China’s local-government debt bomb is a curious piece of financial ordinance. Whether it explodes or, as is far more likely, gets defused, it may end up both costing the central government dearly and blowing up how China’s local government is financed and organized.
A newly published audit by the country’s state auditor puts China’s debt-to-GDP ratio at 58%. By international standards that is a modest number. It is nowhere near the red zone where a country’s sovereign indebtedness starts to retard growth. A debt implosion along the lines of a Greece or Cyprus is widely seen to be highly unlikely. Yet China’s authorities regard government debt as one of the biggest risks to their country’s economy in the medium term and have put addressing it high on their list of economic policy priorities.
The cause for concern is that three-fifths of it is local-government debt. The National Audit Office says local governments’ outstanding debt at the end of June 2013 was 17.9 trillion yuan ($2.95 trillion), including contingent liabilities and debt guarantees. Some private estimates put the number as high as 25 trillion yuan. But even the official figure is still two-thirds higher than it was at the end of 2010, the previous time the state auditor tallied the numbers.
Much of this debt was taken on by provincial and municipal governments in the wake of the 2008 global financial crisis to fund stimulative infrastructure projects. Central government mandated the spending but did not change a system whereby local governments are responsible for the majority of social spending without receiving a commensurate share of tax revenues. Local governments frequently resorted to setting up captive commercial investment companies to take the bank borrowing to cover the gap off-balance sheet. Many of these investments are now not generating sufficient returns to pay operating and interest costs or to repay the loans taken on.
Two-thirds of China’s local-government debt is financed by loans from banks. The U.S. rating agency Moody’s said earlier this year that 53% of all municipal construction companies needed to restructure their loans. As much as a fifth of new borrowing is going to paying off old loans. That underlines the extent to which the banks are at risk of rising levels of non-performing loans. The smaller (and weaker) regional and local banks are most vulnerable, though both the large state-owned banks and the shadow banking system have lent to local governments.
Were matters to go badly awry, either the big state-owned banks would have to bail out the small and shadow banks, or provincial and state governments would be left to hold the can. Either way, the can would ultimately end up in Beijing.
Since the initial audit, central government has reined in new borrowing by local authorities, gotten state-owned banks to impose tighter lending standards, and started to expand municipal-bond issuance as an alternative to borrowing and land sales as sources of local-government revenue. The National Development and Reform Commission, China’s top economic planning agency, has now even said that some special investment vehicles will be allowed to issue bonds to replace high-interest bearing debt, a huge jump in the hitherto cautious progress towards a muni-bond market and a sign of how severe it regards the stress on the financial system to be.
At the same time central government has been writing off the worst of the loans that have gone sour and getting banks to reschedule others in order to avoid any embarrassing failures. Next is to be a hurrying-up of fiscal reform, one of the priorities of November’s Party Plenum setting China’s economic reform agenda.
This will reform local-government governance as well as its finances. In addition to introducing new local taxes on personal income, real estate and resources, and better balancing the responsibilities of taxation and spending between local and central governments, the reform plans propose eliminating extra-budgetary funds, making all local government budgets transparent, and exposing many more provincial and municipal officials to the discipline of the marketplace as the municipal-bond market expands. It will also limit the opportunities for local officials to dip their hands in the honeypot of local public monies.
None of all that will prove particularly comfortable for local officials used, as the old Chinese proverb puts it, to the mountains being high and the emperor far away — especially since these same officials are already feeling the heat of President Xi Jinping’s anti-corruption campaign. But the mountain of debt is forcing the modern emperor to pay close attention. Just as China last introduced radical fiscal reform in 1994 when local-government finances were in disarray, so the steady ticking of the local-government debt bomb is forcing it to do so again.