China Lake Saved From Stink Leaves Fiscal Cleanup for Li

Yueyang’s South Lake became so clean after the city built a sewage system that Qian Shuili can catch fish there to serve in his restaurant.

“My customers really love them,” said Qian, 38, as he stood lakeside in heavy rain, wearing a motorcycle helmet and a dark green raincoat and hoping to hook another catch. “The lake used to be very dirty with rubbish floating on the surface of it -- I didn’t even want to get close because of the stink.”

Qian’s hometown city in China’s southern Hunan province was a beneficiary of the record wave of credit unleashed by the nation’s leadership to combat the 2009 global recession. While the new infrastructure has cleaned up the lake, it’s the financing behind the project that’s murky.

In the U.S., such a system might have been funded by state or municipal bonds subject to scrutiny by investors and credit-rating companies, with the spending open to oversight by elected lawmakers and an unrestrained press. Yueyang’s projects instead were bought with funds from a local-government financing vehicle of the type Premier Li Keqiang is taking steps to eliminate, due to lack of transparency and concern about capacity for repayment.

With China’s economic growth slowing, the challenge for Li is to construct a new local-financing system fast enough to head off a debt crisis.

“If business goes on as usual and debt continues to rise at the current pace, it would be hard for the government to foot the bill” for all the local financing vehicles that go bad, said Ding Shuang, senior China economist at Citigroup Inc. in Hong Kong. “A key difference between a real municipal bond market and the current LGFV bond market is transparency about a local government’s true fiscal capabilities and direct responsibility for the debt.”

Build Infrastructure

Barred from selling debt directly, local governments set up thousands of LGFVs to raise funds to build subways, highways and sewage systems, finding buyers for the bonds in banks, brokerages and fund managers.

The infrastructure work that helped Qian and his customers was funded partly by a 1 billion yuan ($161 million) bond. Yueyang City Construction Investment Co., the financing vehicle, sold the six-year bond at a 5.88 percent coupon in April 2009 to fund roads, a long-distance bus station, and the sewage pipelines and pump stations that improved the lake, which is also a site of dragon-boat races.

The average yield on the Yueyang bond this year of 8.76 percent is up from 6.54 percent for all of 2013.

A controversy that flared when the bonds were offered for sale showed the tangled financing arrangements resulting from local governments’ inability to borrow directly. In this case, the historic Junshan Park was listed as one of the LGFV’s revenue-generating assets.

In a May 2009 article, the Shanghai Securities News said Yueyang was engaging in fraud by classifying public institutions, including the park, as LGFV assets. Sales of the bonds were temporarily suspended and resumed after the vehicle published a legal opinion sanctioning the arrangement.

Not Listed

Junshan Park, which charges 60 yuan to enter, had 12.6 million yuan in revenue in 2007, according to the bond prospectus. In August 2013, when the Yueyang LGFV sold another 1.8 billion yuan of bonds at a coupon rate of 6.05 percent, the park was no longer listed as one of its assets.

Premier Li pledged this month to create a municipal-bond system without giving details on how it would work. The proposed changes would put more local debt onto budgets, with the aim of bringing greater transparency into regional finances and stronger restraints on risky borrowing.

Borrowing under the new system can be used only for development and rolling over existing debt, rather than day-to-day government expenses, Vice Finance Minister Shi Yaobin said in a statement posted today on the ministry’s website. Governments will be able to sell bonds for projects and repay debt with fiscal revenue and new borrowing, Shi said.

China is stepping up efforts to regulate local-government debt and financing vehicles in what Li described as “opening the front door and curbing the side door” at a March 13 press conference.

The shift may not be simple. China needs to revise the budget law and to address issues including setting up credit ratings for local governments, said Citigroup’s Ding, who previously worked for the International Monetary Fund.

Premier Zhu

The nation, which has been testing municipal bonds since 2011, has long struggled to find a sustainable way to finance local projects. Then-Premier Zhu Rongji in 1994 banned local governments from issuing bonds and running deficits after regions borrowed with little oversight to build hotels and golf courses and buy stocks.

China’s growth rate, even with a projected first-quarter slowdown, is still fast enough to produce increasing revenue that can pay off obligations. Yueyang, best known for an ancient tower, said 2013 fiscal revenue rose 11 percent.

Analysts surveyed by Bloomberg News in March see the nation’s expansion at 7.4 percent this year, which while a 24-year low is enough to double the economy’s size in a decade.

Risks from existing LGFV bonds are “relatively small” and will be the last to default because local governments will back them, Ding said. So far, no prominent LGFV failures have been permitted.

Implicit Guarantees

Even so, the current practice of implicit guarantees for local governments adds the danger of moral hazard, or when borrowers take on more risk in anticipation of official aid if their bets sour.

Local authorities’ liabilities rose to 17.9 trillion yuan as of June 2013 from 10.7 trillion yuan at the end of 2010, according to National Audit Office figures. It’s part of a debt surge over the past few years that’s evoked comparisons to the run-up to Japan’s lost decade and the Asian financial crisis.

“The rapid expansion in local government debt is adding systemic risks in the Chinese economy,” said Chang Jian, chief China economist at Barclays Plc in Hong Kong, who previously worked at the World Bank.

— With assistance by Xin Zhou

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