Conquering China’s Mountain of Debt
“Close the back door, open the front door.” That’s the official slogan used to describe China’s most ambitious reform of government finances in two decades, to be introduced later in 2015. The aim is to wean badly indebted local governments—tens of thousands of cities, counties, and townships—off their dangerous reliance on off-balance-sheet financing and backdoor borrowing, from both banks and the unregulated shadow finance sector. Funds to support China’s rapid urbanization—to build infrastructure, keep pension programs solvent, and more—will come from a vastly expanded, newly legalized local bond market.
“The development of a local bond market … is a real milestone,” says Debra Roane, senior credit officer at Moody’s Investors Service. “Once local governments start issuing debt in their own name, it will be clear that they are responsible for it, and that will ultimately lead to more prudent decision- making. They will stay away from riskier projects.”
Ever since China’s last major fiscal reform in the mid-1990s, when then-Vice Premier Zhu Rongji restored control of public finances to the national government, local governments have faced a dilemma. They receive only about half of China’s total tax revenue, while they must pay for 80 percent of all government expenses, including schools, roads, and health care. The local governments are banned from borrowing directly from banks and from issuing bonds.
As a result, a vast, unregulated industry has sprung up in what many call local government finance vehicles. Some 10,000 of these for-profit finance companies raise funds for local needs. They also have enabled local authorities to commit acts of apparent folly. The finance companies, with the implicit backing of local governments, bankrolled entire new city districts that now sit largely empty. “This has led to a very opaque and risky situation, with unclear accountability,” Roane says. “It’s not clear who is responsible for all this debt.”
China’s officially stated deficit is about 2 percent of its gross domestic product. That’s a fiction, says Chen Long, China economist at researcher GavekalDragonomics in Beijing, because it doesn’t include any of this indirect local borrowing. Add it in and the deficit rises to about 5 percent of GDP, Chen estimates. The National Audit Office found that as of 18 months ago, local debt—including indirect borrowing—totaled 17.9 trillion yuan ($2.86 trillion), up 63 percent since the end of 2010, much more than the 40 percent expansion of the economy.
For all future infrastructure projects, local governments will have to split liabilities into separate categories. The first group will include true public welfare projects, important but not self-supporting, such as a school, bridge, or sewer system. These efforts will be formally recognized on local government balance sheets and funded through the new bond market, says Louis Kuijs, chief China economist at the Royal Bank of Scotland in Hong Kong.
Money borrowed to build commercial structures—hotels, office buildings, or high-end apartment towers—will be hived off and classified as corporate debt, Kuijs says. Policymakers also seek to draw private investment into a third category of revenue-producing public works, such as city water systems. China’s State Council has announced that promotions for local officials and bank officers will be tied to their efforts to control local debt.
In 2009 the Ministry of Finance started a small pilot program to see how a local bond market would fare. Its development has been tightly controlled, and yields haven’t been determined by the market. Buyers of the 1.2 trillion yuan in bonds have been almost exclusively state-owned banks that hold these securities to maturity. “Local banks are owned by the local governments, so they can tell them to buy bonds. Because the amounts are so small, the banks have been willing to buy. But that’s not sustainable,” says Chen of GavekalDragonomics, who estimates the market must grow 10 times its present size to meet the needs of localities. “In the future, when they want to sell a lot more, then it will become much harder [to find buyers].”
The plan to end local reliance on indirect borrowing comes as cities and counties are increasingly cash-strapped. Amid a real estate slump, sales of land, a main source of local financing, contracted by 21.5 percent in the fourth quarter, a sharp reversal from the 40.3 percent growth in the first three months of 2014. If regulators do clamp down on the local government financing companies, cities and townships will face a severe fiscal crunch, hurting China’s already cooling economy.
“Later this year, when the slowdown hits its nadir, there will be backsliding,” predicts Andrew Polk, senior economist at the Conference Board’s China Center for Economics & Business. “They say they want to close the back door. Instead, they will probably close it a few inches but then have to reopen it.”
The bottom line: China may have to develop a robust local bond market to reduce cities’ reliance on indirect borrowing.