Editor’s note: In the four-part series In the Red, China Economic Review looks at how and why local governments amassed such huge debt, and the options Beijing has to deal with it. Click to read part one, part three and part four.
When the world was digesting news of Detroit’s bankruptcy in July, the biggest ever by a municipality in the US, attention in China turned to the highly indebted government of Jiangsu province. Provincial, city and county authorities were thought to be sitting on some US$126 billion in debt while the region’s shipbuilding industry, a major generator of revenues, foundered due to overcapacity.
The province in east China was labeled a “ticking time bomb” and potentially the venue for the country’s first local bankruptcy. Stories of Huaxi village in central Jiangsu, where the local party chief had erected a skyscraper and an enormous temple complex on farmland, seemed to exemplify the rampant spending officials had engaged in for more than a decade.
A month later, Jiangsu officials publicly said the debt was manageable, even appropriate for the size of the local economy, quickly easing fears of a provincial default.
Much of Detroit’s US$18 billion in debt is held in municipal bonds. On October 1, when the city defaulted on US$9.37 million in payments it owed to the bondholders, there were few questions over the ownership or amount of the debt. The bondholders are taking Detroit to court.
China, however, is a murkier place. In Jiangsu province, opaque government financing platforms borrowed much of the cash. They took loans from shadow banks and parked funds into risky wealth management products. Unlike Detroit, assessing the risk associated with Jiangsu’s debt will be much more difficult, as will any litigation that follows.
The central government may seek to clear up this financial disarray by developing bond markets. A communiqué issued on Tuesday at the close of this year’s biggest policy meet, the Third Plenum, pointed ever so vaguely at reforming local government finances.
The think tank that developed a reform blueprint for the plenary session, known as the “383 plan,” put the solution rather wryly: “Open the front door, block the back door.” That is, let local governments start issuing debt directly by developing a local bond market. If that part of the plan is adopted and the central government committed to the development of a local bond market, it could substantially reduce the need for covert borrowing.
“You can use the experiences of many foreign countries for reference, and local governments may issue debts by themselves for direct financing,” said Zhang Yingjie, a lead researcher at China Chengxin International Credit Rating. Doing that would necessitate an amendment to the Budget Law.
“If there is any big reform, the first step will be amending this law, and then there may be some improvement,” Zhang said. “If [bond] pilot projects are expanded, that means the local governments may issue municipal bonds by drawing on the experience of US with regard to this.”
China launched local government bond pilots in 2011 and has since expanded the trial. The centrally controlled city of Shanghai, the city of Shenzhen, as well as Zhejiang and Guangdong provinces, were allowed to issue 3-year and 5-year bonds at the time, with the maturity period upped to 7-years in 2012. This July, the State Council expanded the pilot to Shandong and Jiangsu provinces.
Who calls the shots?
The progress with these experiments is encouraging but the market is still very much at a nascent stage. For starters, China lacks the credit rating institutions that would provide bond valuations.
To move forward China will need to develop a credit rating system, pricing mechanisms, a transparent information disclosure system, as well as regulatory coordination between the entities that oversee the bond market, according to An Guojun, a researcher at China Academy of Social Sciences in Beijing.
At present, the Ministry of Finance, not the local governments themselves, calls the shots on issuing bonds, Debra Roane, vice president at Moody’s Investors Services, told China Economic Review. The ministry has tight control over the maturation period and the amount of bonds issued. At some point, officials in these localities will need to take the reins into their own hands.
Perhaps most important, cities and provinces will need to start producing real financial statements that include the liabilities held by financing vehicles. Only then can the risks associated with lending to the governments can be assessed. That’s happening under the direction of the central government in some upper-tier cities, but slowly.
Eventually, Roane said, they will need to “actually disclose those documents and have a greater dialog with the market.”
The bigger they are, the lighter they fall
Developing sound bond markets in cities around China could take years given the process involved. And any progress in that direction would require strong support from leaders at the top. But that doesn’t mean provinces such as Jiangsu will soon end up in default like Detroit in the meantime.
Despite the amazing level of debt local Chinese officials have managed to accrue since 2010, the cadres have little to fear. Analysts and rating agencies agree that it’s unlikely the central government will allow a city or province to go under.
In a more open banking system than the one the country currently possesses, the situation would likely lead to greater concerns over the solvency of the banks that have done the lending, London-based Capital Economics said in a note. However, China’s closed capital account has kept worries of contagion to the global banking system at bay. In the short term, banks will likely continue to roll over the loans to local authorities that are having trouble paying them back, buying some time for the central government to initiate reform.
Should a city teeter on the edge of default, the central government could always give a one-off capital injection into local banks, Capital Economics noted. Still, some small governments can’t take such an option for granted. The central authorities have a penchant for making an example of officials or institutions where they can afford to.
Perhaps the safest local governments are the biggest. As China continues to muster international economic clout, the possibility that Beijing would let a powerful and important city such as Shanghai, an emerging global financial center, file for bankruptcy is slim.
“The central government [would be likely to act] particularly if it was one of the larger, more visible and strategically important local governments,” Roane said. “I think the reputation risk to the central government would be pretty great.”