How to fix local government finance

It is a question of balance: the brake must be applied to prevent overheating, but apply it too strongly and there is a risk of revisiting the downturn of a year ago. This is the central government’s dilemma over property prices, but it is replicated elsewhere with all the same complexity and significance: local government finance.

If the State Council fails to clean up the unqualified projects and recoup uncollateralized loans accumulated by local governments over the last year, the banking system would be left crippled – perhaps even more so than by the property bubble bursting.

While monetary policy remains relatively loose, this year there has been a broad policy shift towards tightening in the face of rising inflation and rocketing asset prices. One focus of the campaign is to temper the pace of investment in local infrastructure projects as jitters mount about waste and sour debt.

Chinese provinces, autonomous regions and municipalities are banned from incurring debt directly through issuing local bonds. Amid last year’s economic turmoil, the Ministry of Finance sold US$29 billion of special debt on behalf of local governments, the first such issuance in a decade since the Asian financial crisis.

In addition, local governments of all levels have set up more than 3,800 fund-raising units nationwide and borrowed heavily through them. About 40% of the US$1.4 trillion in new loans last year reportedly went to these platforms. At least 10% of them didn’t have proper collateral.

Should the central government remove these fundraising platforms, local economies would struggle to maintain their fast, investment-powered growth. But excessive loan extension without proper oversight would reduce credit liquidity and damage to the national economy.

The central bank and the banking regulator have recently issued direct warnings to provincial governors about the risks of local fund-raising units. Whether they heed these warnings is a different matter: governors will be extremely reluctant to close down any projects that are under construction or operation.

Traditionally, Chinese banks have been willing lenders to local governments. The amounts were large, the maturities long and the default ratios low. Even in the absence of sufficient collateral local governments were regarded as quality clients.

It’s unlikely that local governments will face insolvency in the near term amid the country’s robust economic rebound. However, if external demand dwindles and domestic inflation continues to pick up, a slowdown in economic expansion might hinder credit repayment to banks in the long haul. A drop in housing prices would only add to the pressure as local governments rely heavily on land sales for fiscal revenue and often use land as loan collateral.

There are several measures that can be taken to help to avert the potential crisis.

First, it’s important that the central government obtains a clear picture of local authorities’ capital needs in order to set up a system that evaluates the feasibility of investment projects and debt risks. This can only work if local governments provide complete information on the projects for regulatory review. The scales of their debt should be in line with their fiscal strength and overall economic growth.

Second, for loans without collateral, the main targets under the clean-up program, should be returned unless local governments are willing to infuse quality assets such as land and stakes in profitable state-owned enterprises into the debt-carrying projects.

Third, the different fundraising units of local governments should be assessed on a case-by-case basis. For projects backed by strong fiscal revenue and with a low debt ratio, financing should be awarded based on commercial merit. In coastal cities, for example, priority should be given to projects that can improve the overall commercial environment and potentially increase local incomes.

The long-term solution to over-borrowing is the development of a bond market to which local governments have direct access and where attempts to issue debt for project funding would be judged on their commercial merits.

So far, in addition to the special bonds arranged by the Ministry of Commerce, the National Development and Reform Commission has helped local governments raise capital for construction via so-called local infrastructure bonds. Issuance of these bonds surged to more than US$29 billion in 2009 from US$5.9 billion in 2008. Growth is expected to moderate this year.

The creation of a more substantive market for local government bonds is a long-term mission. It requires the a reliable credit ratings system as well as sufficient central government oversight to ensure that capital is used as planned.

Bond issuance is one way that China can encourage greater participation by private investors in sustaining the economic recovery. This kind of reform has long been on the central government’s wish list, but it was pushed down the priority list when the stimulus package was launched last year. Now would be a good time to revive it.