No one knows exactly how much China’s provinces, cities, towns and villages have borrowed – but most experts agree it’s far too much. The World Bank issued a report this month saying that the utter opacity of local finances in China “has led to debt levels higher than would otherwise be acceptable to lenders, investors and policymakers.” An International Monetary Fund official was more succinct, calling the country’s municipal debt burden “way too high.” Fitch Ratings cited the borrowing when it downgraded China’s domestic debt rating in April. And Credit Suisse’s China economists warned last month that they are “deeply concerned about the risk of large-scale default” among local governments, especially with a raft of debt payments coming due late next year and in 2015.
Because Chinese banks have financed much of this local debt through short-term loans, concerns about local government solvency are also raising questions about the integrity of the Chinese financial system—including, apparently, in Beijing. In a note last month entitled, “Fiscal Reform Could Be a Major Focus,” Credit Suisse’s Head of China Research Vincent Chan said the Chinese government will likely announce at an important Communist Party gathering next month a number of reforms intended to curb local spending. Chief among them: new permission for local governments to issue municipal bonds. While on the surface, that may sound like a way to encourage more borrowing, not less, the real intent of such a move would be to keep provinces and municipalities on a tighter leash by making their financial obligations more transparent.
A comprehensive audit of local government debt, which Chinese officials ordered in July, should soon reveal just how much China’s provinces and towns are in hock. Credit Suisse estimates the figure could exceed 17 trillion yuan ($2.8 trillion) – more than one-third the size of the Chinese economy. If that estimate is correct, it would mark a nearly 60 percent increase since 2010, when China’s National Audit Office estimated the total at 10.7 trillion yuan ($1.7 trillion). That, in turn, was nearly double the 5.6 trillion yuan ($920 billion) debt load of 2008, right before the central government unleashed a massive stimulus program in 2009 to stave off the global financial crisis.
Local debt is not just a local problem. China’s overall credit-to-GDP ratio has soared to more than 180 percent from just 120 percent in 2009, with much of that new borrowing being done by special financing vehicles created to fund local government projects. The making of those loans, Chan said, became a “key business” for Chinese banks. Making matters worse, as Credit Suisse China economists Dong Tao and Weishen Deng pointed out in a late September report entitled, “China: Waiting for Reform Signals,” “many of (the local government) investment projects are commercially unviable, funded-by short-term debt, through trust funds, corporate bonds and wealth management products.” Investors have shown their concern by marking down the stocks of Chinese banks, the price-to-book values of which have fallen dramatically since 2007. “The sharp rise in the credit-to-GDP ratio [is] a key reason behind the de-rating of the China market, particularly the Chinese financials, in recent years,“ Chan wrote.
China certainly isn’t the only country where local governments have bitten off more than they can chew. Consider the United States. A study by the St. Louis Fed last year examined the liabilities of eight U.S. states, combining state and local debt with unfunded pension and health care obligations owed to retired public employees. The most frugal state in that study—Tennessee—showed a debt load of about 17 percent of its economy, whereas the most spendthrift, Kentucky, topped 41 percent. Puerto Rico, a U.S. territory whose municipal bonds are widely held, has seen its debt downgraded to just above junk status, and earlier this year, Detroit became the first major U.S. city to declare bankruptcy.
U.S. residents can take some comfort in a better, albeit still not entirely transparent, understanding of what their governments owe, and to whom. One reason the same information is difficult to get in China is that Chinese provinces and towns aren’t supposed to borrow money at all. Chan pointed out that local entities account for about 85 percent of total government spending, even though the central government allocates them just 52 percent of the country’s total revenues. Since they can’t issue bonds, local officials have set up thousands of so-called local government financing vehicles (LGFVs) to borrow on their behalf. These entities use the money made from selling land-use rights to developers as collateral for loans from banks or lightly regulated trusts. Such a system can work just fine in a booming economy, but it gets worrisome in a slowing one.
In the end, the argument for creating a municipal bond system to bring local borrowing under control is a little bit like the one for legalizing drugs: Allowing a previously forbidden activity to take place out in the open, while strictly regulating it, should keep it under better control than letting it proceed in the shadows. Both local legislatures and the central government’s Ministry of Finance will likely have to approve future bond issues, Chan said, with only provinces and perhaps the 15 largest cities allowed to borrow. And when they do so, they’ll likely have to reveal much more detailed financial information than has been required of them to date. Chan also believes the Chinese central government might try to shore up local finances by taking over some of the health care, education and social security spending for which local governments are currently responsible. But what of the rest of the country’s nearly innumerable municipal locales, including even small villages that already have loans on their books? With no clear path to borrowing money in the future, they will surely have to cut down on infrastructure spending. That, Chan pointed out, “would not be very good news for the commodities and capital goods sectors” that are fueled by such local development projects.
The reforms Chinese leaders could introduce next month would go a long way to reassuring investors about the health of the financial system. That’s not to say they won’t hurt in the short-term, as loan growth would undoubtedly slow at Chinese banks if LGFVs disappeared. But in the end, Chan argued, investors will likely be happy to forsake a little growth in exchange for a less leveraged future. “Banks are likely to be turned into slower-growth institutions after this reform,” but would also probably have safer balance sheets, Chan wrote. “If local government borrowing can be more adequately controlled, and China’s credit-to-GDP ratio becomes more stable, it would help to improve the market perception of the risk of China’s financial system.”