Debt Bondage

THE NATIONAL DEVELOPMENT and Reform Commission, China’s top economic planning agency, has chipped in its two-fen-worth on the country’s local-government debt problem, saying that debt levels overall are under control but it will curb the “disorderly expansion” of further debt.

All much as would be expected. But what caught this Bystander’s eye was the NDRC’s suggestion that some of the local government captive commercial investment vehicles used to get round restrictions on direct borrowing by provincial and municipal governments would be allowed to issue bonds to replace high-short-term debt carrying high interest rates.

That is perfectly sensible financial management but it also marks a radical advance in what has been cautious steps in broadening bond issuance. It may suggest the strains on the financial system, and particularly the shadow banking system, which would be the most likely source of high-interest debt, are more acute than is being publicly acknowledged.

China’s Local Government Debt Bomb Still Ticking

IF THERE IS a sliver of comfort in the National Audit Office’s tally of the debt being carried by China’s local governments it is that it is not as dire as feared. The state auditor says local governments’ outstanding debt at the end of June 2013 was 17.9 trillion yuan ($2.95 trillion), including contingent liabilities and debt guarantees. Some private estimates had put the number as high as 25 trillion yuan.

However, the published figure — assuming it is as comprehensive as billed, not necessarily a safe assumption — is still two-thirds higher than at end-2010, its previous count and the first time the numbers were made public. Factoring in central government debt, the country’s debt-to-GDP ratio is 58%, according to the audit office. That is not high by international standards, but the worry is that three-fifths of it is local-government debt, much of which was taken on by provincial and municipal governments to fund infrastructure projects, frequently through captive commercial investment companies used to get around the rudimentary system Beijing has for allocating tax revenues to provinces and cities for spending.

The fear is that these investment get-arounds won’t generate sufficient returns to pay operating and interest costs or to repay the loans taken on. The U.S. rating agency Moody’s said earlier this year that 53% of all municipal construction companies needed to restructure their loans. That indicates a potential rise in non-performing bank loans, especially at smaller (and weaker) regional and local banks, or the risk of local governments left holding the can — which in a country as state-centric as China would mean the can ultimately ending up in Beijing. As a dead-pan finance ministry reported to the National People’s Congress after the 2010 audit, “local governments face debt risks that cannot be overlooked.”

Central government has been containing new borrowing, using administrative guidance to banks to impose tighter lending standards and starting to expand municipal bond issuance as an alternative to land sales as a source of local government revenue. At the same time it has been eating or getting the banks to eat the worst of the loans that have gone sour to avoid any embarrassing collapses. This latest report heralds more of the same and a further urgent push on fiscal reform.

A Push To Push Ahead With Developing China’s Muni-Bond Market

One of the ways to defuse China’s ticking local-government debt bomb would be to expand the muni-bond market. A pilot program that lets a limited number of local governments to issue directly a tiny slither of debt has been running since 2011. The Development Research Center, a State Council-related think tank, proposes expanding it beyond the two provinces and two municipalities that may issue up to 350 billion yuan ($60 billion) of bonds between them over three years. The timing of the Center’s recommendation suggests the issue is likely to be taken up at next month’s Party plenum at which economic reform will be prominent on the agenda.

“Open the front door, close the back door,” the Center says, in a reference to the way local governments got round the 1993 curtailment on their bond issuance by developing off-balance sheet special financing vehicles. The ban, imposed because borrowing had got out of hand, was only lifted in 2009. The finance ministry issued bonds on local governments’ behalf. Opening the front door to direct issuance by Guangdong, Zhejiang, Shanghai and Shenzhen followed two years later.

The purpose of expanding the muni-bond market now would be to bring greater transparency and market discipline to local government borrowing, and some order to local government financing that is mostly dependent on land sales, especially since the 2008 stimulus. So opaque is the process  that central government has had to order a series of  audits. The last one showed local governments holding 10.7 trillion yuan in debt as of the end of 2010. That was widely regarded as a light count. Some unofficial estimates now run to 25 trillion yuan. That would be equivalent to more than two-fifths of GDP. The latest audit is due to be completed in time for the plenum.

Such a level is of concern to policymakers on three scores. First, much of that debt funded unviable infrastructure projects unable to service the loans, let alone repay them. Second, much of the funding was mismatched; local governments were borrowing short-term to fund long-tern projects. Third, the big state owned banks will be left carrying the can if or when that debt defaults or can no longer be rolled over. The U.S. credit-rating agency Standard & Poor’s has estimated that as much as a third of local governments’ borrowing from the banks has turned sour.

Funding more of local government finance through capital markets would spread the risk among multiple investors. It is also assumed, they they would be more hard-nosed in the first place about deciding which borrowers and projects to back than bankers who often have a close relationship with local government officials.

While the central bank has been a proponent of an expanded muni-bond market for some years, the idea has been getting wider support in government circles because of the need to fund the continued rapid urbanization of the country. That is a high policy priority for President Xi Jinping, who sees at as critical to rebalancing the economy. But it also comes with a large price tag — an estimated 40 trillion yuan over ten years. Finance minister Lou Jiwei recently said that a muni-bond market should be the basis of local government financing, but that the transition should be “gradual”.

One reason for a cautious pace despite the urgent need is the fear among some policymakers that local officials may go on an issuance binge, taking advantage of their connections to local banks, which are the main investors in bonds, to get new issues taken up regardless. Another is that the secondary market for muni-debt remains underdeveloped, both the interbank market and that on the Shanghai and Shenzhen exchanges. The primary and secondary markets need grow in lockstep if either is to be successful. Developing the secondary market, however, quickly gets tied up with broader financial markets reform, particularly interest rate liberalization and the thorny question of to what extent the market would be opened up to foreigners both as underwriters and investors. That all suggests progress will be measured.

Then there is the question — never far away in China — of which agency would oversee an expanded bond market — and the plumbing that it would need such as credit rating, disclosure and underwriting standards, and bond holders legal rights. Three agencies now have jurisdiction over various aspects bond market, the People’s Bank of China, the National Development and Reform Commission, and the China Securities Regulatory Commission. The later, particularly under its politically adept former head Guo Shuqing, a long-time proponent of an expanded bond market for corporates as well as munis, has being most active in consolidating its power — it would say unifying supervision — over the bonds markets.

The politically most challenging aspect, however, will be to let even on muni-bond issue default so investors realize that the government won’t always bailout troubled issuers, and that there is a risk to be priced in. That was traumatic enough last year with the first corporate bond default. How much more so would it be to let a municipality or province default on its debt. That may be the biggest brake on progress of them all.

Guangdong Debt, Cooked Books and Pyramid Schemes

In the first five months of this year, the GDP of China’s southern Guangdong province grew by 12.9%, official data shows, while its industry’s electricity consumption fell by 0.1%. Either Guangdong businesses have made a remarkable breakthrough in energy efficiency, or somebody is cooking the books.

Provincial lawmakers think it is the latter. With unusual openness they have challenged the accuracy of the provincial government’s GDP numbers. At the same time they have questioned the province’s reliance on land sales for revenue to service its debt, causing it to borrow evermore to pay the interest on old debt, and tying itself to the cyclical fortunes of the real estate market.

It is this latter concern that that raises the larger red flag to this Bystander. If government finances in as prosperous and progressive a province as Guangdong are raising such concerns, how deep are the similar problems elsewhere?

The strain on Guangzhou’s purse is increasingly evident. Debt plus interest due this year will eat up 20% of the province’s estimated income for the year, a ratio that triggers alarm bells among lenders everywhere. The provincial government’s total debt to income ratio hit 100% as of end-June. Banks have become reluctant to lend to the province, even though in May central government told state banks to be accommodating in their lending standards where necessary.

Beijing has become increasingly jittery about the ticking time bomb of the country’s local government debt. Last month, it ordered a national audit to be conducted. The last time it conducted such an exercise, in 2010, it came up with a number equivalent to 27% of China’s GDP. Unofficial estimates put the ratio now at 40% of GDP. That translates to 20 trillion yuan, or $3.5 trillion of indebtedness.

It is also reaching the point of a pyramid. Local government borrowing, mostly to finance the infrastructure growth that powered decades of double-digit growth, and since the global financial crisis of 2008 to forestall a too-rapid slowing of that growth, has become unsustainable. Investment projects, often conducted through special investment vehicles (SIVs) to get round restrictions on direct local government borrowing, are not providing sufficient, and in many cases no returns to cover their cost of capital, typically a bank loan secured against anticipated land sales.

An IMF study published in April found that four out of five cities and two out of five counties had secured infrastructure financing against future land sales. We shall pass over the social stability risks involved in appropriating the land for such sales to note that provinces and municipalities are having to borrow anew to repay principal and interest on their existing debt. When confidence tricksters do it, it is called a pyramid scheme.

They tend to come tumbling down in the end. We don’t for a minute think Beijing would let matters get to that point. China has bailed out its big state owned banks before in the 1990s after they had had to bail out local governments. Older hands may remember the’ 90s version of SIVs, provinces’ international trust and investment corporations.

Beijing has the wherewithal to do so again if necessary. The political will to do so would quickly be marshaled in the face of the potential social unrest.

Meanwhile, China has been slowly moving towards establishing a muni-bond market to provide an alternative for provinces to bank borrowings. Capital markets have a Darwinian approach to credit worthiness which few local governments would survive as things now stand. Hence Beijing’s caution and issuance blessing for only those administrations that can muster an AA+ credit rating or better.

For its part, Guangdong plans to issue a record $12.1 billion yuan of bonds this year, a 40% increase on last year’s issuance. That, though, is as much a sign of the size of the problem as a solution.

Averting China’s Local Government Defaults

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.

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.

China Said Set For Big Boost To Muni-Bond Market

China looks set to give a big boost to its nascent muni-bond market this year. The Finance Ministry is to quintuple the quota for local government bond issuance to 250 billion yuan ($40 billion) this year, Caixin reports.

In addition, more provinces will reportedly be added to the list of those able to issue bonds directly. Since 1994, the ministry has done that on behalf of local governments but started an experiment in direct issuance in October last year with Shanghai, Shenzhen, Guangdong and Zhejiang. That privilege will be extended to six more provinces and municipalities. The ministry is expected to maintain the close control over the bond issuance by the larger group that it has exercised over the trial quartet, including having a big say over what the funds raised can be used for.

Expanding the muni-bond market is both part of the broader reforms of the financial system and local government finances. The latter are teetering under the burden of 10.7 trillion yuan of debt, at least 3 trillion yuan of which falls due by the end of this year. Much of the debt piled up as a result of the stimulus spending in the wake of the 2008 global financial crisis. Much of it is infrastructure loans, for things like toll roads to nowhere, that are weighing heavily on the creditworthiness of China’s banks.

Earlier this month the China Banking Regulatory Commission ordered banks to clean up their balance sheets with regard to local government lending. It first told them to do that in June last year, but progress clearly hasn’t been rapid enough, or, as a result of the cooling of both the economy and the property market, problem loans are mounting. Good and bad loans alike were probably rolled over when banks tackled the 2 trillion yuan of local government loans that fell due last year. Another red flag raised by China’s audit office: irregularities it has found with 530 billion yuan worth of the lending. Taken together, an estimated 2 trillion-3 trillion yuan of local government lending has soured, which would be sufficient to raise the banks’ non-performing loan ratios to 5% from their current average of 1.1%.

The new quota of 250 billion yuan for bond issuance won’t wipe away the problem but every little bit helps–though places like Greece serve as a reminder that bond issuance is not an infallible inoculation against the highly contagious disease of government fiscal profligacy. Yet while the immediate priority is to deflate China’s local-government debt bubble before it can go damagingly pop, an expanded muni-bond market also pushes provincial and municipal governments in three other desirable directions: less reliance of land sales to raise revenue, less need for the off-balance sheet financing via captive investment vehicles that local authorities have resorted to get round restrictions on official borrowings, and more transparency generally about their finances.

A Missed Tock Of China’s Ticking Debt Bomb

This Bystander is hardly cheered, if not surprised, to read this report via Bloomberg:

China’s local government debt may be almost 3 trillion yuan ($473 billion) higher than the figure given by the nation’s audit office, if loans taken out by township governments are included, the Economic Observer reported, citing research from an independent institute.

Borrowing by townships, an administrative tier of government below provinces, cities and counties, wasn’t included in a report by the National Audit Office in June that put debt from those three levels at 10.7 trillion yuan, the weekly newspaper said in a report on its website dated Nov. 12, citing Beijing Fost Economic Consulting Company.

At a total of 13.7 trillion yuan, or $2.2 trillion for those of you keeping score at home, that is only chump change at that level off Italy’s outstanding sovereign debt ($2.6 trillion). We’ve seen how these ticking debt bombs can upset markets and oust political leaders. China is fortunate not to have a democratically elected government that investors could force to resign, as they did in Italy and Greece.