China's Debt Puzzle Grows Complex as `Off-Book' Bonds Surge

  • UBS says special bonds inclusion brings deficit ratio to 4.3%
  • Calculating ratio of actual fiscal gap remains difficult

China’s evolving means of selling government debt is masking the true extent of the government’s planned borrowing levels.

The official budget deficit target is 3 percent of economic output, but that doesn’t include all government debt. One category falling outside of the forecast is off-book bonds -- or special bonds as they’re known in China -- whose sales have swollen to eight times 2015 levels.

Provincial governments and some cities have the green light to sell 800 billion yuan ($116 billion) worth of such bonds this year to pay for highways, railroads and other construction projects. That issuance would bring the deficit ratio to 4.3 percent of gross domestic product, according to UBS Group AG and Oxford Economics Ltd.

Such booming growth suggests cash-strapped local governments still can’t break their addiction to infrastructure stimulus even as services now account for more than half of GDP. That means splurging on new subways, airports and skyscrapers will likely continue as local officials spend to keep the economy humming while monetary policy shifts to neutral.

Off-book funds can help support growth and employment, but they’re still just "good old stimulus" more appropriate for a recession than steady expansion, said Michael Every, head of financial markets research at Rabobank Group in Hong Kong. "It’s unsustainable. Enjoy the ride for now, but don’t expect a happy final destination."

China started allowing local governments to sell special bonds in 2015. They were excluded from the budget deficit due to their initially small volumes and because the debt was repaid with revenues generated by projects they financed. While the bonds’ popularity has since surged, the return rates of projects have been too small to cover the debt in many cases, and governments have had to use some of their own revenues to repay the debt.

Read More: China’s Finance Minister Indicates Room for More Government Debt

While President Xi Jinping and other top leaders have signaled stability is the paramount objective before this year’s twice-a-decade reshuffle of key officials, reining in risk related to the record debt binge won’t be easy. Total outstanding credit climbed to about 260 percent of GDP by the end of 2016, up from 160 percent in 2008, according to Bloomberg Intelligence.

"Special bonds will continue expanding for the foreseeable future," said Zhao Quanhou, a researcher at the Chinese Academy of Fiscal Sciences, a research institution in Beijing that’s affiliated with the Ministry of Finance. Local authorities need money to support infrastructure construction, and special debt is attractive because it isn’t counted as part of the budget deficit, Zhao said.

For credit markets, the risk and pricing of special bonds is similar to general bonds, as both are issued by local governments.

One potential complication is that property purchase curbs are starting to cool housing markets, eroding authorities’ ability to raise funds from land sales.

"The sustainability of the debt will be put to a test" because land sales support such a large part of government finances, said Zhu Zhibin, an analyst at China Bond Rating Co. in Beijing. "Keep an eye on the risks arising in places where special bonds have grown rapidly."

Risks Rising

The strain is starting to show on provincial ledgers. In Guizhou, the total outstanding amount of special bonds climbed to 188.4 billion yuan last year while the government revenue that can be used to cover the debt was about 71.6 billion yuan. Yunnan had 120 billion yuan of special bonds and 43.2 billion yuan of revenue to cover them. Inner Mongolia’s special bond issuance is twice the size of the revenue allocated.

Calls to the finance departments of Yunnan’s and Inner Mongolia’s governments went unanswered. Guizhou’s government declined to comment.

People’s Bank of China Governor Zhou Xiaochuan said fiscal policy is "very helpful" for structural reforms, at the recent Boao forum in China’s southern island of Hainan. But different provinces have differing capacities to implement proactive fiscal policy: “Some provinces are really over-indebted, but some of them still have room,” he said.

Explicitly stating the amount of off-book bonds is a step forward, according to Wang Tao, head of China economic research at UBS Group AG in Hong Kong. "The central government has brought some local government debt above board. Debt growth used to be hidden."

Still, getting a clear read of the real fiscal deficit ratio remains difficult. Wang estimated last year that the fiscal deficit, when taking things like off-budget spending into account as well, exceeded 10 percent of GDP. That gap is set to widen even more this year, but it’s hard to tell exactly how much, she said in an interview.

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Different methods of calculation are part of the problem. Other challenges stem from local officials coming up with newer, more indirect ways to fill their coffers following a crackdown on local government financing vehicles.

"Governments should be more open and precise with the size of debt," Wang said. "One can’t understand the economy well and make effective policies based on assumptions."

— With assistance by Yinan Zhao, Jing Zhao, Xize Kang, and Zheng Wu

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