<$BlogRSDUrl$>

Wednesday, February 10, 2010

Looming Problem of Local Debt in China-- 1.6 Trillion Dollar and Rising

Did China accomplish the impossible? Did it generate almost 9% growth and maintain low debt to GDP ratio even as its export plummeted by 20%? What about claims that the torrent of investment in China has come without too much leveraging? After spending half a year looking into the debt level of local government investment entities-- some 8000 of them-- my conclusion is no. As in the past, the Chinese government just ordered banks to lend to investment companies set up by both central and local governments. Local governments have fully taken advantage of the green light in late 2008 and borrowed an enormous sums from banks and bond investors starting in late 2008 (well, a large amount even before that). In an editorial in the Asian Wall Street Journal yesterday, I outline some problems with this massive amount of borrowing:

Beijing is no longer sure how much money local investment entities have borrowed from banks and raised from bond and equity investors. The amount, however, must be large. In September, the Chinese press, citing government sources, suggested that these entities have borrowed $880 billion (6 trillion yuan). In a January interview with the Twentieth Century Business Herald, a Chinese newspaper, the vice chairman of the Finance and Economic Committee of the National People's Congress, Yi Zhongliu, revealed that local investment entities borrowed some $735 billion in 2009 alone.

These are mere guesses, however. A National Audit Agency audit conducted late last year uncovered so many problems with the data that Premier Wen Jiabao ordered another large-scale audit of local investment entities. Until a thorough audit is completed and the results announced to the public, no one really knows the total scale of local borrowing.


Given the information vacuum surrounding this issue, I spent half a year collecting data that would allow me to provide an estimate of total local debt (and also for each of China's provinces). Again, in the WSJ piece, I briefly outline my methodology and the results in the piece.

To obtain an independent estimate, I collected data from thousands of sources, including regulatory filings, bond-rating reports and press releases of government-bank cooperative agreements. I estimate local investment entities' borrowing between 2004 and the end of 2009 totals some $1.6 trillion. The data are far from perfect because borrowing by low-level government entities and lending by small banks are difficult to track. Nonetheless, my evidence suggests that the scale of the problem is much larger than previous government estimates. At $1.6 trillion, the size of local debt is roughly one-third of China's 2009 GDP and 70% of its foreign-exchange reserves.


So basically, in addition to the 20% of official debt-to-GDP ratio, one has to add an additional 30%. We also have to add other debt that the central government guarantees, such as the nearly 1 trillion RMB in Ministry of Railway bonds and bonds issued by the asset management companies. All of this gives China a high debt to GDP ratio. Also, there are some disturbing implications of this high debt. For one, local governments would have to sell lots and lots of land every year for many years to come to pay interest payment on this debt. Thus, to the extent that there is a real estate bubble today, it must continue for local governments to remain solvent. Regardless of what you believe about Chinese real estate, you have to think that this growth in real estate and land prices must slow or reverse at some point.

I think that the best course of action for the Chinese government is to credibly stop leveraging by local investment companies. Instead of the half measures in place today, a public and stern order should be given to banks to stop lending to all new projects undertaken by these local entities. Other measures should follow:

Since county governments are in the poorest fiscal shape and have the least ability to repay banks, the central government should take over the debt of almost all of the county-level investment vehicles. Although this will increase China's debt-to-GDP ratio significantly, the total would still be low by international standards.

A sudden contraction of lending to local investment vehicles will generate a wave of nonperforming loans, but a greater reliance on market mechanisms can easily solve this problem over the next few years. First, banks will fully recover the debt of the healthiest local entities, which may account for half of total local debt. For the remainder, the government needs to allow banks to directly sell subprime or distressed loans to both foreign and domestic investors. Beijing need not fear that China's listed banks will sell their nonperforming loans at below-market prices, as these banks report to shareholders. Banks, in conjunction with investment banks and distressed-asset investors, should also explore ways to securitize local debt for sale to both domestic and international investors. The latter in particular would have a healthy appetite for yuan-denominated security, anticipating a currency revaluation soon.

Basically, I think the Chinese government can turn this into a great opportunity for market reform in the financial system and the internationalization of the RMB. However, it has to act soon before local debt gets too large to handle.

Comments:
Hi Victor,


I'd like to first thank you for putting this together. For some time, I've been very puzzled by the question who is over leveraged in China? Thank for clarifying this.

I have the following questions.

1. Can you share some insight into the distribution of maturity dates of the local government debt (perhaps a chart of debt volume and maturity date)? If most debts are of a long term nature than the potential problem is some what lessened. After all, the best and most affective way to deal with high debt to gdp is to grow gdp rapidly. At China's annual 10% gdp growth rate a lot of debt problems can potentially be grow out of in a few years. On the other hand, if these debt are of a short term nature, than the none performing loan issue for Chinese banks will be a big issue.

By the way, I completely agree with you that China need to reform the financial system and the internationalization of RMB. My comment for the potential of growing out of the debt problem doesn't change that.


2. What are the local governments doing with the debt? 30% of GDP is a lot of money for the local government to take on. It can't just be for the normal operation of the local government. Can you perhaps shed some light on the usage categories of all that money?


3. What is the driver for the demand for residential housing? I understand the incentive for local government to keep the housing bubble going from the supply side. However, local government cannot force people to buy houses. Home ownership in China is already above 80%. Unlike the US, there is no subprime mortgage to attract new marginal buyers of limited means. What is driving up the demand for housing?



I will need sometime to digest this piece and should have more questions. Thank you again for sharing.
 
You are right that these tend to be long-term loans, but calculate the interest payment on 1.6 trillion dollar and compare that with annual local government income. It's not pretty.
 
Hi Victor,

Thank you for putting this together. I have been looking for this sort of data and it is not easy to come by.

I am much obliged to you.

Best wishes
Ben
 
Don't trust the Wall Street Journal!

""""""""
A sudden contraction of lending to local investment vehicles will generate a wave of nonperforming loans, but a greater reliance on market mechanisms can easily solve this problem over the next few years. First, banks will fully recover the debt of the healthiest local entities, which may account for half of total local debt. For the remainder, the government needs to allow banks to directly sell subprime or distressed loans to both foreign and domestic investors. Beijing need not fear that China's listed banks will sell their nonperforming loans at below-market prices, as these banks report to shareholders. Banks, in conjunction with investment banks and distressed-asset investors, should also explore ways to securitize local debt for sale to both domestic and international investors. The latter in particular would have a healthy appetite for yuan-denominated security, anticipating a currency revaluation soon.

"""""""""""
A wave of defaults on bad loans will NOT be solved by market mechanisms. More than a few bad loans will render the entirety of the lending universe suspect and credit will freeze. This was demonstrated by mortgage derivatives blowing up two years ago.

That the WSJ would suggest credit derivatives for "overseas sales" is simply insane. It's bad enough that Wall Street itself is running a bucket shop. the world does not need another one.

That the overseas investors would have a "healthy appetite" for suspect Chinese- risk is just flat out wrong. A loss is a loss in any currency. The suggestion that the Yuan will appreciate is also flat out wrong. The yuan is pegged to the now super- hard dollar. The buck is hard because the Saudis have pegged dollars to crude oil.

Oil prices and dollars are bound together in a deathly spiral of deflation. As crude prices decline, the dollar becomes even harder. Good for Saudia, bad for everyone else.

As a consequence of the crude/dollar peg, the various short- dollar- and dollar carry trades are coming apart at the seams.

China is frantic to decouple from the dollar otherwise it will be importing massive USA deflation and kill off its export business at the same time. China has to flood the country with cash and just recently announced raises for Chinese workers.

China has a lot of bad loans, that's the only part of the WSJ's article I can agree with.
 
Hi Victor,


I really like to get a sense of how long the local government can sustain the current debt situation.

Any idea on what the local governments are doing with so much debt?

What is the average return on investment are the local government getting?
 
Professor Shih,


Is it possible there are double counting of debt in your analysis of local government debt? Let me elaborate.

I suspect local bureaucrats are forming local business to share in on the central government's largesse for infrasturcture building. These businesses will most likely need to front a lot of the cost of new infrastructure building.

In this scenario, is it possible for both the local and central government to show debt for the same infrastucture project? In this case, the loans the local business take on are ultimately backed by and accounted for by the central government. However, both local and central governments have debt entries on their book.

One thing should always be true. Even local bureaucrats are motivated by profit. I would not be surprise if local bureaucrats don't care about the economic utility of a particular infrasturcture project. However, I would be very surprised if many of these bureaucrats will take out so much debt for business ventures (the bureaucrats most likely have controlling stake) without knowing if someone else, the central government in particular, will ultimately pay.

Thank you for taking the time out in your busy schedule to share your thoughts.
 
Beijing need not fear that China's listed banks will sell their nonperforming loans at below-market prices, as these banks report to shareholders.
 
Post a Comment

This page is powered by Blogger. Isn't yours?