Nomura Says China May Allow Defaults of Local Debt

(Corrects name in second paragraph.)

Policy makers in China may allow some local governments’ debt to default next year to improve market discipline as borrowings surge, according to Nomura Holdings Inc.

Local government financing vehicles’ debt grew 39 percent from 2010 to 19 trillion yuan ($3.1 trillion) as of the end of 2012, Nomura economists led by Zhang Zhiwei wrote in a report released today. That’s 37 percent of gross domestic product, according to the investment bank.

China will complete an audit of the debt this month to assess risks to its financial system, ahead of a Communist Party meeting in November to set economic policy. Non-performing local-government and corporate liabilities will probably have a “significant impact” on China’s credit and economic growth, according to half of the economists in a Bloomberg News survey conducted in July.

“The central government may allow a number of individual credit defaults to take place to set examples to the rest of the sector –- and investors,” the report said.

Premier Li Keqiang said on Sept. 11 that China is taking “targeted measures” to address the issue of local-government debt that “people are all concerned about.” The rising borrowings underscore the risks President Xi Jinping’s government faces as it tackles the effects to the financial system of a record credit boom.

Stimulus Effects

Regional governments set up more than 10,000 LGFVs to fund the construction of roads, sewage plants and subways after they were barred from directly issuing bonds under a 1994 budget law. A 4 trillion yuan stimulus plan during the 2008-09 financial crisis swelled loans to companies, which they have been rolling over or refinancing with new note sales.

LGFVs may hold more than 20 trillion yuan of debt, former Finance Minister Xiang Huaicheng said in April.

The reliance of the financing vehicles on land sales and rising land prices to repay debt creates “many problems,” People’s Bank of China Governor Zhou Xiaochuan wrote in a commentary published on the central bank’s website Sept. 9.

Zhang, chief China economist at Nomura, said in a media call today that any defaults are more likely to occur in shadow-banking activities, such as trust businesses, than the bond market. That’s because any non-payment in the latter would affect retail investors and become a high-profile issue, he said.

To contact Bloomberg News staff for this story: Judy Chen in Shanghai at xchen45@bloomberg.net

To contact the editor responsible for this story: Katrina Nicholas at knicholas2@bloomberg.net

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