Local $1.6 Trillion Debt Pile Impedes Rate Freedom: China Credit

Chinese local governments’ $1.6 trillion in bank borrowings are a major obstacle to the freeing up of interest rates in the world’s second-largest economy, according to BNP Paribas SA and Capital Economics Ltd.

The financing arms of municipal authorities owed lenders

9.7 trillion yuan ($1.6 trillion), or 14 percent of all loans, in mid-2013, according to China Banking Regulatory Commission figures. Most have weak credit profiles, Moody’s Investors Service said in a Nov. 5 report, noting that only 53 percent of 388 such companies it surveyed in June had enough cash to cover estimated debt payments and interest this year without refinancing.

If rates are liberalized and advance quickly, “it will make it very difficult for the government to roll over debt as the cost of doing that will be rising fast,” said Chi Lo, Hong Kong-based senior strategist at BNP Paribas Investment Partners, which oversaw 478 billion euros ($642 billion) globally as of September. That’s partly why “I won’t bet on deposit rates being fully liberalized within the next year or two.”

China is seeking to give markets a greater say in setting borrowing costs without triggering a surge in interest rates that would boost loan defaults. Years of state-directed lending and interest-rate controls led to a banking crisis in the late 1990s and the government spent more than $650 billion over a decade on bailouts. Bad loans at the nation’s four biggest banks rose in the third quarter by the most since at least 2010.

Surging Yields

Government bond yields surged this week to the highest levels in at least five years as the Communist Party leadership met to outline the country’s economic and social policies for the coming years. A communique released after the four-day session ended Nov. 12 said market forces would be given a “decisive” role in allocating resources, though it didn’t provide further details.

“Investors are expecting interest-rate liberalization to accelerate and funding costs to increase quickly, so it’s very hard for bond yields to come down,” said Min Shuai, a Shanghai-based fixed-income analyst at Guotai Junan Securities Co., the nation’s third-biggest brokerage.

The yield on 10-year government bonds rose 47 basis points this quarter to 4.47 percent yesterday, the highest level since 2008, according to Interbank Funding Center data. One-year sovereign debt yielded a record 4.16 percent on Nov. 11, after a 61 basis point advance this quarter. The rate was at 4.12 percent yesterday. The yuan, which has gained 2.3 percent this year, advanced 0.02 percent to 6.0916 per dollar as of 2:24 p.m. in Shanghai today.

Truncated Auction

China Development Bank, the nation’s biggest lender, cut an auction of bonds this week to 10 billion yuan from 24 billion yuan. The average yield on its 10-year debt soared to a record

5.56 percent on Nov. 11. That exceeds the 2.66 percent on financial notes globally, according to Bank of America Merrill Lynch indexes.

The premium over top-rated notes for five-year AA debt, a common rating for the financiers of roads, sewage plants and subways known as local government financing vehicles, widened 12 basis points in the second half of this year to 98 basis points yesterday. The comparable gap in India is 43.5.

Deposit Rates

The People’s Bank of China in July removed a floor on borrowing costs set at 30 percent below the benchmark. It may allow onshore trading of negotiable certificates of deposit by the end of this year and establish a deposit insurance program in 2014 before scrapping the limit on savings rates by 2015, Deutsche Bank AG forecast in a note in September.

This will subject the nation’s 3,800 banks to greater competition, forcing them to pay savers more to retain their share of the country’s 101 trillion yuan of deposits. The PBOC has described the policy shift as the “most critical and risky” step in its banking overhaul.

The nation has this year intensified efforts to control the raising of debt by LGFVs, which allow authorities to circumvent a ban on direct borrowing. A nationwide audit of local authorities ordered by the State Council in July will show their overall debt may have surged to more than 20 trillion yuan, Liu Yuhui, a researcher at the Chinese Academy of Social Sciences, said on Sept. 16.

Lack of Details

The communique from the third plenum stopped short of offering any details on interest-rate reforms or local government finances. A lack of consensus over changes to the financial sector may be the reason, Zhang Ming, an economist at the Chinese Academy of Social Sciences in Beijing, said in a Bloomberg Brief today. Reforms will progress at a slower pace than anticipated and deposit rates will remain capped in the short term, he said.

The lack of details could also be related to large local government debt found in the audit report, according to Alicia Garcia-Herrero, chief economist for emerging markets at Banco Bilbao Vizcaya Argentaria SA in Hong Kong.

“Under liberalized interest rates, banks will have no choice but to increase the lending rate,” said Garcia-Herrero. “If they do that, LGFVs may have to say, ‘Sorry, I can’t pay, there’s too much on our plate.’ ”

China expanded a program to allow local authorities to sell notes directly in July, 20 months after the trial started, to let borrowing costs better reflect debt quality and provide transparency.

Rollover Costs

While local authorities will try to roll over debt for as long as possible, costs have already started to climb, said Bin Gao, head of Asia-Pacific rates strategy at Bank of America Merrill Lynch. “The difficulty China Development Bank faced in issuing notes recently suggests that even if municipal bonds take off, they might not be able to roll all the debt,” Hong Kong-based Gao said.

The bank wrote yesterday that while reform details from the plenum will come out later, “leaders still seem to emphasize stability over decisive actions” and that will make it harder to implement difficult policy changes. It said budget and land issues would be among the toughest to tackle.

China’s local governments are responsible for 80 percent of spending while getting about 40 percent of tax revenue, the legacy of a 1994 tax-sharing system, according to the World Bank. The local share of spending has surged in recent years, causing regional authorities to rely more on land sales and borrowing via investment vehicles, Credit Suisse says.

Bad Debt

Bad debts at Industrial & Commercial Bank of China Ltd., China Construction Bank Corp., Agricultural Bank of China Ltd. and Bank of China Ltd. rose 3.5 percent in the third quarter to

329.4 billion yuan, data compiled from earnings reports show. Their average bad-loan ratio widened to 1.02 percent.

Municipal debt “makes it much more difficult to reform banks and liberalize the financial system,” said Mark Williams, London-based chief Asia economist at Capital Economics Ltd. “If China is to liberalize interest rates and the financial sector before dealing with the implicit guarantee on state-owned companies and LGFVs, it would increase risk in the system.”

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