According to the most recent audit of China’s local government debt by the China Banking Regulatory Commission, municipal authorities owed lenders somewhere in the region of 9.7 trillion Yuan, or USD 1.6 trillion. The audit, the results of which were timed to coincide with the start of the Third Plenum highlights just how much of an issue local borrowing has become in China and just how seriously it is viewed by the central government.
Despite the woolly, vague and wooden language of the policy announcements which followed the plenum, it’s probably safe to say that tackling the nation’s hidden debt bomb was probably fairly high on the agenda. A point highlighted by the timing of the audit, the third such survey requested by Beijing in as many years. But the big question for many is just how did China’s local governments get themselves into such a mess, how can they get themselves out?
To understand this it’s important to understand the way in which this debt is structured. After local governments were forbidden from borrowing directly in 1994, there emerged a proliferation of local ‘holding companies’ – or local government financing vehicles (LGFV) – ostensibly owned by or on behalf of local governments. According to the most recent audit, these holding firms are responsible for 45 percent of the debt payment of local governments.
These holding companies were ostensibly responsible for undertaking local infrastructure investment. This investment was seen as essential by many local authorities for meeting growth targets – the primary yardstick political performance for government functionaries in China. This process then accelerated exponentially in the wake of the financial crisis as exporters saw foreign markets dry up.
The main problem for local governments is that in terms of generating economic growth, construction is really the only game in town. Or at least the only game that generates returns quick enough to reap the political benefits. The situation was made worse by a culture of corruption and blurred lines of ownership which disproportionately rewarded government officials that green-lighted infrastructure and construction projects. Land could be appropriated from rural owners at massively below the market price and sold on to holding firms for development financed by cheap loans from local banks. Land laws which prevent local peasants any meaningful property rights over the land they work exacerbated this problem and local officials were further incentivised to make risky investments safe in the knowledge that if they paid off in the short term, they would have moved on to greener pastures once the bills come due.
This over-investment in construction projects led the housing market to saturation point in some regions of China as ‘ghost towns’ like Ordos in Inner Mongolia testify to. As meaningful infrastructure projects became harder to find increasingly grandiose white elephant projects were financed to keep the economic growth train rumbling along.
One story in the China Daily which outraged Chinese netizens across online micro blogging platforms illustrates the lengths to which local governments will go – an USD 11m, 2,300 ton, 295 foot-long puffer-fish. The gaudy, almost surreal scene is billed as the world’s largest metal construction, at roughly the same length as the height Statue of Liberty. The 15 story viewing platform was erected by local officials from the town of Yangzhou to celebrate the opening of a local agricultural exposition but in many ways is symbolic of waste and folly that lurk behind some of China’s impressive economic statistics.
Recent attempts however to curtail profligate lending and temper China’s housing market restricted credit lines and demand for housing already in the pipeline, forcing the LGFV to turn to other sources of financing to keep their projects solvent in some cases and to continue serving debt repayments in others. To find the money, local governments turned to brokerage houses which securitized the debt as bods and resold it through high street banks to high street savers as wealth management vehicles – ostensibly risky, high interest savings accounts. This proliferation of debt through the banking the system is sometimes referred to as the shadow banking sector.
It is important to note here, however, this is not the first time China’s local governments have got themselves into hot water running up bills that can’t be paid. And the central government has already been forced to clean up the mess once, no doubt making them loath to pick up the pieces again. The last time was after the last borrowing frenzy in the 1990s, after which the government simply bought all the debt off the books of the ‘Big Four’ State banks and consolidated it in what were euphemistically called Asset Management Companies, where it has languished, essentially untouched for nearly 15 years.
In recent months there has been a lot of speculation as to just how Beijing intends to deal with this build up – particular as many now believe that interest payments are rapidly approaching unserviceable levels in many regions. One solution suggested by a Beijing think tank is to simply allow local government holding companies to default on their bond repayments. A fairly harsh medicine intended to puncture the confidence of investors and cut off funds to local governments. Such a radical approach is however very unlikely as it would hit middle class savers hardest – the one core demographic the government is terrified of upsetting.
In another attempt to resolve the web of debt, Beijing has rolled out a Municipal Bond trial program across two Provinces and recently extended it to a third. The program is intended to allow local governments to finance their debt directly by issuing bonds. Such a move would make local government debt more transparent but it’s unlikely it would go very far toward resolving the issue with additional borrowing disappearing into the money hole servicing existing debt.
In fact, groping for substance in the woolly language of the Third Plenum, it is possible that the government will first reform land laws making it more difficult for local governments to use poor property rights as an easy source of political and financial capital, effectively trying to stem the bleeding before mopping up the mess.