Is Local Government Debt a Serious Threat To The Chinese State?

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Joseph Horbec's picture

In the financial crisis of 2008, Beijing determined that local governments would now be able to officially run fiscal deficits, which would be implemented from 2009. By doing so, the central government was effectively providing cheap credit to soak up any damage a volatile global economy may inflict upon Chinese interests. Prior to this, municipalities in the People's Republic of China had lost out from the major taxation reforms of 1994. Whereas before it was common for them to achieve surplus while the central government could not , revenues were extremely constrained afterwards through the new tax code and centralisation of bank management. Furthermore, the Asian Financial Crisis of 1997 saw many poorly performing SOEs and local financial institutions closed down, causing the municipalities losses. It was clear by 2009, when the Ministry of Finance delivered its budget report to the National People's Congress, the increasing distortion of expenditures to revenues by municipalities required attention. The fiscal deficit in the municipalities was officially ¥230 Billion (USD $35 Billion) but considering ¥2.89 Trillion (USD $423 Billion) came from tax-transfer payments from the central government, this accommodation itself accounts for 49% of revenues totalling ¥5.9 Trillion (USD $865 Billion). Obviously, allowing such a massive subvention to continue would prove untenable; hence the genesis of the municipal bond market.

When given the go ahead from the ¥4 Trillion stimulus, collateral requirements were lowered for local governments to implement new projects, and they duly complied indulging with little risk in their own economic excess. Before 2009, the municipalities had leveraged their infrastructure, utility and property assets but after doubling up, they were truly fettered to their connection to land assets and the property market. By mortgaging investment in residential and commercial developments, much like the Chinese banks, the provinces were betting that property valuations would continue to increase hence support capacity for increased borrowing.

Moreover, as most of China's provinces do not have valuable real estate, these poorer cousins leveraged themselves borrowing from the better endowed coastal municipalities. This cross-pollination of loans accounted for 90% of all stimulus spending by September 2009 to the tune of ¥6 Trillion (USD $880 Billion), which account for 240% of revenues and 40% of total new credit issued nationwide. In 2009 alone, outstanding municipal debt grew 30% to ¥7.8 Trillion (USD $1.14 Trillion). Herein lies the magnitude of the threat to the Chinese economy; it is commonly acknowledged at the epicentre of authority in China that "if the financing chain for the platforms is not broken, they [the investment platforms] will be able to dissolve potential credit risks in the course of current economic trends." Written in the Chinese Banking Regulator Commission report, the comment emphasises the dependence on rolling over old debt in new issues and also, the necessity for existing "development trends," namely the growth in valuation of Chinese assets, to continue robustly and independently from the global macro-economy. As Walter and Howie note in Red Capitalism, re-issuing new debt to pay the old has become endemic in the Chinese economy in the last 20 years, and seems to be the only idea the government has in handling this matter.

It is important to also examine exactly how these Chinese local government bonds differ from international counterparts. While very few US municipal bonds are short term, medium term notes and commercial paper were also issued in large quantities. These were unsecured loans that should only be backed by entities with high credit ratings; unlikely to be the case given the municipalities' unofficial deficits in the last 15 years. Furthermore, the fact that these bonds are not tradable on a secondary market, like bonds elsewhere, severely impacts upon their valuation. At present, we can surmise that the Ministry of Finance facilitates the bonds' sales close to prices on their own bonds to the banks. In other words, the banks are forced to buy these bonds, far above their true value, hold them to maturity on their balance sheet, by which time they would technically default but the debt is officially rolled over again. No other nation in the world could function in such a manner but China can, effectively since their bonds never encounter the scrutiny of foreign bondholders and are always issued in the local currency.

Comparing China to Brazil or even Eastern European economies , these nations either do not issue local government bonds due to perceived moral hazard over municipalities believing themselves to be insured by the national government or if issued, are done so in limited numbers and are kept in check by the market mechanism as buyers remain cautious. Hence, issuance would be detrimental to its international credit; something China clearly has no need to worry about. By keeping its capital markets acquiescent, offshore speculators and vulture funds have no way of challenging the Party's valuations. As with many policy initiatives, the Chinese state has learnt from history and understanding past international debt crises, to the extent that the strategy it implements has the veneer of an emerging quasi-Western based capital market, when in truth, it is seeking complete control over the economy.

Since it is not possible to question the central authority's valuations and the banks complaisantly fall into line when ordered, can municipal debt be considered dangerous? On a social level, 76% of issuance occurred in Shanghai, Beijing and Guangdong and their environs yet this imbalance can be seen as emblematic of other social issues such as governance of autonomous regions and striking manufacturing workers demanding higher wages. From a fundamentally economic standpoint, excessive debt is only troublesome if lenders believes it so. It is feasible to keep rolling over debt so long as it is possible to repay all obligations in the future by perhaps allowing inflation to run free and erode the value of the debt. The danger lies within the precipitous triangulation of interest rates, debt value and collateral values. In most countries, monetary policy is implemented to effect a balance between inflation and unemployment. In China, the trade-off is between inflation and default on loans. The Party's challenge is to keep interest rates high enough to combat inflation in food prices affecting the majority of the population , and low enough so that developers are still able to purchase property with loans. Property developers are betting that rates will be lowered and are refusing to sell off their stock. If rates rise, developers may default on obligations or sell off inventory, property prices would fall, collateral values in the bond agreements would likewise decline and China would be left with both municipalities and banks defaulting on their obligations. It is not the size on the municipalities debt which is most pressing; by estimates 23% of GDP in total , but the interconnectedness with the collateral valuations that could cause massive headaches for the central authority.

The poorly scrutinised arrival of local government bonds in 2009 has caused some serious concern for the Chinese state. Currently, the banks hold these bonds on their balance sheets, which are overvalued relative to their risk. A possible solution would be to inaugurate an internal secondary market whereby banks trade the bonds to find a fair value. Doing so would possibly mean large discounting, which is an undesired outcome. Beijing could effectuate a policy of tax-shields, which would provide additional value to bondholders. This secondary market would force greater fiscal discipline amongst the provinces as obviously it would be in the banks' best interests to invest in holding municipal bonds wisely, no longer impeded by national fiat.

A second approach would be for the central government to assume a portion of the debt and counter the moral hazard that occurred with the initial offerings with stricter collateral limitations perhaps working on a province by province basis to ensure equality for the less-endowed provinces. This policy-stance would be amenable to Beijing; centralised and in control of the possible outcomes. However, the most likely alternative is simply for the central government to do nothing, and especially, not float the Renminbi and allow a Yen-like appreciation to burst its asset bubble. Upon maturity, the provinces have the option of rolling them over for another five years; meaning the bonds effectively have eight rather than three years to maturity. This reflects upon recent history in which the Ministry of Finance will restructure the debt when the time comes and force forward any obligations. Once again, it is hard to see how this will eventually affect the Chinese macro-economy when all agreements remain internal.


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