Chinese Cities’ Risky Borrowing Binge

A debt-fueled construction boom backed by questionable land values

Workers toil by night lights with hoes, carving the Olympic rings into the ground in front of an unfinished 30,000-seat stadium, a gymnasium, and a swimming complex in Loudi, a city of 4 million in Hunan province. Loudi is paying for the project with ¥1.2 billion ($185 million) in bonds, guaranteed by land that city officials value at $1.5 million an acre. That’s about the same as prices in Winnetka, a Chicago suburb where the average household earns more than $250,000 a year. People in Loudi take home $2,323 annually. And there are no Olympics scheduled to arrive here. Ever.

The project will increase property values throughout the city, officials reason, and sales of city-owned raw land for residential development will help pay back the loans used to finance the improvements. “The debt isn’t a problem as Loudi is not a developed place,” says Yang Haibo, an official with the city’s financing authority, as he sits with colleagues in a smoke-filled meeting room under a No Smoking sign. “It’s an emerging city.”

Loudi is just one of scores of cities across the country borrowing to build roads, commercial centers, and subways after the central government urged them to spend their way out of the 2009 global recession. Local governments have sold more than ¥400 billion of bonds since 2008—part of as much as ¥14.2 trillion in local borrowing. The governments have set up more than 10,000 financing vehicles in the past decade to get around laws prohibiting them from taking direct loans. One third of those financing vehicles don’t have cash flow to service their loans, China’s banking regulator says. Loudi’s investment vehicle had a negative operating cash flow of ¥187.1 million in the first half of 2010, a period during which it borrowed ¥284 million. “China is playing with fire like we played with fire,” says Carl Walter, who retired this year as chief operating officer in China for JPMorgan Chase. Yang, the Loudi official, isn’t worried. “When we get to the end of our loan,” he says, “we’ll just pay it back.”

Residential land values in China slumped 30 percent this year as local officials increased sales of government-owned property to repay loans, according to Credit Suisse Group. “We are forecasting a lot of local governments will have to default,” says Jinsong Du, a Credit Suisse analyst in Hong Kong. A research team at Standard Chartered estimates that ¥4 trillion to ¥6 trillion of local government loans—and possibly much more—ultimately will not be repaid, according to a June 29 report. “It’s a huge myth that land sales are going to be able to even support the interest payments, let alone the principal payments,” says Stephen Green, the head of Greater China research at Standard Chartered.

The building binge being powered by the mound of debt is evident in cities such as Loudi. Cranes abound among new high-rise apartment complexes with names like Wealthy City. Loudi City Construction Investment Group, the city’s financing vehicle, plans to use 21 percent of the proceeds from the bonds issued in March for the stadium complex and the rest for a new expressway, water treatment facilities, and a park, according to its prospectus.

Who would be hurt in a default? Chinese banks are among the leading holders of China’s mushrooming corporate debt, according to data compiled by ChinaBond, the country’s bond clearinghouse. (Because they are issued by financing vehicles, local government bonds are counted as corporate debt.) This year, Chinese mutual funds have been the biggest buyers, according to investment bank China International Capital Corp.

Buyers are attracted to high yields and have faith that the central government will bail out any borrowers in trouble, says George Weisi Tan, head of bond investments at Fortune SGAM Fund Management in Shanghai. The yield on Loudi’s bonds was 7.3 percent on July 7, according to data from China Foreign Exchange Trade System. “They think the interest is risk-free,” says Tan. “This is really a big systemic risk.”


    The bottom line: Analysts at Standard Chartered estimate that at least ¥4 trillion to ¥6 trillion of local government loans will never be repaid.

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