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Is China at Risk of a Debt Crisis?
Is China at Risk of a Debt Crisis? China’s economy is showing clear signs of improvement as policy easing starts to feed through the economy: GDP growth increased in Q2, PMI data continues to improve and credit is easing.
Local government debt has been highlighted as one of the economy’s key vulnerabilities. The large absolute size and growth of local government debt together with the opacity of its financing has been highlighted as one of the key risks to China’s economy.
In this edition of the China Macro Monitor we analyse China’s government debt situation, roll-over risks and medium-term financing solutions. We find that while the growth rate and some of the financing methods are of concern, when the debts of the central government and local governments are combined they do not appear to be oversized relative to other countries or to pose a near-term systemic risk to the economy. Even when we add China’s government debt to private sector debt, China’s total indebtedness seems moderate relative to other countries (see chart below).
Near-term risks are low, but moves to increase transparency and controls through the development of municipal debt markets are necessary and likely. The central government now recognises that current restrictions on local government financing have led to a lack of transparency and unnecessary complexity. The central government has already started raising bond finance on behalf of some local governments and we believe that this pilot scheme will eventually pave the way for the development of a municipal bond market.
ASSESSING CHINA’S LOCAL DEBT CONDITIONS
The central government’s crackdown on corruption led to a pull-back in local government investment in Q1 2014 in fear of being accused of indulging in excess. However, Premier Li Keqiang recently lambasted this behaviour and we have already started to see a reversal of cut-backs1. In the second half of this year we expect local governments to step-up policy implementation which will require funding. While some analysts fear debt-financed growth, we believe that leverage, especially in the government sector in China is sufficiently low enough to accommodate more debt. However, we believe that lack of transparency is a key issue and could inhibit confidence in China. Local government financing will likely be an area of reform in coming years. In this China Macro Monitor we assess the current level of indebtedness and explain how local governments finance themselves.
How local governments finance themselves
In contrast to most countries, local government debt in China is larger than central government debt2. Most of the debt is used to finance off-budget spending. Local government reliance on off-budget spending is related to the fiscal reform in 1994 when the central government’s share of fiscal revenue increased from less than 30% to around 50% in 20123. There were no corresponding changes made to expenditure assignments and local governments were saddled with the same if not more spending obligations but less access to tax revenue. According to the IMF, local governments are responsible for a large part of infrastructure spending, service delivery and social spending. Together that accounts for 85% of total expenditure. Because local governments have little flexibility on tax rates and policy they are reliant on transfers from the central government, which only cover current spending. For everything else, including the long term infrastructure spending, local governments need to rely on borrowing.
However, local governments are technically prohibited from borrowing directly. To get around this problem, local governments have taken to off-budget mechanisms to raise finance. Local Government Financing Vehicles (LGFV) are companies set up by local governments that borrow from banks, trust companies and the bond market. They are usually set up for the sole purpose of infrastructure spending. This system of financing is often compared to public private partnerships used in both developed and emerging markets. However, the “private” here refers to the LGFV. While these companies may generate some revenue streams (e.g. toll charges, utility rights etc.) they are usually insufficient to cover debt repayments, requiring the local government to use its own revenue to make debt payments.
National Audit Office recognises debt obligations
In December 2013 the Chinese National Audit Office (CNAO) published for the first time a full audit of the nation’s government debt4. They identified how much of the debt is in LGFVs and specified whether the debt is a direct obligation, guaranteed or another contingent liability. This audit is likely to be a work-progress with potential revisions to come. Most of the debts are classed as direct obligations and given the nature of the Chinese market, with very little history of default, we are inclined to classify all the debts for which the government has guaranteed or is partially liable for under the CNAO definition as debts that the government bears full responsibility for.
Despite being prohibited from borrowing since 1994, the audit has identified local government borrowing not only through LGFVs, but more directly through government agencies and other public institutions. The audit also included the debts of state-owned enterprises and other self-supporting enterprises that may not be included in the general government statistics for other countries5. That could leave the figures for China looking comparatively high.
Banks play a central role in local government financing
Bank loans are the main source of financing for LGFVs, providing 57% of local government debt. Trust companies which are also regulated by the same entity that oversee banks, the China Banking Regulatory Commission (CBRC), provide about 8% of the debt financing. Bond financing provides another 10%. Build and transfer (BT) is a form of project finance where a company builds and operates an infrastructure project and eventually transfers it over to the government. BT accounts for another 8% of debt obligations.
Ministry of Finance assisted bond issuance pilot: a precursor to a municipal bond market
The central government has recognised that local governments have debt financing needs and the charade of off-budget financing is untenable in the long-term. With transparency a central tenet of well-functioning debt markets the current system will need further reform. While the full development of a municipal bond market is some way off, the Ministry of Finance has been issuing bonds on behalf of some local governments and some local governments are able to issue bonds within a quota. A total of 10 local governments can issue bonds with Beijing, Jiangxi, Ningxia and Qingdao being added to the list in June.
Eventually we expect the government to bring in the necessary reform to allow local governments to raise bond finance more directly through something akin to the municipal bond market in the US. The pilot scheme with these 10 local governments is therefore an important precursor to further liberalisation and better oversight of local government financing.
Local government’s role in achieving targets reaffirmed
We believe that until this precarious system of financing is fully reformed local governments will shy away from long-term planning in fear of being caught up in the central government’s clamp-down on corruption.
The CNAO in a recent update claimed that growth in local government debt slowed in the second half of 2013 to 3.8%, down 7% from the first half of the year. We expect debt-financed local government spending continued to slow into the first part of 2014 before the central government reaffirmed the role of local governments in reaching its targets.
Premier Li Keqiang pressed local leaders in June to help the economy achieve its annual growth target. Li reminded local leaders of their “inescapable responsibility” to achieve this year’s economic targets and stressed that “no delay in action is allowed”.
Local government debt likely to rise
In light of the push to meet its annual growth targets we are likely to see local government debt financing grow. We acknowledge that rising leverage has its risks, but for now China’s government debt is quite moderate6. Indeed China’s government debt is significantly below other countries’ where debts are considered to be excessive. At the same time China’s economic growth is considerably higher than most countries with comparable or higher levels of debt.
Refinancing alone will account for a large part of future debt issuance
Most local government debt is relatively short-dated with approximately 40% of all outstanding debt maturing in 2014 and 2015. Refinancing existing loans is likely to account for a large part of financing needs over the next year.
Financing activity picks up sharply
In the month of June aggregate financing grew by 40% m-o-m, 90% y-o-y, in part aided by the message from the central government to local governments to stop procrastinating (as well as the general higher appetite for borrowing from households and corporates).
Economy continues to respond positively to stimulus
Q2 2014 GDP growth surpassed consensus forecasts, rising to 7.5% q-o-q annualised (7.4% in Q1 2014) in a sign that stimulus is having a direct impact on the economy. Industrial production, manufacturing PMIs and retail sales all grew at a faster pace in June than in May. Early July data indicates this has continued into the second half of the year.
The recovery path is unlikely to be incident-free. Given the central government’s focus on making sure the market is pricing risk appropriately, it is conceivable that it will let more companies default on loans to combat investor complacency and reduce moral hazard in the system. However, growth targets take priority and the government will do all in its power to ensure selective defaults do not become a systemic problem.
Investor sentiment continues to improve
With economic data becoming increasingly positive, investor sentiment has improved and China equities have started to perform. The China A share market (as measured by the MSCI China A Index) is currently trading around 9.5 times prospective earnings (11.1 times trailing earnings), making it one of the cheapest markets in the world. With H1 policy stimulus starting to take hold and further stimulus planned in the coming months, we anticipate local and foreign investor sentiment will continue to improve and push local equities higher.
Important Information
This communication has been provided by ETF Securities (UK) Limited (”ETFS UK”) which is authorised and regulated by the United Kingdom Financial Conduct Authority (the ”FCA”).
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