July 25, 2011

China Faces Deep, but ‘Solvable,’ Debt Woes, Report Says

Standard Chartered’s Stephen Green explains the causes and solution to local debt problems in China

chinese flagAs the U.S. government grapples with its fiscal issues at the national level, Chinese authorities are wrestling with local government debt problems, according to a report released Monday by Standard Chartered.

The report, written by Stephen Green, looks at the scope of the problem–now about $1.5 trillion to $2 trillion (or 10 trillion to 14 trillion renminbi)–and possible solutions.

In “China–Solving the Local Government Debt Problem,” Green said, “Relying on tax revenues and land sales will probably not work, we argue: The funds available are simply not large enough. Neither are the banks in a position to digest more than a small part of the potential loan losses. We believe that the problem will need some kind of central-government resolution.”

While a significant hurdle, the local debt problem need not necessarily trigger a banking crisis or a macro-economic slowdown, Green argues. “The central government’s balance sheet and tax collection capabilities combined with strong nominal growth should mean this challenge can be met,” he said.

Short-Term Fixes

In the short run, the Standard Chartered analyst believes the Ministry of Finance (MoF) needs to boost infrastructure spending to provide required liquidity for troubled projects and stabilize the most exposed banks.

At least one of the national policy banks should get involved, Green adds, by issuing bonds, buying nonrevenue-generating loans from the banks and managing projects through to completion. Also, some budgetary revenues and a portion of land-sale revenues should be used to finance an Infrastructure Sinking Fund (ISF), which would be used to buy back bonds over 2012-2015.

Other needed reforms include: more centralized responsibility for spending, published government budgets and increased local-government autonomy in revenue-raising and debt issuance.

According to provisional figures from the China Banking Regulatory Commission (CBRC), about 2 trillion to 3 trillion renminbi ($300 billion to $450 billion) or 6% of GDP) of local government investment vehicle (or LGIV) loans are in trouble.

“We believe that repayment problems will likely spread across the country, and that a formal central-government led LGIV debt-resolution mechanism will soon be required. There are signs that Beijing is already considering some kind of bailout mechanism,” Green said.

In the short term, increased MoF transfers to local governments could be “a relatively easy way” to support these projects and maintain financial-sector stability, according to the report.

Long-Term Solutions

Overall, Green says, Standard Chartered “believes the problem, though large, is solvable” due to a multitude of factors. “Given the low level of official government debt, forecast nominal GPD growth over 2011-15 of a brisk 12-15%, strong capacity in tax collection and conservative spending habits, low foreign debt and still-extensive capital controls, this problem need not trigger a banking or broader economic crisis,” he wrote.

Still, he notes, China does need to rebuild its fiscal and financial systems to ensure that the same mistakes are not repeated the next time an economic crisis hits. “This is a huge undertaking,” the analyst noted.

Regardless of when the principal is due, the interest burden is huge–with interest payable on LGIV and local government loans at 600 billion to 900 billion renminbi this year, or about $7 billion to $10 billion a month.

“As repayment stress spreads across the system, rumors of loan covenants being broken will proliferate, depositors will become more nervous about the small city banks most exposed to the LGIVs, budgetary tricks to cover up the problem will become murkier, land requisitions will become more frantic, and banks will become even more conservative in their lending behavior,” the report explained.

As a result, Green says both banks and local governments will require a “sizeable bailout” from the central government. Still, he adds, resolving bad banking-system debts is not a new challenge to Asian economies.

Given the fact that the bulk of today’s problem loans are concentrated in the public infrastructure, Chinese authorities must cope with the fact that there will be no market for these bad loans, given the non-commercial nature of the underlying assets, the analyst says.

In the medium term, China should expand spending on transport-related infrastructure, he notes.

“If properly handled, China’s local government debt problem does not have to mean the end of the road for China’s economic growth or its banking system,” Green concluded. “Our proposals show that the ultimate impact on the central government’s total balance sheet in solving this problem is limited. The last bank bailout cost some 22% of GDP; this one looks to be about the same size.”

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