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 two, part three and part four.
Where is the home of the cleverest businesspeople in China? This is a raging debate. Southerners say Chaozhou in Fujian province. Coastal Wenzhou folk certainly have a claim given their entrepreneurial rigor. Shanxi province in the north holds out for a shot at the title.
While they argue among themselves, a simple answer is readily available: Regional government officials, north or south. These cadres in provinces and cities across the country have built monumental projects and accumulated extensive asset portfolios, all paid for by creative off balance sheet borrowing that dodged strict central government laws preventing them from getting loans from banks.
Over the past nearly 20 years, local officials have set up companies that find the cash for them. These corporations – legally detached from yet headed by officials – take loans, develop property and build bridges and stadiums. Their legacy is visible in almost every part of China.
They’ve racked up a hefty bill in the process. Many projects lose money; it’s probable that much of what was borrowed will never be paid back. Worst of all, the regulations that stop the localities from formal borrowing have pushed them into a grey market for funding. The debt isn’t accounted for in the local budgets because the governments haven’t borrowed the money, their companies have.
“I think the issue is, that when you impose severe restrictions on local governments, they typically find a way around those restrictions,” said Debra Roane, vice president at Moody’s Investors Services.
Now Beijing is trying to figure out just how much was borrowed in this manner.
In August, the State Council, the government’s central decision-making body, dispatched an accounting team to tally up this hidden debt. Although the results aren’t due until later this year, early estimates from analysts put the outstanding balance at up to US$3.9 trillion, or 47% of China’s 2012 GDP.
A similar audit was carried out in 2010. Since then, it is possible the debt has more than doubled, pointing to the increasingly small return the government gets on investment-fueled growth and, therefore, a need to spend more. Unfortunately, the decreased returns will also make much of the debt unserviceable. A note from London-based Capital Economics pointed out that the returns on many recent infrastructure projects are likely to be low.
The debt is likely a main topic for discussion at the Third Plenum, the high-level political meet in Beijing taking place November 9-12. The “383 plan,” a reform blueprint that was issued by an influential State Council think tank in advance of the event, noted possible changes that could be made to the regulations that have forced regional authorities so far into the red.
Less isn’t more
Local officials have had little choice but to drive themselves in to such heaping debt.
In 1994, under austerity measures taken by then-Premier Zhu Rongji, the central government put its hands on a major portion of local government tax revenues while at the same time requiring the localities to shoulder huge costs for social programs such as pensions and health care.
A demand was also made for local officials to drive the country’s economic growth. For more than a decade regional governments have been charged with building many of the massive public works projects that have buoyed China’s breakneck development. While headline central government GDP expansion targets have settled at around 10% for many of the past 20 years, local governments have been pushed to shoot for higher growth, often topping 15%.
Faced with such burdens, and effectively kept out of the formal borrowing sector, cadres were left scratching their heads over how to find the money to build the country.
The solution has been entities known as local government financing vehicles. At its simplest, this is a state-owned firm set up by a government to borrow money from banks and bring in the capital needed for public spending.
A basic model involves a shell company that uses government-entrusted land titles as a guarantee against loans from a state bank. Those funds then primarily go to other state-owned firms that build roads, bridges and any other infrastructure.
Finding the bodies
Unsurprisingly, the borrowing loophole isn’t as straight forward as that. The questions facing these financing platforms today concern the true holders of trillions of yuan in debt. Legally speaking, local governments can’t be held responsible because they are not allowed to borrow from banks. Yet the boards of the companies are populated by local officials, often powerful people with influence over state lenders. Executives at local financial institutions have been put in quite a bind.
What convolutes the problem further is how this method of indirect borrowing is tied into other prominent risks to China’s financial stability, namely shadow banking and wealth management products.
Grey market lending from unofficial creditors has surged since the 2008 global financial crisis. Companies in search of capital have racked up US$4.56 trillion in debt, according to Moody’s estimates of the broader the shadow banking sector.
Many of those businesses were state owned. About half of the debt issued indirectly to local governments since 2010 may have been borrowed though shadow banks, as financial intermediaries often operating outside of regulatory oversight are known, according to Wang Qinwei, China economist at Capital Economics.
“But it can only explain a small part of the financing through shadow banking in the whole country,” he said over the phone. “How much and what’s the structure? What kind of borrower? None of that is clear right now and it’s all part of the risk.”
Standard and Poor’s estimates that up to 80% of local government debt is held by Chinese investment firms, much of which could be in risky wealth management products. Last year, the central government fingered investment and trust companies for the opaque nature of the investment products they offered. Funds were loaded into speculative property buy-ups and coal mines. Huaxia Bank’s notable default on its wealth management products brought some visibility to the issue last December. Nationally, the products were valued at US$1.2 trillion at the end of 2012.
Lightening the load
The intertwining of local debt between wealth management products and the shadow banking sector – the two of which are also thought to be tightly entangled – has made assessing the true risks increasingly difficult.
Perhaps the risk became clearer to top policymakers this weekend. The preliminary findings of the national audit were expected to be presented at the Third Plenum, which started on Saturday and ends on Tuesday. Many leaders also likely looked for long-term solutions in the 383 plan.
The proposals in the plan are wide ranging and have the potential to bring about major changes in the way local governments operate.
The government could extend a local bond pilot that would help render backdoor lending obsolete. It may also let local officials levy property taxes as another way of generating transparent, on-the-book revenues to fund projects. The 383 plan
has even suggested lightening regional governments’ social responsibilities, a move that would lessen their expenditures.
Yet the plan’s bold ideas are matched by the difficulty and the length of time required to enact them – should part or all be approved. Over the next three articles in this series China Economic Review explores how the central government plans to pull regional authorities out of the red.