The Financial Times‘ estimate that China’s banks rolled over three quarters of the 4 trillion yuan ($642 billion) of local government debt that fell due at the end of 2012 to avert defaults puts a hard number on a soft but growing fear that has been gnawing away at China’s policymakers for some years.
Some history bears retelling. Much of Beijing’s stimulus package in response to the 2008 global financial crisis flowed through local government spending on public works. Local government debt rose by 62% in 2009 over the previous year, as local authorities laded up with bank debt–and the banks, state owned, with potential bad debt. Bank borrowing increased by a further 19% in 2010. By the end of that year, China’s central government debt was a modest looking 17% of GDP. Its local government debt was the equivalent of 27% of GDP.
By February 2011, the China Banking Regulatory Commission (CBRC) was alarmed to discover that more than half of new bank lending wasn’t meeting its new credit rules designed to mitigate the build-up of potentially bad loans. The CBRC’s particular concern was direct and indirect lending to the three top tiers of local government, provincial, municipal and county-level local authorities.
The following month, the finance ministry alerted the National People’s Congress (NPC) that “local governments face debt risks that cannot be overlooked,” though the line was buried deep in a budget report. What concerned officials was the risks involved in the 7.7 trillion yuan of bank loans (as of June 30, 2010) made to local governments’ captive investment vehicles. These local officials were using to get round restrictions on direct borrowing. A finance ministry audit turned up more than 6,000 of them. The audit also found that there was no cash flow to repay 23% of their loans. The suspicion was that by the time the ministry made its report to the NPC the numbers had worsened significantly, intensifying a general concern in Beijing about the overall weakness of local-government governance.
By November 2011, officials were fearful that China’s local government debt had reached 13.7 trillion yen ($2.2 trillion; Italy’s outstanding sovereign debt at the time was $2.6 trillion) including a previously uncounted 3 trillion yuan borrowed by townships, the administrative tier of government below counties. Reforms to local government finance started to be put in place and a rolling 2 trillion-3 trillion yuan bailout deployed to shore up loans backing projects with neither collateral nor viable cash-flow to cover their debt service. Banks were also made to plump up their cushions of capital reserves.
These measures were sufficient to keep the situation manageable through last year. The risk of a local government debt default remained low–as long as economic growth remained brisk and state-owned banks could be made to absorb the worst bad debts. When growth slowed in the middle two quarters of 2012, the banks had to take more of the strain. How much more is delineated by the the Financial Times estimates, as is the challenge China’s local governments face in working down their massive debt loads.
There is one intended and one unintended consequence of all this. Banks have all but stopped extending new loans to local governments. Some authorities have turned to the nascent municipal bond market to raise new debt. But others have turned to the shadow banking system comprising unregulated non-bank financial institutions including trust companies. There have been a series of defaults and near-defaults around these in the past couple of months. None catastrophic. At least not yet. If China’s debt bomb seems to be ticking less loudly, that may just be because it has moved.