China Responds To Alarming Local Debt Crisis

On Thursday, the Chinese central government announced on its website that the State Council, with the approval of the National People’s Congress, will establish quotas for borrowings by local governments.

Moreover, Beijing said it was banning fund raisings through special purpose vehicles and other “corporate channels”  and announced it will not fund bail outs.

The central government statement said that local governments should not force banks to lend them funds.  Instead, they should scale back projects, sell assets, or reduce spending.

Local governments, for decades, have been cash-strapped, starved of funds by revenue-sharing formulas favoring Beijing.  Although prohibited from borrowing by the Budget Law from 1994 to this year, these units have circumvented prohibitions by forming the infamous—and now banned—LGFVs, local government financing vehicles.

The National Audit Office reported that local government debt and contingent liabilities amounted to 17.9 trillion yuan as of June 30, 2013, up 67% from the end of 2010.  The NAO said nearly 40% of such indebtedness was incurred through more than 7,000 special purpose vehicles.  There were probably closer to 10,000 LGFVs and certainly much more debt than Beijing reported.  Some localities evaded NAO auditors by accessing informal borrowing channels, writing IOUs and going to loan sharks, for instance.

Thursday’s statement represents a new approach to a problem that, at least according to the Budget Law, should not exist.  Instead of trying to solve the local debt crisis with an all-out prohibition on borrowing—the tactic of the last two decades—last week’s statement recognizes the local need for loans and tries to limit them to prudent amounts.

This more realistic approach is also behind Beijing’s move to make borrowing legal by opening the bond market to local governments.  In May, the Ministry of Finance authorized ten localities to issue bonds directly, and in late August, the rubber-stamp National People’s Congress passed legislation permitting local governments to directly sell such debt.   Even though borrowing for general spending purposes will be prohibited by Thursday’s statement, opening up the bond market will give local governments a new source of funds.

Yet only a few local governments will be creditworthy enough to issue bonds.  So the effect of Beijing’s recent policies will be to restrict credit flowing to lower-tier governments.

Central government technocrats can impose rules and quotas, but local officials still need to pay salaries, clean streets, and provide schooling.  Unfortunately for them, the new borrowing quotas will hit them at a particularly difficult time because other inflows cannot replace new loan proceeds.  For instance, with a stagnant economy, tax collections this year cannot grow much.

Moreover, the housing market is now trending down.  August was the fourth-consecutive month of month-on-month home price declines, and September will undoubtedly be the fifth.  This means developers have cut back their buying of land, and so the land-sale revenue of localities, with the possible exception of a few Tier-One cities like Beijing, is plunging.

China Index Academy reports that in the just-completed quarter land-sale revenues from residential sites fell in 300 cities by almost half year-on-year.  A separate survey by research institute China Real Estate Information found that in Q3 land sales volume in 100 major cities was down 6% from the previous quarter and 47% from the same quarter in 2013.  Total revenue was down 18% quarter-on-quarter and 75% year-on-year.

These figures suggest that some localities, which have become dependent on land revenue in recent years, will hit the wall soon.  In July, Qilu Bank in Shandong province’s Jinan seized property from Licheng District Comprehensive Development Corporation of Urban Construction in what is called “the first official disclosure of a LGFV default on a bank loan.”

Beijing is aware of the problem and has taken steps in recent days to prop up home prices.  On September 30, the People’s Bank of China and the China Banking Regulatory Commission announced measures intended to support the housing sector.  At the same time, 41 of the 46 cites that restricted residential purchases are now trying to stimulate sales by removing the measures they had put in place.  Developers in first-tier cities are still buying land, but the fall off in housing will be felt just about everywhere else.

The central government’s Thursday statement did not say when its quotas and prohibitions will go into effect, and it will surely take a long time for Beijing to implement them.  After all, not only will they hit the budgets of localities, they will undermine the country’s economic growth, at least at first.  As Tommy Xie of Oversea-Chinese Banking Corp. notes, “Short term, local governments will be more cautious, which may trigger deleveraging.”  Long term, their effect should be beneficial.  They will, he tells Bloomberg, increase transparency and “boost the efficiency of resource allocation.”

Xie is correct, but many city managers only worry about now, meeting payroll and dealing with their existing debt, some of which may have been hidden from National Audit Office auditors.  Almost 40% of the 17.9 trillion yuan in local debt and contingent liabilities outstanding as of the middle of last year either has or will mature by the end of December.

The central government’s plan announced on Thursday, a significant step forward in many respects, may not be implemented until next year, at the earliest.  Expect localities to fight the quotas and new rules—or to evade them altogether.  Local officials have been particularly adept at outfoxing Beijing’s technocrats—they invented LGFVs after all—so they can surely figure out ways to take out loans without alerting central auditors.

Culled from forbes.com