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IMF Sees Increases In China’s Growth And Debt

THE INTERNATIONAL MONETARY Fund (IMF) has upgraded both its economic growth forecast for China in 2018 and the downside risks of debt.

In its July update to its World Economic Outlook, the Fund says its projections reflect the strong first quarter growth this year and expectations of continued fiscal support.

It now says it expects growth next year to be 6.7%, the same as this year and in 2016, and 0.1 percentage point higher than previously forecast. Growth in 2018 is expected to slow by 0.2 percentage points less than previously projected, to 6.4%.

This the Fund believes will be because authorities will sustain high public investment to achieve the target of doubling in real terms 2010’s GDP by 2020. This, in turn, implies that debt levels will not be attacked as actively as needed and financial reforms delayed.

The National Financial Work Conference, the high level policymaking agency chaired by President Xi Jinping that concluded its quinquennial meeting on July 15, emphasized that policymakers’ priority was to deleverage state-owned enterprises (SOEs) within its focus on limiting systemic financial risk.

First, though, Xi has to get through the forthcoming Party plenum, which should provide clues to the strength of his position to tackle the politically powerful interests that control the SOEs.

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Stabilised Growth Lets China’s Focus Switch To Deleveraging

GOVERNMENT STIMULUS KEPT GDP expanding at 6.7% for the first three quarters, as close to bang in the middle of the official target range of 6.5%-7% as makes no difference. The economy has stabilised and looks to be back on its glide path of steady but slowing growth. However, the cost has been a deceleration of the ‘rebalancing’ of the economy towards consumption-driven growth and an acceleration in the accumulation of debt, particularly corporate debt, and particularly the debt of state-owned enterprises with excess capacity and real estate.

It was state government infrastructure spending, not private investment that kept growth going in the third quarter. An uptick in the property market helped, too, though caution is advised here given there was a 34% surge in sales but a 19.4% fall in new construction starts in September year-on-year as central and provincial governments introduced measures to cool off the property market).

Overall, state fixed-asset investment grew 21.1% in the first nine months whereas private investment was up 2.5%. However, the slowing growth in private investment seems to have bottomed out in the middle of the year while state investment growth similarly appears to have topped out in the first half.

That state investment spending has been on tick. The IMF’s Financial Stability Report released earlier this month highlighted the rising gap between credit growth and GDP growth. Total debt is about 250% of GDP, with corporate debt equivalent to more than 100% of GDP.

It is not so much the size of the debt-to-GDP ratio that is a concern; the United States has a similar ratio, for example, and the eurozone’s is a bit higher at 270%. It is the pace at which China’s is growing that alarms. At the end of 2007, the year before the stimulus to counteract the global financial crisis was launched, the figure was only 147%.

History suggests that any economy that has experienced such a rapid pace of debt growth will be confronted by either a financial crisis (e.g., the United States) or a prolonged growth slowdown (e.g., Japan). It is just a massive challenge for an economy to deploy such volumes of capital productively over a short time. Either the projects available offer diminishing investment returns and more and more loans to fund them go bad; there are only so many bridges to nowhere that can be built. Or credit starts to dry up.

The interconnectedness between the banks and the government due to the centrality of the state-owned sector in the economy makes a crisis unlikely. The government is effectively creditor and debtor. Also, domestic savings, not flighty foreign capital funds the debt. There is plenty of liquidity in the financial system, the People’s Bank of China will readily supply more if needed, and capital controls are in place to check capital outflows should they start to happen on a significant scale.

That is not to say the risk is totally absent. The proliferation of shadow banking products, particularly those offered by the country’s small banks, remains a significant vulnerability that could test the resilience of the country’s capital buffers.

Nonetheless, Beijing’s challenge in managing down debt levels is to avoid the second consequence, prolonged slow growth, and to do it with one hand tied behind its back having set itself in 2010, the target of doubling GDP and per capita income by 2020.

Of late, supporting short-term growth has been given priority over deleveraging to ward off long-term financial risk. Now, that growth looks to have stabilised (and slowing GDP growth to below 8% has not brought the apocalypse of social unrest predicted in the double-digit growth days), the priorities are changing.

The IMF has long expressed concern at China’s debt levels and the perils that persist in the shadow banking system. It recommends corporate deleveraging and opening up of the state-dominated service sectors to private firms, along with a stronger governance regime and hard budget constraints on state-owned enterprises within the broader context of moving to a more market-based financial system.

New guidelines from the State Council allowing creditors to exchange debt for an ownership stake in a debtor company are likely only a first step in that direction.

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China’s State-Owned Debt Problem

WHEN, AS IS expected later this year, the U.S. Federal Reserve starts to raise interest rates, it will put renewed strain on emerging economies’ debt management. Those most vulnerable are countries with high levels of dollar-denominated external debt and those with high public debt.

Where does that leave China? As so often, slightly oddly placed.

China’s external debt exposure is low. Foreign debt is estimated to be equivalent to less than 10% of GDP. That modest figure by international standards is because China funded its infrastructure building domestically and not by borrowing from abroad. Thus it has avoided one of the textbook potential triggers of an emerging market debt crisis. It helps that China has a financial system that is semi-detached from global capital markets.

On the other hand, China’s domestic borrowing is huge. Total debt, including debt of the financial sector, nearly quadrupled between 2007 and 2014, by the reckoning of the McKinsey Global Institute (MGI), rising from $7.4 trillion to $28.2 trillion, or from 158% of GDP to 282%. This increase was a consequence of the investment-driven stimulus Beijing launched to offset the 2008 global financial crisis and which was funded by bank credit, albeit domestic not external borrowing.

That new debt was largely taken on by non-financial corporations. MGI calculates that that set’s debt accounts for 125% of GDP. Rating agency Standard & Poor’s estimates that China surpassed the United States as the largest corporate debt borrower in 2013.

China’s non-financial corporations are a broad church, however. Their debt is concentrated within state-owned enterprises, not anymore in private companies with the one significant exception of firms in the property sector. MGI estimates that approaching half of non-financial corporate debt connects in some way to real estate development, with 60 firms accounting for two-thirds of it.

An IMF Working Paper on corporate indebtedness in China published by Mali Chivakul and W. Raphael Lam in March puts it thus, “while leverage on average is not high, there is a fat tail of highly leveraged firms accounting for a significant share of total corporate debt, mainly concentrated in the real estate and construction sector and state-owned enterprises in general.”

Chivakul and Lam go on to argue that development and construction firms could withstand a modest interest rate shock, but other corporations in the wider economy would feel the knock-on effect of a slowdown in the property sector. “The share of debt that would be in financial distress would rise to about a quarter of total listed-firm debt in the event of a 20% decline in real estate and construction profits,” they say.

A separate report from economists at the Hong Kong Monetary Authority comes up with a similar analysis — that China’s debt problem is largely an SEO debt problem — and points the finger at  ‘policy driven lending’. “SOEs’ leveraging has been mainly driven by implicit government support amid lower funding costs than private enterprises,” they say.

There is now less such politically driven new lending than before. That partly reflects the passing of the post-2008 stimulus but also a recognition that private firms create the new jobs that are critical to social stability. It also reflects the shuttering, particularly since 2012, of small, inefficient and heavily polluting and indebted SOEs in industries such as steel, cement and mining.

A further round of such ‘SOE reform’ seems likely. And to this Bystander, the corruption investigations into SOEs seems in part an attempt to accelerate those reforms, given that  SEOs are seen as acting as a drag on the wider push for reform and economic rebalancing.

From SOEs it is but a short step to China’s other deep pool of domestic-debt concern — local government borrowing. Outstanding debt has reportedly reached 16 trillion yuan ($2.6 trillion), up 47% from June 2013. Overall, government debt is equivalent to 55% of GDP, again not a concerning high level by international standards. But it is concentrated in pockets, closely tied to real estate, and a further drag on an already slowing economy.

Beijing has both the political will and the financial wherewithal to underwrite local government defaults and forestall any threat of financial systemic risk. However, policy makers will use the mere hint of it to push local government finance reform and deepening municipal bond markets.

Local governments have relied on land sales for revenue, and also seek to turn a yuan from commercial activities conducted through captive off-balance-sheet special financing vehicles, which have borrowed heavily from both mainstream and shadow banks. So the threat of contaigion is real. Rising interest rates will only make it more so, and aid the cause of local government finance reform.

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Beijing Calls A Halt To Direct Local Bond Issuance

China has called a halt to an experiment launched last October that let local authorities issue bonds directly. The provision permitting it was dropped from the draft budget law for its second reading earlier this week. State media quote Hong Hu, deputy director of the National People’s Congress’s law committee saying, “Considering the rapidly growing scale of local debt, attention must be paid to the accompanying problems and potential risks.”

Local authorities’ debt was 10.7 trillion yuan ($1.7 trillion), approaching 30% of GDP, as of the end of 2010, according to a June 2011 official audit, the first time the numbers were made pubic. While China’s local government debt bomb has concerned central government for some time, the roll-back follows a review of local government’s captive commercial investment companies. These take local government obligations off-balance sheet, and mostly put them in a murky world of local property development. These investment vehicles have raised 330 billion by issuing corporate bonds so far this year, compared to total new issuance of 300 billion yuan in the whole of last year.

With 28% of the local-government debt issued as part of the stimulus introduced in the wake of the 2008 global financial crisis falling due this year and next, Beijing is increasingly aware of the risks of bond defaults, particularly at a time when it is seeking to expand its capital markets, including the muni-bond market, as part of broader financial reform. The World Bank has warned of systemic risk.

The finance ministry will continue to issue bonds on local authorities behalf. That issuance will reportedly increase fivefold to 250 billion yuan this year. The draft budget law includes a loophole that would let local authorities issue bonds with specific permission from the ministry, an indication that direct issuance will be reconsidered once the clear and present danger has passed.

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Debt Takes Its Toll

Vehicles wait at the Langdong Tollgate on the Guilin-Beihai Highway in Nanning, capital of the Guangxi Zhuang autonomous region, October 2011

Yet another rumble of local-government debt trouble. After a three-year highway building boom across China, outstanding debt for toll-road construction is 2.2 trillion yuan ($346 billion), according to numbers compiled by Caixin. That is much higher than the 1.3 trillion yuan outstanding at the end of last year counted by an official audit published earlier this year covering 16 of China’s 29 provinces. Banks have provided 90% of the lending. Toll roads in Guangdong account for 10% of the total, at 227 billion yuan, with another eight provinces collectively accounting for a third more, the Caixin report says.

The danger lies in tolls barely raising sufficient revenue to service the debt. China’s toll roads account for 95% of the country’s 74,000 kilometres of highways, such as the Guilin-Beihai Highway shown in the Xinhua picture above. Yet the audit found that they generated only 170 billion yuan in revenue last year, with just four provinces and municipalities a profit at the tollgates. Guangdong, Caixin says, collected 789 million yuan in road tolls last year and had to use all but 19 million of that on debt repayment. Other provinces are having to take out new loans to pay off old ones.

The audit found that more than half of new highway loans were being used to that end. That is getting more difficult for provinces to do as Beijing tightens the liquidity spigot, leaving some highways uncompleted as construction comes to the same dead stop as their funding. Meanwhile, other political constraints don’t give provinces much if any scope to raise tolls.

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China’s Local Government Debt Is Large But Manageable–For Now

The audit of China’s local government debt paints a reasonably reassuring picture. The question is how complete that picture is.

The National Audit Office put the debt at 10.7 trillion yuan ($1.7 trillion) at the end of 2010. That is 27% of GDP, far lower than the worst expectations (this is the first time the numbers have been made public). It is also much higher than the central government’s debt of 17% of GDP. Add in all the usual liabilities that goes into a country’s public debt number and China is looking at an overall number  of 80-90% of GDP, not particularly high by international standards but in such a state-centric economy, it will all come back to central government one way or another.

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). The borrowing increased by a further 19% in 2010.

It also encouraged the widespread use of special investment vehicles to get round restrictions on borrowing. The audit says that there were 6,576 such vehicles, with a combined debt of $5 trillion. Yet this shadow financing system is only partially accounted for by the audit. Only loans explicitly guaranteed by local governments has been included.  Beijing is already reported to be planning to shore up local government finances with a 2 trillion-3 trillion bailout to cover the 23% of the lending to projects with neither collateral nor viable cash-flow to cover their debt service (this bailout could include some securitization of loans for resale to private investors or through the bond market). In addition, the central bank has told banks to increase their capital reserves against similar projects that are only generating sufficient cash flow to service part of their debt.

The situation seems manageable for now, though central policy makers’ concern remains acute as they work on defusing the debt bomb. Most local-government debt has long maturities and fiscal and land revenues have been strong, even if land sale revenues are now softening. The risk of a local government debt default remains low–as long as economic growth remains brisk and the state-owned banks can be made to absorb some of the worst bad debts. The tick-tock of the debt bomb may be getting a bit less audible but it is still there.

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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.

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