In 2008, China’s central government launched its own New Deal, heavily promoting massive infrastructure development after the economic downturn. Local governments were more than happy to take up the banner. Now, they are left with shiny new plazas, towering office buildings, highways to nowhere and a lot of debt—much of it financed through questionable vehicles and backed by land assets. The topic of local debt became popular among Western observers in the summer of 2011, but has become even more salient now. As the real estate market slows, land is losing value, throwing into question the quality of many of these loans. Additionally, an upcoming power transition in the fall of 2012 has made even the most certain policies worthy of re-examination, especially when China seems to be heading down the wrong path.
Cheng Siwei, deputy head of China’s 9th National People’s Congress, noted China’s “version of the U.S. subprime crisis is the lending to local governments, which is causing defaults” (China Daily, September 17, 2011). Complex types of financial instruments, including “special purpose vehicles” and the securitization of mortgage loans, have caused problems in the United States. Similar such instruments now are being used by local Chinese governments, but China has not yet felt the effects.
What implications do local government funding instruments have for local governments, or even the central government as a whole? As the land market slips, the precarious nature of local government financing and the lack of proven alternatives may pose a real challenge to economic stability.
The Emergence of Local Government Financing Vehicles
1994 was a landmark year for local government finances. First, fiscal decentralization left local governments with more responsibilities but fewer funds, and second, local governments were forbidden from directly borrowing from banks or issuing loans. As local governments approached infrastructure development needs with limited resources, another funding method sprang up: local government financing vehicles (LGFVs) or, alternatively, local financing platforms (LFPs).
LGFVs are limited-liability companies financed by local government asset pools (composed mainly of land). Backed by these assets, these companies act as intermediaries by securing bank loans and funneling the money to local governments. LGFVs gained popularity in 2008–2009 in conjunction with the central government’s stimulus package, which called for massive infrastructure spending. During that period, the central government decided that local governments would be allowed to run fiscal deficits and that local investment companies and utilities would be allowed to issue enterprise bonds approved by the National Development Research Council. As a result of these policy changes, the National Audit Office of China estimates that by the end of 2010 there were an estimated 6,576 LGFVs .
Trust companies also have emerged as financial players. They serve as intermediaries that take bank-raised funds and transfer them to LGFVs as equity investment. This investment allows LGFVs to meet minimum capital requirements to obtain bank loans. Local governments do not have to raise money directly, benefitting smaller localities, even if banks are saddled with increased risk. Additionally, trust companies allow banks to stay within banking regulations by facilitating off-balance sheet loans. The central government has tried to curb this practice through new regulation. In November 2010, the China Banking Regulatory Commission (CBRC) issued regulations on the minimum net capital of trust companies; in 2011, it restricted the sales of trust products that invest in commercial paper; and, in January 2012, the CBRC issued further regulations (Xinhua, January 13).
So how big is local government debt? According to the National Audit Office of China, local government debt totaled 10.72 trillion yuan ($1.7 trillion) at the end of 2010. Financial analysts and media research have thrown this number into question. Moody’s estimates the local debt burden could be 3.5 trillion yuan ($554 billion) more than stated by the Audit Office (Reuters, July 5, 2011) .
In Chongqing, the debt burden is estimated to be 100 percent of gross regional product, compared to the 22 percent average nationwide (Wall Street Journal, April 23). This anomaly can be attributed to the social welfare spending of former Chongqing Party Secretary Bo Xilai, the rising star and Mao revivalist who currently is embroiled in a career-ending scandal involving accusations of wiretapping, torture and murder. Massive (and expensive) public housing projects were just one of the ways he attracted attention and public support.
Additionally, surveys by the central bank and the CBRC found that bank loans by the end of 2009 accounted for 240 percent of local government revenue. Of local government debt, debt from LGFVs was 4.97 trillion yuan ($787 billion), or 46.4 percent of the total. The danger with this is that LGFVs have a number of systemic problems. According to a November 2011 report by the National Audit Office of China, these problems include the following:
· Funds were invested “in projects that are energy-intensive, highly polluting and with excessive production capacities or with low productivity, or in overlapping projects;”
· The funds were “devoid of standardized management” and "their profit-yielding capabilities [were] weak;”
· 1,033 of the companies were guilty of “false-financing, the registered capital [not being paid in], [and] illegal provision of funds and withdrawing them by local governments and departments, involving a sum of 244.15 billion yuan [$38.7 billion]” .
Additionally, the audit found 73.2 billion yuan ($11.6 billion) of loans with improper collateral, 131.98 billion yuan ($20.9 billion) of funds not used in a “timely manner” and 46.5 billion yuan ($7.4 billion) of illegal funding guarantees (Wall Street Journal, January 4).
There are inherent characteristics of LGFVs that have made them dangerous to China’s economic system, including their credit worthiness. Banking analyst Michael Werner notes there is a mismatch between the duration of the liabilities and the return on investment, since the funds are being used for long-term infrastructure projects: “If you’re building a railroad or a highway, it takes several years and you’re not going to get direct revenues” (Bloomberg, December 18, 2011). Additionally, the asset backbone of many LGFVs is land. The Audit Office found that at the end of 2010, “the debt balances whose sources of repayment were revenues from land sales ran to 2.547351 trillion yuan ($403 billion), covering 12 provincial, 307 municipal and 1,131 county governments” .
There is significant doubt that land prices and values will be able to keep up with loan payments. Land prices and real estate values have fallen precipitously since the implementation of increased tightening measures (including restricted credit and more regulations on home purchases) in the fall of 2011. From a peak nationwide average land price per square meter of 2,307 yuan ($365) in September 2009, land prices fell to 1,384 yuan ($219) in October 2011, according to real estate agency Soufun. In the midst of the current decreases in land and real estate prices, Chinese officials have been quoted as saying that real estate prices would have to fall by a further 20 percent in order to be reasonable, and all signs point to a continuance of central government tightening measures. Stephen Green of Standard Chartered stated: “It’s a huge myth that land sales are going to be able to even support the interest payments let alone the principal payments,” noting that at least four to six trillion yuan ($633–950 billion) of local government loans—possibly much more—will not be repaid by the projects (Seattle Times, July 23, 2011).
Central government policies also have led to a credit crunch among developers—leading to a number of bankruptcies—which will have a further downward impact on land prices. At the same time, debt continues to come due. According to the head of the CBRC, Shang Fulin, 35 percent of the current debt of LGFVs will come due in the next three years (Dow Jones, March 18). In response, LGFVs have been servicing debt by taking on more loans. In 2009, a major investment company in Wuhan borrowed $230 million and used almost a third to repay bank loans (New York Times, July 6, 2011). According to the Audit Office report, in 2011, 358 LGFVs repaid existing debts by acquiring new debt, to the tune of almost 106 billion yuan ($16.8 billion) .
The outstanding levels of debt certainly have consequences for the nation’s banks, primarily in the form of non-performing loans (NPLs). Banks are involved heavily in LGFVs. The CBRC noted that 17 percent of total bank lending in 2009 went to LGFVs for a total of 7.4 trillion yuan ($1.2 trillion). By the end of 2010, bank lending to LGFVs accounted for 9.1 trillion yuan ($1.4 trillion) . This also may be only the tip of the iceberg. In December 2011, Bloomberg did an extensive study on LGFV loans and found that the debt of just 231 LGFVs (out of a total of 6,576 LGFVs) comprised more than 75 percent of the total debt load reported by the National Audit Office. This indicates there are most likely vast sums not accounted for in the NAO’s official figures (Bloomberg, December 18, 2011).
It is difficult to gauge the impact of local government debt on banks. In March, China Development Bank Corporation Vice President Wang Yongsheng reported that “almost none” of the bank’s loans to LGFV had gone bad. Additionally, Yang Kaisheng, president of the Industrial and Commercial Bank of China (China’s biggest commercial lender), said the bank’s LGFV loans had a non-performing rate of 0.73 percent, compared to an overall rate of 0.94 percent (China Business Newswire, March 7).
A number of Western analysts however have taken a different view of the banking situation, one perhaps less biased than that of Chinese banks. UBS has estimated that over the next few years, LGFVs could produce $460 billion in loan defaults, a larger percentage of China’s GDP than the recent U.S. bailout program (New York Times, July 6, 2011). In January 2012, Standard & Poor’s indicated that 30 percent of loans issued to LGFVs may become non-performing (China Business Newswire, January 13). A report by Moody’s last summer noted potential NPLs could reach eight to 12 percent (Moody’s, July 5, 2011). In an October 2011 report, Credit Suisse estimated that real estate, manufacturing, local government and SME loans account for more than half of the loan portfolio, but will contribute more than 80 percent of NPLs, creating an overall NPL ratio of eight to 12 percent (Credit Suisse, October 12, 2011).
Financing LGFVs and other alternative sources of local government debt damages China’s banking culture, as Tsinghua professor Patrick Chovanec points out. He writes that, while Chinese banks have been trying to become “viable commercial entities,” as a result of the stimulus plan and the pressures to loan indiscriminately, they “reverted to being slush funds for government largesse” (chovanec.wordpress.com, June 2, 2011). Government control of banking has created a system that is not allowed to focus on profitability, but must instead respond to central government orders.
Responding to LGFVs
In 2010, the CBRC took a number of steps to correct these problems, including the following measures: requiring banks to analyze LGFV loans through “stringent classification of loans, clarification of debt repayment parties, enhanced cushion, sufficient provisioning and prompt write-offs”; requiring banks to “classify their LGFP exposures through diligent cash flow analysis, and take ex ante remedial actions to mitigate the associated credit risks”; and recommending the re-categorization of LGFV loans into corporate loans if they met cash flow standards and were verified by the funding platform, lender and local government (CBRC Annual Report 2010, pp. 47, 56).
Attempts to correct the problem continued in 2011 and 2012. In May 2011, Chinese banks launched a major reorganization of the system, which shifted 2-3 trillion yuan ($316–475 billion) of debt from local governments onto state banks. The banks will most likely shift them off their balance sheets as asset management company (AMC) bonds (Reuters, May 31, 2011). To prevent defaults, in October 2011, CBRC Vice Chairman Zhou Mubing announced LGFVs meeting collateral requirements would be allowed a one-time extension on their loans. In February 2012, Caixin reported banks also were going to adjust repayment schedules and let borrowers roll over existing debt into new loans (Caixin, February 26; China Daily, December 26, 2011). Finally, in March, the CBRC asked banks not to lend money to LGFVs, report on their current loans to LGFVs and work out a plan for covering LGFV debt, including raising cash (China Daily, March 2).
At the National People’s Congress in March of this year, Premier Wen Jiabao announced that the central government would monitor levels of local government debt, including it in the central government’s fiscal budget, and would “impose greater discipline and scrutiny on local government investment and borrowing plans” (Shanghai Daily, March 20).
Moving Forward on Local Government Financing
In the future, we can expect real estate prices (and accordingly, land prices) to continue to drop. The leadership transition this fall will bring in new faces, but most likely, not new policies where real estate/land policy is concerned, leading to continued restrictions on lending and borrowing. Local state interests are becoming more powerful, and efforts to create more sustainable types of growth (at the expense of quick, profitable growth) may encounter increasing resistance. At the heart of this issue is the problem of moral hazard: local governments feel comfortable borrowing excessive funds and racking up impressive deficits, assuming that the central government will not let them fail. They are also relying on the continuance of the “growth at all costs” policy that has been at the forefront for the last decade, and doing so because of their significant revenue constraints and expenditure requirements. The response of local governments will be a significant challenge for the new party leadership, which is expected to be weaker than even the current leadership.
The central government, however, has signaled that there will be more of an emphasis on sustainable growth in the future. At the National People’s Congress in March, Premier Wen’s annual work report called for a new growth target of 7.5 percent, deviating from the long-held 8 percent target. His remarks focused on promoting more sustainable development, including encouraging domestic consumption and managing inflation. It is difficult to tell whether this policy will be able to trickle down to the local governments, or if it will override certain institutional policies that have continued to promote growth (such as cadre promotion based on growth figures).
The needs of local governments mean that the future will depend on the development of alternate sources of income for local governments. There have been concrete steps toward this goal. First, in October 2011, the Ministry of Finance launched a trial bond program, which allowed the cities of Shanghai and Shenzhen as well as the provinces of Zhejiang and Guangdong to issue municipal bonds. Second, a trial property tax was launched in Shanghai and Chongqing in January 2011 (“China’s New Property Tax: Toward a Stable Financial Future for Local Government?” China Brief, March 2). Though these programs face tremendous implementation hurdles, there has been talk of expanding them to additional cities and provinces, suggesting Beijing believes they have promise. These programs will help fill the revenue needs of local governments, hopefully transitioning them to more sustainable forms of income that would make them less reliant on risky financing schemes like LGFVs.
- Walter, Carl E. and Fraser J.T. Howie, Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise, Hoboken, NJ: John Wiley & Sons, 2011; Audit Findings on China’s Local Government Debts, No.35 of 2011 (General Serial No. 104), National Audit Office of China, November 16, 2011.
- Audit Findings on China’s Local Government Debts, No.35 of 2011 (General Serial No. 104), National Audit Office of China, November 16, 2011.
- Kai Yuen Tsui, “China’s Infrastructure Investment Boom and Local Debt Crisis,” Eurasian Geography and Economics, Vol. 52 No. 5, 2011, 52, pp. 686–711, 702.