Markets

Christopher Langner is a markets columnist for Bloomberg Gadfly. He previously covered corporate finance for Bloomberg News, and has written for Reuters/IFR, Forbes, the Wall Street Journal and Mergermarket.

Debt is cheap in China, and it's going to remain that way. Everyone's welcome to take more and the government will lead the pack. Those are some of the takeaways from Premier Li Keqiang's work report to the National People's Congress -- China's equivalent of the U.S. State of the Union -- delivered on Saturday.

The biggest engine of that growth will be cities and provinces as they replace trillions of yuan of debt issued through special purpose vehicles. Yes, that's the same structure that U.S. banks used to take subprime residential mortgages off their balance sheets before 2008. The vehicles were created to help fund the construction of everything from ghost towns to a Chinese replica of Manhattan. 

What China needs is not a Manhattan, it's a Detroit. The U.S. city filed for a record bankruptcy in 2013, enabling it to cut $7 billion from obligations by the time it emerged from the process in December 2014. That's something that would probably never have happened in China.

As the government brings all the debt from local authorities out of shadowy structures and onto its balance sheet, China is having to reckon with the true size of its public liabilities. The next step -- which the country is reluctant to take -- is to create a real municipal debt market, where investors don't expect to be bailed out by the central government and defaults do happen.

In his address on Saturday, Li said the government deficit for 2016 is projected to be 2.18 trillion yuan ($335 billion), an increase of 560 billion yuan over last year. That marks a rare acknowledgement that China has to learn to live with higher debt, including at the government level. Of the deficit, 1.4 trillion yuan will be carried by the central government, and the remaining 780 billion yuan at the local level.

After issuing a record 3.8 trillion yuan directly last year, provincial and municipal governments are expected to sell as much as 5 trillion yuan more this year. Almost 85 percent of the 2015 amount was sold to replace bonds from companies they had created to raise funds for construction, their way of sidestepping regulations that prevented local governments from selling debt directly. 

Embracing Local Debt
Chinese local government bond issuance jumped almost ten times last year
Sources: Bloomberg; Chinabond

These paper companies sold debt in China and abroad to the point that Beijing lost track of how big the liabilities were, prompting the government to deploy 50,000 auditors to cities and provinces. The results are still being dealt with and culminated in the nation's decision to open the spigots of municipal debt issuance and with the higher deficit target.  It's not that China is hiding the numbers; it may not know what they are.

The Part That's Known
There is still at least 3.8 trillion yuan outstanding of local government financing vehicle bonds
Source: Bloomberg

Compounding the difficulty of tracking the true size of liabilities is that, on top of municipal bonds, local government funding vehicles continue to issue more debt. In a further irony, now that everyone recognizes these are going to be backstopped by Beijing, raising funds this way has actually got cheaper. 

Cheaper Debt
Average coupons on bonds sold by debt vehicles created by local governments has almost halved
Source: Bloomberg

What China needs is not more municipal debt that people recognize as being guaranteed by the central government. ``If China feels that there's too much debt on their balance sheet, they can truly privatize it by creating project bonds" like the ones school districts and city utilities sell in the U.S. muni bond market, Olivier Delfour, Fitch Ratings' managing director of global infrastructure and project finance, said in an interview on Friday.

As in the U.S., China needs municipal bonds that are subject to the risk of default. Only then will the markets help China deal with its local growth and borrowing troubles, and ultimately enable the national debt to grow in a more sustainable way.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Christopher Langner in Singapore at clangner@bloomberg.net

To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net