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

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Yao Yang Teo's picture

Introduction

To cushion the global economic crisis in 2007, China came up with a credit-fueled stimulus package that resulted in municipal debt levels tripling since 2008 (Li, 2011). This poses both credit risks for the banks as well as fiscal risks for the governments. In my essay, I will argue that the risks are insignificant in the short run due to China’s tightening measures and presence of favorable economic dynamics. In the long run, however, I am convinced that the deeper implications of rising debt levels will resurface again, especially if we see a slowdown in China’s economic growth.

There are 2 key reasons why I believe that local debt will not pose a serious threat in the near term.

Ongoing implementation of policies to tackle problem

In 2011, the government has given the go-ahead for Shanghai, Shenzhen, Guangdong and Zhejiang to issue bonds for the first time in 17 years. Part of the reason why municipal debt spiraled out of control is due to the lack of channels for local governments to raise funds. Therefore, these governments set up investment vehicles in order to obtain loans from banks. These investment vehicles do not come under direct supervision of any central government agencies. To make matters worse, local governments believe that the central government will bail them out should they experience default risk. The implicit guarantees by the central government, coupled with the lack of transparency, partly caused local governments to undertake excessive loans.

With the new regulations, local governments can now issue bonds to help solve their own debt needs in the short term. Aside from increased transparency, this would also allow local governments to roll over their debts in a more sustainable manner by extending their repayment period. According to National Audit Office data, over 50 percent of the local government financing vehicle debt will mature in 1.5 years. Most of these loans were investment in infrastructural projects that take a long time before they can generate sufficient cash flows to service the debt. Therefore, the longer maturities of bonds would therefore help mitigate the problem of mismatch in debt structure.

In 2011, the central government has also stipulated that financing for government projects will be required to be secured against the future revenue stream of the project. Essentially, this has  imposed the much needed level of stringency when it comes to financing government projects. However, certain issues remain unresolved.

The deeper problem: Unsustainable method of evaluating projects

Even though future projects will be required to be secured against projected revenue streams, I still believe that it is unsustainable in the long run. Given China’s artificially low interest rates (Cong, 2012), the hurdle rate for local government projects is inevitably lenient. Moreover, there are cases of local governments inflating projected revenue streams by including revenue from unrelated sources such as land sales. With such artificially low hurdle rates, most projects are approved as viable projects, even though the underlying investment still does not make economic sense.

In the long term, this unsustainable method of evaluating projects will only lead to further waste and economic inefficiency, evidenced by the ghost towns, empty roads and superfluous rail lines in China (Pierson, 2011)

Favorable economic conditions

China is in an enviable position. Even though China is currently raising interest rates to combat inflationary pressures, the country still enjoys favorable debt conditions. As China’s nominal interest rate is below its nominal GDP growth rate, public debt will be sustainable as long as economic growth continues.

Also, China has massive assets such as land and stakes in various large state-owned enterprises. Should China find the debt problems insurmountable, these assets can be sold to raise funds for debt servicing. Lastly, China’s huge current account surplus also cushions the country’s domestic economy from external-driven crisis. Unlike other countries such as Argentina who had difficulties in dealing with debts, I believe that China’s predicament is less problematic.

China: A repeat of Argentina debt crisis?

The Argentina debt crisis is a good example for comparison. The causes of the Argentina debt crisis are: an overvalued fixed exchange rate and massive levels of foreign debt. Due to the overvalued fixed exchange rate, Argentina exports were too uncompetitive while imports soared. The massive trade deficit made it impossible for Argentina to service its foreign debt. The foreign debt reached 50% of its Gross Domestic Product (GDP) and was owed mainly by the local governments.

Unlike Argentina, China has an undervalued exchange rate. With massive trade surpluses, China’s net creditor status puts the country in a relatively comfortable position to service its debts. The local government debt is also largely held by residents. Due to this low dependence on foreign financing, China’s financial vulnerability and exposure to external risks are largely limited.

In a recent report by Fitch, a stress test was conducted by aggregating the debt of all the entities in China and assuming that real GDP growth is set to decline from 10% to 6%, real interest rates will rise by 200 basis points and fiscal balance will decline by 1% of GDP. Even under these conditions, the results concluded that China would not run into default risks simply because of its massive reserves.

Therefore I am convinced that China’s debt problems are not in the same magnitude and seriousness as Argentina’s because of favorable economic conditions. However, I still believe that there exist inherent weaknesses within China’s constitutional arrangements that could undermine its economic performance in the long run.

Poor constitutional arrangements

China follows a highly decentralized method of developing its cities. Municipal governments are given the autonomy to plan for its own infrastructural developments. At the same time, the extent of infrastructure development is often used as an indicator for the central government to judge the success of local leadership. To make matters worse, local governments need not be concerned about the macroeconomic policies such as economic overheating or inflation at the national level.

This creates an undesirable environment where the linkage between infrastructural investments and rewards is very strong. Therefore, local governments have the tendency to be overly aggressive in its infrastructural investments, even if these projects do not make economic sense.

What should China do?

In my opinion, the most urgent issue is for the local governments to minimize their debt exposure or stretch out the repayment periods of their loans. Allowing local governments to issue debt is a good start, but I believe it should be complemented with increased sales of assets by local governments.

An effective solution needs to address the political issues as well. I believe that there is a need to implement polices to improve the way local governments use their funds. Firstly, local governments should be evaluated in a holistic fashion, taking into account not just only infrastructural improvements, but also their debt funds expenditure efficiency. This will encourage local governments to be more prudent in the way they use funds.

Secondly, there should be proper supervision and monitoring of local government debt levels by a central government agency. Currently, there is a lack of transparency over debt disclosure by local governments, leading to unreliable national statistics because there is no central government agency that requires local government investment vehicles to report on their financial status.

Conclusion

Although I believe that local government debt poses minimal threat to China’s economic well-being in the near term, it is in my conviction that the current problems are merely symptoms of the actual issues – namely unsustainable method of evaluating projects and poor constitutional arrangements. If these issues remain unresolved in the long-term, China would be placed in a dangerous situation especially if economic growth starts to slow down.

References: 

1. The World Bank, (2012). GDP Growth [Data File]. Retrieved from http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG

2. National Audit Office of China. (2011). No.35 of 2011 (General Serial No. 104) Audit Findings onChina’s Local Governmental Debts. Retrieved from http://www.cnao.gov.cn/UploadFile/NewFile/2011121620816635.pdf

3. Chan, V. (2011). Opinion: China’s debt time bomb. Asiamoney; Jun2011, Vol. 22 Issue 5, p91-91, 1p

4. China Banking Regulatory Commission. (2012). Commercial Banks Main Supervisory Indicators Table [Data File]. Retrieved from http://www.cbrc.gov.cn/chinese/home/docView/20110513802A974AF04EC97BFFEC...

5. China Banking Regulatory Commission. (2012). Banking Financial Institutions Assets and Liabilities Table [Data File]. Retrieved from http://www.cbrc.gov.cn/chinese/home/docView/201105132105E7CD74D71508FFA6...

6. Trading Economics. (2012). China Government Debt to GDP. Retrieved from http://www.tradingeconomics.com/china/government-debt-to-gdp