bebe00144feab49a.html#...
5. “China’s Three-Year Local Government Bonds Undersubscribed”. Business China [updated 2011 Jul 13; cited 2012 Feb 12]. Available from http://en.21cbh.com/HTML/2011-7-13/LGFV.html
6. Yao, Yang. “Serious, but Not Devastating”. The New York Times [updated 2011 Jul 18; cited 2012 Feb 12]. Available from http://www.nytimes.com/roomfordebate/2011/07/06/chinas-debt-monster/chin...
7. Case, David. “China’s Mountain of Debt, Explained”. Global Post [updated 2011 Jul 8; cited 2012 Feb 12]. Available from http://www.globalpost.com/dispatch/news/regions/asia-pacific/china/11070...
8. Zhu, Shanshan. “Clash Erupts over Wage Spat”. Global Times [updated 2011 Jun 8; cited 2012 Feb 12]. Available from http://china.globaltimes.cn/society/2011-06/662899.html
9. “China Debts Dwarf Official Data with Too-Big-to-Finish Alarm”. Bloomberg [update 2011 Dec 18; cited 2012 Feb 12]. Available from http://www.bloomberg.com/news/2011-12-18/china-debts-dwarf-official-data...
10. Orlik, Tom. “China Tallies Local Debt”. The Wall Street Journal [updated 2011 Jun 28; cited 2012 Feb 12]. Available from http://online.wsj.com/article/SB1000142405270230444780457641101357522110...
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