Concern is growing that the country's investment-driven, credit-dependent growth model is crumbling
For three months, most China watchers expected the worst.
In October last year, the new Chinese leadership was set to reveal the long-awaited results of its most extensive audit of surging local government debt. But Beijing was ominously silent after reviewing the report of the National Audit Office (NAO).
This delay led to local media raising the spectre of an imminent debt crisis. The fear was that local governments had been discovered to have overdosed on debt, were too cash-strapped to repay it, and were too hooked on easy credit to wean themselves off.
This would destabilise the slowing Chinese economy – which had relied heavily on state investment sprees for its rebound last year – as well as the fragile global recovery since the 2008 financial crisis.
Speculation was rife that Beijing, having learnt for the first time how crippling the credit addiction had become, feared letting the truth out would hit investor confidence, drive up interest rates as lenders no longer dared to roll over credit, and trigger defaults.
As the Caixin financial magazine put it: “Suspicion had mounted about how horrible the figures were, considering it took so long for the government to publish them.”
Former Chinese finance minister Xiang Huaicheng and JP Morgan economist Zhu Haibin reckoned local government debt came up to 20 trillion yuan (Bt108.7 billion) – roughly double the amount in 2010.
Standard Chartered economists had an even more drastic estimate: about 24 trillion yuan.
Finally, on December 30, the NAO released the report, based on the findings of 544,000 auditors.
It turned out that local governments were in the red by 17.9 trillion yuan. Combined with central government debt, the total figure was 30.3 trillion yuan.
After all the hand-wringing, the total debt – at 53 per cent of gross domestic product (GDP) – did not seem so bad. While it dwarfs the United States’ 18 per cent, it is still lower than Brazil’s 60 per cent level and the 90-plus per cent in some European countries.
So there appeared no immediate danger of a debt crisis. In fact, the debt levels “were still manageable”, said Moody’s analyst Thomas Byrne. Local governments’ capability to pay the debt off would be enhanced if China’s annual GDP growth remained around 7 per cent over the next five years, he added.
This growth pace – believed to be Beijing’s new baseline to ensure enough job creation and social stability – would provide local governments with income to repay, or at least roll over, their bank borrowings, avoiding a default.
But digging deeper into the figures throws up some disturbing findings.
It is not the amount of debt, but the growth trends in local government debt that are worrying. Analysts say debt levels are rising at a pace that is drastic and unsustainable.
In 2010, local government debt was 10.7 trillion yuan. By mid-2013, it had surged 67 per cent to 17.9 trillion yuan.
In some provincial capitals like Shijiazhuang, debt levels were as high as 220 per cent of annual revenue.
Local governments have also been forced to borrow with increasingly short tenures, at higher interest rates. “A little more than half of the debt will mature within the next one, two or three years,” said Byrne.
This contrasts with US municipal debt that is typically five or 10 years in length.
What is more worrying is that much of the funds have reportedly gone into projects that boost GDP rates but are low-yielding or even loss-making. These include White House-style official buildings and shoddy highways.
The peak of this investment spree was during the financial crisis, according to Peking University’s Professor Lin Shuanglin, who estimated that the local governments’ credit grew 62 per cent in 2009 alone.
Feeding the addiction
But the borrowing spree continued, even after the economy stabilised and Beijing sought to ban local governments from borrowing directly from banks in order to curb debt.
In October last year, western Sichuan province announced a 4-trillion-yuan local stimulus package equal to 179 per cent of its 2012 GDP. It is believed to be largely funded by loans.
Such borrowing is compounded by what Peking University’s HSBC Business School professor Christopher Balding calls “backdoor debt”.
“Due to their constraints, they are pushing the investment onto corporate balance sheets and special purpose vehicles,” he said.
To evade Beijing’s ban, local governments have set up an estimated 10,000-plus financing vehicles to raise loans.
In 2010, the central government tried to close this loophole by instructing banks to cut lending to these vehicles.
This led the financing vehicles to tap the shadow banking industry, which includes trusts, underground lenders and banks’ off-balance sheet lending activities. That was not enough to feed the addiction. So local governments tapped other sources, from issuing IOUs to having state-owned enterprises borrow on their behalf.
All this debt is unlikely to be captured fully by the audit numbers, which showed that local government debt climbed 13 per cent – likely to be an underestimate – in the first half of last year.
Yet even this 13 per cent pace is viewed by UOB economist Suan Teck Kin as “clearly unsustainable”, especially as growth starts to moderate and China moves towards more market-oriented interest rates.
So far, the growing mountain of debt has not forced any local government into bankruptcy – at least, none that has been made public.
But analysts worry about what may happen if growth drops below 7 per cent, and President Xi Jinping proves more aggressive in pushing reforms that expose local governments to market forces, as he pledged to do at the Communist Party’s policy summit in November last year.
This year, Xi is expected to scale back local governments’ investment binges and their state monopolies, cool the property market and slash overcapacity in industries like steel and coal.
All this could shrink local governments’ traditional income sources – particularly land sales – while potentially slowing economic growth, which is tipped to fall to a 24-year low of 7.4 per cent this year.
Meanwhile, local governments’ costs of borrowing could climb if interest rates are liberalised. This is because the market will charge higher prices to compensate for the rising risks.
The local governments’ switch from bank credit to shadow banking loans – which have even shorter maturities – is like “drinking poison to quench thirst”, as government think-tank researcher Yuan Gangming put it. This is highly risky because it exacerbates the mismatch between the short loan tenures and the longer pay-back periods of government projects.
While major insolvency has not surfaced, there are signs local governments are starting to choke.
The NAO said last year that over 10 per cent of debt owed by two unnamed provincial capitals in late 2012 was in default. StanChart economists put the chances of default this year at over 50 per cent.
There have already been some small crises which signal that China’s investment-driven, credit-dependent growth model is crumbling, argued Silvercrest Asset Management managing director Patrick Chovanec.
China suffered two liquidity crunches in June and December last year. Interest rates in the vital interbank lending market surged above 10 per cent, as China’s bad debts ballooned and sucked up new capital because they were being rolled over rather than written off. The authorities egged this addiction on by injecting just enough extra liquidity to bail out the banks.
To be fair, Beijing has taken steps to rein in local debt. It has added debt management as a performance criterion for local officials and paved the way for local governments to issue bonds to boost their incomes so they can repay loans.
At a key central economic work conference late last year, Xi made controlling debt risks a key priority this year.
One step is creating asset management firms, each with at least 1 billion yuan in capital, to clean up toxic debt held by banks and local government special vehicles.
But he will need more drastic moves to force local governments to go cold turkey. This could include removing banks’ incentives to create more local government debt, which carries a much lower risk weighting than other types of loans.
However, Beijing does not seem ready for that yet. Its focus for now will be on controlling the future debt flow, “instead of resolving or cleaning up the stock of local government debt soon”, noted UBS economist Wang Tao.
Still, there is a widespread expectation that Xi will not let any major bankruptcies happen that might derail the economy – especially during his first five-year term till 2017.
The problem, though, is that inaction today on local debt growth can fuel a full-fledged financial crisis in the national economy tomorrow.