Bailing Out China’s Indebted Local Governments

This falls into the important if true category: Reuters reports that China’s regulators plan to move 2 trillion-3 trillion yuan ($308 million-462 million) of debt off local government’s books. This Bystander has highlighted before the potential debt bomb waiting to explode in local government finances. The finance ministry said with measured understatement in its report to the National People’s Congress in March that “local governments face debt risks that cannot be overlooked” and gave fair warning that it was going to get local government finances under control.

Following a nationwide flash audit of provincial and municipal governments’ borrowings, both direct and indirect, that has reportedly determined that local governments have borrowed around 10 trillion yuan with around 2 trillion yuan worth of that at risk of default, Beijing is now sending in its financial UXB squads. Some of the debt will be written off directly, Reuters says, while the big state owned banks will be required to eat some of the rest, and still more of it will be put into undefined investment vehicles that sound like a “bad debt bank” that will take in private investment.

The most significant change that Reuters says is in the offing is one that has been long trailed, developing the nascent muni-bond market. The idea is that provincial and local governments will bolster their finances with more a more transparent source of funding, bonds, in place of the off-balance sheet captive investment vehicles, also known as financial platform corporations, that they have resorted to to get round existing restrictions on official borrowings. As of last June, these captive investment vehicles accounted for 7.7 trillion yuan of local government borrowings (more than three-quarters of the total, note), and had become some of the most dangerous parts of local government finances in the eyes of the finance ministry. We assume the flash audit only confirmed ministry fears that the situation has deteriorated since. (Update: the central bank says there at 10,000 captive investment vehicles, up 25% from the end of 2008.)

What makes that so potentially destabilizing for the economy is that so much of China’s development spending goes through local rather than central government. Last year, for every yuan that central government spent directly, local governments spent four and a half (though 44% of local government’s revenue comes from Beijing in the form of tax rebates and transfer payments). This is a huge tail wagging the dog.

Changing this situation is likely to face institutional resistance from China’s sprawling bureaucracy. As well as expanding the embryonic muni-bond market, it will require a move away from rewarding local officials for promoting economic growth above all and from local government’s dependence on land-sales for revenue. Greater transparency will also make the dipping of local hands into the honeypot of public money more difficult — another potential source of resistance.

But it will be fought. Beijing has little choice. A exploding local government debt bomb and a bursting of the property market bubble, (the two are so closely linked that the one would likely trigger the other) are the banking system’s greatest vulnerabilities. With the leadership transition already under way, the last thing that the new leadership will want to start with is a full-blown domestic banking crisis, especially as the outgoing leadership prides itself on how well China survived the 2008 global financial crisis, even though China’s banks are among the world’s least efficient when it comes to assessing risk and allocating capital.