China’s economy is going slower than most expected. But not me. I am seeing among things a new mini infrastructure stimulus in the works, and this will take at least a quarter to kick in. This one will be much more more targeted than the first. But, whether or not the proposed projects and those in the pipeline actually move–and stoke GDP–depends in large part on the ability of local governments to secure debt for them.
It’s possible that as China has rolled over much of the local debt acquired in the first stimulus, new space for local borrowing has opened up. Especially when the Central Government wants new investment to boost GDP. And, in any case, in this casino, the players and the house are for the most part one and the same. That said, even the house here may have ‘a limit.
Putting local debt in perspective is ‘Local Government Financing Growing Increasingly Precarious’ by Eve Cary of Brookings and focuses on local government financing vehicles (LGFVs). After a thorough review of LGFVs and their abuses, Ms. Cary gets to the core problems and dangers:
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” .
Because of these and other problems, such as the impact on banks, Ms. Cary predicts:
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. [paragraphs added]
Should these proposals be successfully rolled out, the second will add local tax revenue–good; the first, bonds, will in the end, add sustainable debt upon unsustainable debt–fair. For local governments to be actually ‘sustainable’ more is needed: an overhaul of Central-local political structure (something that has been argued about for more than a 1000 years) and newcriteria for promoting local officials (less emphasis on GDP growth at all costs, including unsustainable debt), to name two. And these two and others like them are far tougher to implement than municipal bonds or new taxes.