Tag Archives: off-budget financing

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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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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Defusing China’s Local-Government Debt Bomb

The finance ministry’s budget report to the National People’s Congress contained the line, “local governments face debt risks that cannot be overlooked”. It was buried deep in the text but caught this Bystander’s eye for the red flag raised by its very understatement. Beijing is now looking very hard and directly at those risks.

A nationwide flash audit of provincial and municipal governments’ borrowings, both direct and indirect via captive investment vehicles (also known as financial platform corporations), was launched at the beginning of this month, Caixin reports. Eighteen teams of auditors have four months to complete it.

Finance ministry officials and bank regulators have been concerned for sometime about the risks involved in the 7.7 trillion yuan ($1.2 trillion) of bank loans made to local governments’ captive investment vehicles as of June 30th, with 23% not backed by cash flows.  The China Banking Regulatory Commission (CBRC) discovered in February that more than half of new bank lending wasn’t meeting its new credit rules designed to mitigate the fear that China’s banks are sitting on a potential dung heap of bad loans; its concern was particularly acute about direct and indirect lending to local governments.

The unexpected new audits suggest that the concern over the debt risk to local-government finances is deepening, and that, perhaps, the numbers have worsened significantly since last June, intensifying a general concern in Beijing about the overall weakness of local-government governance. The finance ministry has cataloged the points of vulnerability:

We are fully aware that some prominent problems concerning fiscal operations and management still exist, the main ones being: Some county and township governments remain in rather difficult financial circumstances, and assurances of adequate basic funding for them have to be strengthened. The system for ensuring that financial resources are correlated with responsibilities still has yet to improve, and the task of making basic public services uniform between regions and between urban and rural areas is quite arduous. The fiscal and taxation policies for promoting the transformation of the pattern of economic development need further improvement, and public finance must play a larger role in adjusting income distribution. Local governments face debt risks that cannot be overlooked. Management of revenue and expenditures from the sale of land-use rights urgently needs to be strengthened. Fiscal management remains weak, and the pace at which expenditures are made throughout a fiscal year is not sufficiently uniform.

What is needed is an intensified pace of structural reform. Central government policy under the new five-year plan sharpens the focus of economic development to provide social services and public welfare projects to narrow the regional inequality gaps and blunt the corrosive inflation seen as so threatening to political stability. Provincial and local governments will be the vehicles for delivering much of that. Last year, for every yuan that central government spent directly, local governments spent four and a half yuan (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.

Beijing doesn’t want the dog dropping dead because the tail implodes. So the finance ministry is sounding tough about getting to grips with local-governments’ debts:

We will strengthen supervision of local government debts and strive to guard against financial risks. We will promptly set up a system for the overall management and dynamic monitoring of the debts of financing platform corporations , and standardize management of these debts. We will accelerate the establishment of a mechanism to control the scope of local government debts and a mechanism to warn when they get too large, and promote the standardization of local governments’ debt financing.

Easier said than done given China’s sprawling local bureaucracy, and it will require a change to rewarding local officials for promoting economic growth above all and to local government’s dependence on land-sales for revenue. But none the less urgent for that. In 2011, Beijing plans to increase the amount of money it will hand over to local governments by a budgeted 15.3%. In all, local-government spending is budgeted to increase 11% from 2010’s levels. The finance ministry will cover a collective 200 billion yuan local governments deficit with bond issues.

Local governments can expect to be increasingly under Beijing’s thumb to be accountable for the money they are getting. They can also expect unrelenting reform of their finances and governance. The finance ministry has already said that  that it will “eliminate all extra-budgetary funds and place all government revenues under budgetary management.”

None of this will be particularly comfortable for local officials used to the mountains being high and the emperor far away. The transparency the reforms imply, if it can be brought about, will also make the dipping of local hands into the honeypot of public money more difficult — another potential source of discomfort. None can say they are not getting fair warning. But if China’s local-government debt bomb explodes first, that will be the least of everyone’s worries.

 

 

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