Local government officials are parsing their balance sheets and pacing in their offices, waiting for a sign from above – or from Beijing, rather. When top leaders give the word, provincial governments will officially unveil companies specifically designed to choke down bad loans from a pool of about US$3 trillion on local government balance sheets.
These so-called local asset management companies (AMCs), when established, will mirror the kind of work their central-level equivalents did 10 years ago when China’s biggest banks were struggling with bad debt: Take on tens of billions of dollars worth of toxic assets and shift the onus of responsibility from the banks that made the loans to the state that told them who to lend to.
Local AMCs will have a lot of work on their hands. A nationwide audit showed publicly in December that local governments had borrowed US$1.17 trillion since 2010. At the county level, debt increased by 77% over the three-year period. Economists have pointed out that poorer areas of China remain at risk of default. Guizhou, one of China’s poorest provinces, had a debt-to-GDP ratio of about 79%. Inner Mongolia province has been late on more than one in four of its loan payments.
The asset quality of local government loans and the relatively high rate of unpaid loans could be the biggest worry – and potentially the rallying call for a new class of asset management firms to sweep the provinces.
No final decision has yet been made on the AMCs, however. In May 2012, long before China’s local debt problem came to the forefront, China Banking Regulatory Commission (CBRC) and the Ministry of Finance issued a notice to provincial governments that told them to set up AMCs. At the end of last year, CBRC set a minimum capital requirement of US$605 million (RMB1 billion) for individual AMCs and now several provinces are preparing the cash, Caixin Online, an independent Chinese news website, reported in January.
These instructions to regional leaders have not been made public. Rumors that an AMC in Zhejiang province, one of the most heavily indebted areas, circulated last year then fell out of sight. Some insiders that spoke to China Economic Review said all provincial-level governments are in the process of establishing the companies now, but are waiting for the final cue from Beijing. Liao Qiang, a bank analyst at Standard & Poor’s in Beijing, said local AMCs were “not a rumor.”
Roll over, play dead
China isn’t engulfed in a local debt crisis – at least not yet. But local governments must continue spending on old and new projects while servicing their debt. So far, Beijing has only scratched the surface in dealing with outstanding liabilities and the debt that is still to come. AMCs could quickly become a necessity.
China’s provinces are a powerhouse for growth. The large-scale public works projects that local governments build help usher rural dwellers into cities and make a crucial contribution to the country’s overall GDP figures.
At the same time, local governments struggle to finance this growth. Since 1994, a budget law has barred them from borrowing directly from banks. So they have struck it out on their own, forging often-creative means of funding, but mostly with land sales and off-balance-sheet borrowing through local government financing vehicles (LGFVs). By some counts, up to 60% of non-performing loans at the local level are connected to land transactions and LGFVs; the two are closely connected (See box on left).
Beijing can’t simply step on the borrowing breaks in the provinces. While central leaders have reduced their expectation for provincial growth, and governors have posted lower targets for this year than in the past, the spending must continue regardless of an emerging debt crisis.
“For most of these projects, because they have already started construction, there’s no option to slow it down or completely stop it. In most cases they have to continue attracting investment. That’s the first part,” said Li Yan, a senior sub-sovereign ratings analyst at CCXI, one of China’s biggest rating agencies. “The second part is finding financing to pay off old loans.”
The central government allowed local governments to start rolling over loans earlier this year. Total local overdue debt at the end of June last year was US$187 billion (RMB1.15 trillion), or an overdue ratio of 10.7%, according to figures reported by the National Audit Office in late December.
As local governments roll over these loans, borrowing will not noticeably slow down, Li said, even in the face of a higher cost of lending.
China’s interbank rates have risen sharply since June last year. That has increased the financial pressure on local governments that will pay higher rates to roll over loans than they did on the original loans. LGFVs “continue to operate under soft budget constraints and thus are not very sensitive to interest rates changes,” Wang Tao, China economist at UBS, said in a report in February.
Introducing asset management companies at the provincial level is bound to raise eyebrows among those familiar with China’s central-level AMCs, one of which listed in Hong Kong late last year.
In 1999, the central government set up four asset management companies to take over a wave of debt at some of the country’s biggest banks. In the first years of operation, the companies answered directly to the ministry of commerce and the banking regulator, earning them a reputation as powerful “policy companies,” as opposed to policy banks such as China Development Bank.
The companies issue bonds and use the proceeds to buy bad debt from banks. Once in control of the assets, they restructure them, often efficiently. The AMCs break apart some of the assets, usually struggling state firms, and sell the pieces to other companies. They also liquidate the assets if they can’t be salvaged.
The central government’s plan was to dismantle the four AMCs – Cinda, Huarong, Great Wall and Orient – 10 years after taking on the original wave of bad assets. That didn’t happen. Instead, the big four have been commercialized. Their tight connections to policymakers have earned them licenses to conduct business across the board in insurance, wealth management and financial leasing, as well as broking of trusts, futures and real estate.
In December, Cinda went public in Hong Kong with an IPO worth US$2.5 billion, the second biggest on the Hong Kong Stock Exchange in 2013. The listing received orders worth US$65 billion, perhaps demonstrating investors’ willingness to bet against the financial soundness of China’s state banks.
The longevity of the central government’s AMCs is likely one of the factors holding back an official announcement on the local ones. That is to say, local government debt is big business for anyone that deals in bad assets, and the influential big four would prefer to do the work themselves.
“I think the existing four asset management companies did not like the idea, because they think [local governments] are taking their business,” said Oliver Rui, a professor of finance at China European International Business School (CEIBS) in Shanghai. “So that’s why even though the original notice was issued in 2012, to my knowledge there hasn’t been any establishment of local AMCs yet.”
Provincial authorities might make a good case for having control of their own AMCs instead of handing the business over to the big boys.
After 10 years, companies such as Cinda know this niche but lucrative industry well. Yet their experience has been with big banks and the central-level assets to which those institutions lent. Although provincial leaders may not have that same
expertise, they have a better understanding of operations on the ground in their region, Rui said. That understanding will be valuable to local AMCs when taking over assets and trying to restructure them in the local economy.
Granting provincial cadres control over AMCs is one way to commit local governments to solving their debt woes, Li Yan at CCXI said.
“If they establish asset management companies to specifically address local debt, they should be able to de-package and clarify the nature of the debt, the source of insolvency and how to recover the debt, as well as better controlling the risks,” Li said.
But that comes with its own risks, too. For one, markets could view the move as a sign that the local debt problem is worse than it was reported by the National Audit Office.
“Sentimentally, I suspect it will not be good as the market will view this as a recognition that [non-performing loans] are indeed much greater than reported publicly,” said Junheng Li, head of research at New York-based JL Warren Capital. Junheng Li pointed out that the first objective of local AMCs wouldn’t necessarily be to solve the debt problem but rather to recapitalize local banks – just as the central AMCs did with China’s major lenders to prepare them for public listings.
Perhaps another reason the central government has thus far refrained from giving the final public nod to local AMCs is the dangerous message it will send to local banks.
When AMCs take over bad assets from state-backed banks, the responsibility for those assets is transferred onto government shoulders. Provincial authorities are already culpable for the balance sheets of the state lenders in their regions. After all, for years leaders have pressured banks to open up lines of credit for projects that the financial institutions would likely deem unprofitable if they were able to make a purely commercial evaluation. Bringing in AMCs to clean things up is implicit recognition that governments got the banks into the mess in the first place.
But it would also send a precarious signal that, after years of risky lending, local state banks still won’t be held responsible for their practices. If the government takes the blame this time around, there’s little reason to trust that lending practices will improve and that China can avoid local debt crises in the future.
“Once they give the green light, it kind of encourages local commercial banks to be less responsible for their decisions,” said Rui at CEIBS. “They’ll think ‘the government will take care of me even if I make bad decisions.’ I don’t think the central government wants to send this kind of signal.”