By Houze Song
China’s local government debt problem has received headlines recently, for good reason. Local government fiscal expenditure accounts for more than 20% of China’s GDP. A 10% drop in local governments’ spending could lead to a near 2% drop in GDP. When you add in off-balance-sheet financial vehicle investments and loans, local governments account for an even bigger role in the economy. To make matters worse, China’s local governments’ borrowing is very opaque: Four months into 2015, the Ministry of Finance still hasn’t figured out the exact size of total local government borrowing as of the end of 2014. The world learned an expensive lesson from the European sovereign debt crisis of 2009: debt-fueled investment bubbles eventually burst.
The creditworthiness of local governments is directly connected to the health of China’s overall banking sector, which is heavily exposed to local debt. More than 60% of all lending to local governments is made by the banking sector, roughly equaling the banks’ total net worth. China’s banks also extend a significant percent of loans to sectors that rely on local government investment, like construction, heavy machinery, steel and cement. If there is a sudden decline in local spending, those loans would be affected, too.
But there are encouraging signs that Beijing is taking measures to deal with the problem before a crisis unfolds. In recent months, Beijing has issued a series of new policies aimed at building a sustainable and stable local government fiscal system. In my opinion, these new policies should reduce the risk embedded in the current system. Ultimately, local fiscal reform could help stabilize and boost China’s growth.
The local debt issue stems from a number of fundamental, structural problems:
A mismatch between local revenue and expenditure leads to reliance on land sale for revenue. Local governments collect only half of China’s total revenue, but are responsible for more than 80% of its total fiscal expenditure. Though Beijing does allocate some additional transfers, they are not enough to meet the needs of local governments. The reality is that local governments have little choice but to borrow from banks (through poorly regulated local financing vehicles), or to sell land.
The government is still too highly connected to the overall economy. After three decades of reform, a robust private sector accounts for the majority of China’s economy. But the state sector is still large and complex, making monitoring of China’s local government debt extremely difficult. Each level of government—provincial, city, county and town—owns its own SOEs, utilities, financial vehicles and public institutions such as public schools and hospitals. The liabilities of any of those institutions—and there are more than 150,000 of them across the country—might count as local government debt. In 2013, more than 50,000 auditors worked for two months to get a comprehensive picture of China’s local debt.
Lack of transparency and oversight exacerbates the problem. Local audit offices are on local governments’ payroll, making it difficult for them to monitor lending. Though local People’s Congresses review government budgets, they don’t have much control over them. And those agencies only cover official debt, which leaves the more problematic, off-balance-sheet problem unattended.
China’s financial system is plagued by “moral hazard” problems: lending decisions are not based on sound investment analysis, but instead on the assumption that bailouts will happen if problems occur. Even government-affiliated institutions can borrow at interest rates lower than the private sector, because the market believes they will be bailed-out if they run into trouble. Borrowing by such quasi-government entities has grown at more than 20% per year in recent years.
The good news is that Beijing is well aware of the above-mentioned problems. A series of new central government policies should help avert a crisis.
1) Beijing has effectively banned local governments from borrowing through financial vehicles; the only way to finance their deficits is by issuing bonds. This will help spread risk outside of the banking sector, and increase the transparency of borrowing. To persuade institutional and retail investors to purchase bonds, local governments will have to demonstrate that they have the resources to make repayments. This will require them to disclose balance sheets, and their creditworthiness will be rated by third-party rating agencies.
2) Beijing has made it clear that it will not bail out local governments. To make this promise credible, Beijing will assign a borrowing cap to each province that is determined by factors related to the creditworthiness, economic strength and debt ratio of local governments. By allocating borrowing rights only to provincial governments, Beijing has given them an incentive to monitor the fiscal health of the local governments within their jurisdiction. If a city or county government goes bankrupt, the provincial government will be the one to step in and bail it out.
3) The government has also required that issuing of bonds must be approved by local People’s Congresses, which will create another layer of oversight. Since the public is expected to be a major investor in municipal bonds, local people will be incentivized to monitor the fiscal health of their government. The local government will become more accountable to the public: after all, investors can always refuse to reinvest their holdings of local bonds when they mature.
There are still, of course, reasons for concern. The new policies probably will not spell the end of government guarantees for SOEs, public institutions and connected private enterprises. The latest news that the People’s Bank of China has organized a bailout of Baoding Tianwei (a subsidiary of a central SOE) underscores this concern. It’s also unclear how well the new provincial lender-of-last-resort responsibilities will work.
But the bottom line is that China has the ability to avoid a local fiscal crisis. Total assets owned by local governments, including land, mineral resources and local state-owned enterprises, are way larger than their debts. The net worth of all local SOEs is greater than 17 trillion RMB, roughly the size of total local government debt.
The new municipal bond market is a major step forward—especially in the face of a slowing economy. The bonds will provide local governments with an important source of low cost, long-term funds at a time when they will need to increase spending to keep the economy growing. The money must be invested wisely, of course—which is exactly why Beijing is encouraging the private sector’s participation in infrastructure investment.
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