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

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Cheuk Hin Anthony Yu's picture

Local municipal government debt is becoming a serious problem to the Chinese state. The debt rose to 10.7 trillion RMB in December 20101, with a public debt-to-GDP ratio of 27%2. This ratio has been increasing rapidly, as in June 2010 it was only 20%3. It is estimated that the debt now reaches about 40% of GDP4. This high ratio, together with its foreseeable increase in the future, will absolutely threaten fiscal sustainability5, and hence harm the stability of China financial market. In this essay, we will look into the reasons of this increase, its predicted results and possible measures to avoid the threat.

To begin with, we should look into the reasons why local governments have to raise debts. China state government implements an infamous policy, the so-called Eight Percent Protection Policy, which is aimed at keeping GDP growth rate over 8%. Originally local governments already have enough funding from central government and taxation so they can sustain an 8% economic development. However, this situation changed in 2008, when the Global Financial Crisis caused economic recession all over the world. Among the components of GDP, net exports had the largest growth rate, and China relied on increase in net exports to keep its economic growth rate high6. The recession resulted in a decrease in demand for exports from China, lowering China’s net exports7. To maintain the growth rate of GDP, China turned to another GDP component – consumption. To stimulate local consumption, local governments invested in infrastructure, e.g. railway and highways8. This policy was also implemented in the US after the crisis, through the American Recovery and Reinvestment Act of 20099. However, there was an obstacle in front of this policy: developing infrastructure requires huge funding from municipal governments to support massive construction projects, as in the case of the US in 2009, when US$105.3 billion was invested10. Local governments certainly did not have enough money so they issued debts to raise money. This resulted in the large increase in debt-to-GDP ratio as mentioned above.

However, as investments in infrastructure are long-term and do not immediately turn into government income, local governments had to find other financial resources that generate cash flow to pay off interests and installments of debts. Since it was not possible to raise taxes again due to high tax rate, the government decided to sell land to property developers, who could make good use of the land to develop housing and shopping centers. The resulting urban development improves citizens' living standard and raises local consumption, while selling land generated lots of cash for local governments. It even accounted for almost 50% of local government revenue11. However, as housing prices rose, ordinary citizens found themselves almost impossible to buy a flat12. To solve this problem, the state government implemented policies to suppress speculation in housing prices and reduce the growth of debts, including a series of increase in required reserve ratio and restrictions on buying and selling of real properties.

These measures were effective in stopping the growth in housing prices. To prevent losses, property developers stopped building houses and buying land, in view of a future ease in these regulations. Through simple supply-and-demand economics, we can easily figure out a drop in land prices. Earnings from selling land immediately deteriorated, leaving municipal governments with maturing debts but not enough income. As local governments no longer had any method to increase their income, they will soon be unable to pay off their debts as the debts come due. This means that municipal government debts, although shown as A-grade risk-free debts, have a high chance of default. What makes the problem worse is that frauds have been found in these debts, including invalid investments (the sum of money probably fell into the hands of government officials) and investments in industries with excess supply13. These frauds further reduce government income and worsen the economic situation of local governments. As a result, the chance of default becomes very high. The policy of reducing housing speculation seems to continue and it is predictable that housing prices will continue to decline.

When this happens, municipal governments will have no choice, but to default their debts. The financial situation of Chinese banks will deteriorate and the state government will be forced to rescue these banks, just like the situation in USA during the Subprime Mortgage Crisis14, otherwise some Chinese banks will eventually go bankrupt, leaving consequences similar to that during the bankruptcy of Lehman Brothers. After saving these banks, the state government will have its financial situation seriously worsened, and will suffer from huge fiscal deficit. It may implement quantitative easing, the policy also used by the US, UK and Eurozone during the financial crisis of 2007-2010, by printing money15. Inflation in China will increase. Ordinary citizens will suffer from increasing necessity prices, while the whole economy will suffer from lowering export demand since the relative competitiveness of Chinese goods will decrease. This will definitely be a bad news to China.

To avoid such a tragedy, one possible measure is to buy out all municipal government debts from commercial banks. However, this requires a huge amount of money in trillions, an amount that may use up a considerable percentage of foreign-exchange reserve. Therefore, the state government cannot simply buy out all debts as it is too costly. An alternative method is to ease the restrictions on housing speculation. This can be done by lifting restrictions on buying and selling of flats and lowering the required reserve ratio, so that more mortgages can be issued for buying flats.

The situation of the housing industry will improve and property developers, being happy to see this situation, will resume building houses and buying land. There will be a rise in government income from selling land and municipal governments can accumulate enough cash to repay debts, with the cost borne by ordinary citizens, who suffer due to high property prices. The third method is to defer the maturity of the debts, i.e. to undergo some kind of debt restructuring. This allows more time for municipal governments to accumulate enough cash to pay off debts and helps prevent default. This is a policy that is impossible to be implemented in Western countries, since commercial banks are held by private individuals, and this policy requires bank consent. But everyone can infer from the request that the government has difficulty in repaying the bonds, i.e. risk of holding the bonds is high. To protect shareholders’ interest, banks will obviously choose the option with lower risk – turn down the government’s request.

This situation does not appear in China because many commercial banks are held by the state, thus it is probable that banks will accept the government request and defers the maturity of the debts. This is the major difference between China and Greece in European sovereign debt crisis. Therefore, it is probable that China will not face the bitter choice of large budget cut or defaulting, as in the situation of Greece. However, we should still note that this measure is just a short-term solution and the risk of default may come again after a few years, when the debts come due again.

As a denouement to the problem, the state government gave an order to Chinese banks on February 13 to roll over the debts for as long as 4 years16, and announced a decrease in required reserve ratio on February 1817, avoiding the upcoming threats.

However, besides resolving the immediate problem, the state government should also draw up policies that encourage prudent borrowing by government bodies, i.e. reduce unnecessary borrowing to improve financial situation of the government. In the situation of China, the first step is to reduce frauds caused by corruption. For example, sums of money have been classified as debts to be paid off, but these sums are actually drawn away by government officials. This will, in the long term, reduce extra losses incurred by the government and improve government financial situation.

Also, China need not to adhere to Eight Percent Protection Policy, as it cannot be sustainable forever. This policy is now causing various problems, including the sovereign debt problem in question now. Instead, the government should intend to make ends meet, i.e. to have enough money to cover expenses by maintaining a balanced budget. If the government succeeds, its financial situation will gradually improve. Hong Kong acts as a role model in this aspect, as implementing this policy eventually resulted in budget surplus so the government even had extra money to improve welfare.

References: 

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