China to Clear Off Billions in Local Government Debt

Move will reduce default risk and hazards to Chinese economy

China's regulators intend to move 2-3 trillion yuan ($308-463 billion) of debt off the books of local governments, paying off some and forcing some of its "Big Four" banks to absorb some losses. The move is intended to restore confidence in Chinese banks in the wake of the economic stimulus package launched in late 2008 by Beijing as a response to the global financial crisis.

Reuters reports that bad debt lurks in local government financing vehicles, which are hybrid company/government establishments that were used by local governments to circumvent official restrictions on borrowing. Totals may run as high as $2 trillion yuan, out of a total of about $10 trillion yuan in total debt. The stimulus brought about unrestricted lending during the crisis, and the resulting pile of bad debt, say analysts, could pose a major risk to the Chinese economy, particularly in the midst of an economic slowdown.

However, if instead of allowing local governments to default, Beijing steps in to absorb some of the losses, analysts do not expect broad problems with banks. Part of the plan also includes allowing provincial and municipal governments to sell bonds, which will provide them with more transparent sources of funding and shore up their balance sheets.

One anonymous source cited in the report said that the process is expected to begin in June and be complete by September; another unnamed source said it would require more time. Three government bodies, the bank regulator, the Finance Ministry and the National Development and Reform Commission, China's state economic planner, are expected to conduct the process.

Banks will be required to take a hit, according to the first source, who was quoted saying, "It's to rescue local government finances, not banks. It's different in nature from the bailout of the four big [state] banks in the late 1990s before they listed [on stock markets]." The source referred to a setup in 1999 of asset management companies by Beijing that cleared 1.4 trillion yuan off big state-owned banks' books; the bad debt was a result of political lending that took place over decades.

The Big Four are Industrial and Commercial Bank of China, Bank of China, China Construction Bank and Agricultural Bank of China. One source said that state-owned China Development Bank accounts for approximately a third of all local government loans; the rest came from city commercial banks and large state-owned banks.

While plans are not yet complete, the first source said in the report, "The central government will swallow some of it," and "some local governments will be allowed to issue bonds." According to the second source, "The government hopes to resolve this problem before the 18th Congress next year." Political leadership is expected to change at that event.

While details of the plan were not known, sources said it may include funds from private investors.

Guo Tianyong, an economist at the Central University of Finance and Economics, said the plan would not necessarily solve the problem of who would end up paying for the bad debt, even though it would remove the debt from the books of local government. He was quoted saying, "I feel it won't fundamentally solve the problem by hiving off and selling the debt to other investors."

Worries about bad debt are not limited to China. Fitch cut the outlook for China's local currency in April to negative, and Standard & Poor's said in May that nonperforming loans could hit 5-10% of all Chinese loans in the next three years.

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