– On China's Provincial Finances, and the Prospect of Their Reform
Interesting and potentially important news has emerged from China over the past few days. Reuters has reported on two different stories: first, it announced that the Chinese government plans to shift 3 trillion yuan ($463 billion) in bank borrowings away from provincial governments that are struggling to repay their debts.1 It appears that the central government will assume some of those debts, and pay some off; and it may force commercial banks to write off the remainder. Second, after a long delay, the government will finally lift a ban on the issuance of municipal bonds.2
Details regarding both stories are scarce, and neither story has been verified by an official source. Still, if the reports prove correct, they represent welcome news: in my opinion, any serious effort to shore up and make transparent the finances of provincial governments is an unmitigated positive development.
I am heartened by this news because I have been concerned that the finances of many provincial governments are dire. To put my concern in perspective: many China-watchers fear a property bubble in the country, and I don’t rule out the possibility – but I perceive greater risk in the balance sheets of local governments. Between 2008 and 2010, when there was concern about a severe economic downturn, provincial and city governments were encouraged (if not pushed) by the central government to borrow. The goal was to invest in capital projects and infrastructure, so as to simulate job growth. No comprehensive statistics on banks’ lending to provinces are available, though estimates suggest that it totaled approximately 10 trillion yuan (about $1.5 trillion).3 If that figure is accurate, it means that local governments and related entities were responsible for just over half of all the bank borrowing that occurred during those two years – a period characterized by unprecedented volume growth in domestic credit.4
How those funds were deployed is not known with certainty in the marketplace. I have asked management teams at Chinese banks firsthand, and they were either unable or unwilling to disclose, or both. However, reports have emerged in the Chinese media that 2 trillion ($310 billion) of that lending has soured, as it was deployed in projects that were not economically viable.5 That sum represents about 6% of China’s annual gross domestic product.
Adding to the challenge, most provincial governments are not authorized to borrow directly from banks; so they set up project-oriented subsidiaries (sometimes called “window companies”) to borrow on the local government’s behalf. Some of those subsidiaries may not have been properly capitalized. It is my understanding that many were granted (legally questionable) liens against the parent governments’ revenues. Those revenues are tied to tax receipts, transfers from the central government, and fees – and the fees arise from property-related transactions and development. If property markets correct, those fees may be choked off, jeopardizing the subsidiaries’ ability to repay their debts.
How can I be positive, especially when it appears that reckless borrowing has put provincial governments in dire position? I am certainly not pleased about the prospect of looming losses, but I am encouraged that the central government might pre-empt a bigger mess. No one really knows how much debt has gone bad; even worse, no one knows who will ultimately bear the cost. Many observers have blithely assumed that the central government will step in to cover the losses, given that it encouraged the provinces to borrow in the first place. I have never been convinced, though: China’s central government has not always bailed out provincial governments that have managed their finances poorly. If the government follows through on its plan, it could alleviate a major source of uncertainty – arguably the greatest threat to the country’s financial stability, and to business confidence.
The news regarding the creation of a municipal bond market is a critical adjunct. If a proper muni market is formed, it could avert repetition of this episode. Provincial governments were able to borrow with abandon because their creditors (mainly state-owned banks) assumed their finances were implicitly guaranteed by the very solvent central government. 10 trillion yuan ($1.5 trillion) in byzantine, implicit guarantees is more than I care to stomach! Hopefully, a muni market will bring much-needed transparency to the provinces’ finances, improve creditors’ claims on those finances, and clarify where credit risks ultimately reside within the system.
If China pursues this reform in earnest, it could reap broader benefits. By securitizing previously opaque and illiquid debts, it could enhance liquidity, and bring the market’s discipline to the valuation of municipal credits. Most importantly, it could reduce dependence on the much-too-big-to-fail banks that are presently at the heart of the country’s financial system. When analysts opine on China, they often long for “an improvement in the allocation of capital,” even as they might lack a clear sense about how it might be achieved in practice. I think a proper muni market is a major step forward – a critical component of the solution.
Ironically, I doubt markets will react positively to these two reports – at least not at first. There will be handwringing over whether the government has done too little, or too much; there will be fear and consternation over which banks bear what losses. Some will accuse the central government of promoting “moral hazard” via any proposed bailout. Undoubtedly, there will be ugly skeletons hauled out of the provinces’ collective financial closet. These are all legitimate sources of concern – my own fear is that the central government won’t act decisively, or quickly enough. For the moment, though, I am optimistic: when I look through the news, I see capacity for change, a commitment to modern capital markets, and the potential to put serious financial problems in the rear-view mirror.Andrew Foster
The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
- Reuters, Exclusive: China to clean up billions worth of local debt, 31 May 2011.
- Reuters, Exclusive, ibid.
- Reuters, UPDATE 2-China local govt debt plan a quick boost for banks, economy, 1 June 2011.
- Peoples’ Bank of China, Summary of Sources & Uses of Funds of Financial Institutions, 2008-2010.
- Reuters, UPDATE 2, ibid.