Still Time to Avoid a Crisis
Rising financial risks associated with local governments concern markets. Predictions of the amount of debts governments have racked up range from 10 trillion yuan to 50 trillion yuan. The National Audit Office (NAO) announced on July 28 that it would evaluate the financial risks of all levels of governments from villages to central authorities. The audit will mainly focus on infrastructure projects, including railways and subways, government investment vehicles, and projects supported by land-transfer fees. The State Council, the country's cabinet, will likely receive the final report by mid-October.
How Bad Is It?
Based on the most recent official estimate, local governments racked up 10.7 trillion yuan in unpaid debt by 2010. This number should be the lower limit of the current audit since governments picked up the pace of borrowing since then. An earlier audit targeting 36 provincial capital cities shows they had 3.85 trillion yuan of debt. Nine of the 36 had debts higher than their GDP in 2012.
We estimate that the average of all local government debt falls between 40 and 60 percent of the GDP. In other words, between 20 trillion yuan and 30 trillion yuan.
In addition to the sheer volume of debt, the financing mismatch is also a big concern. At the end of 2010, 53 percent of local government debts were due in three years, while 60 percent of their infrastructure investment projects had 10-year contracts, a 2011 report by the NAO showed. The most urgent problem they face is a liquidity squeeze.
Despite the enormous scale and mismatch, we believe the debt problem is not beyond control. Unlike state governments in the United States, local governments in China own a large amount of assets, including infrastructure, buildings, natural resources and state-owned enterprises. At the end of 2010, local governments had 10.2 trillion yuan worth of productive assets; 7.8 trillion yuan in non-productive assets such as buildings, equipment and other fixed assets; and 44.3 trillion yuan worth of natural resources. Moreover, tax revenue doubled in the last five years. Getting rid of the debt problem through continued fast-paced growth is still a possibility.
The situation at hand is grim but still manageable. Before any default occurs, local governments must take short-term measures to deleverage and explore long-term solutions to sustain growth.
Fastest Ways to Deleverage
Debt-ridden local governments can reduce the ratio of debt to equity through asset trading, debt reconstruction and central government aid.
For local governments with debt well above the upper limit, the fastest way to deleverage is to sell some assets. This is an effective solution for cities with relatively robust economies and high-value assets, such as the ones in the Yangtze River Delta and the Pearl River Delta regions. Nanjing, the capital of Jiangsu Province in eastern China, had debt higher than its 720 billion yuan GDP in 2012, but it also owned 331 billion yuan worth of assets. By privatizing some underperformed productive assets, local governments can reduce debts and improves management efficiency.
Restructuring debts through the four state-backed asset management companies (AMC) – Huarong Asset Management Corp., Cinda Asset Management Corp., China Orient Asset Management Corp. and China Great Wall Asset Management Corp. – is another way to deleverage. Local governments might be able to transfer bad loans to the four AMCs at discounted prices and term out debt to longer maturities. Presently about 80 percent of government debts are in the form on bank loans. In some sense, this solution might give rise to ethical concerns, but it is a good one-time solution to swiftly reduce the debt ratio.
A third possibility is direct aid from the central government. Beijing might help local governments in less developed western regions repay some of their debts. This was common before 2003. Back then, some local governments in these less-developed regions had no revenue from leasing land and struggled financially. In 2001, the central government provided local governments with 40 billion yuan in bonds. In the following two years, the amount was gradually reduced to 25 billion yuan.
Review Balance Sheets
Once local governments meet their goal of deleveraging, they must follow up with three long-term measures to ensure sustainable growth and secure a healthy financial condition.
First, local governments should be able to issue bonds. Since 2009, local governments have been able to apply to the central government to have bonds issued on their behalf. But there is only a limited quota of these bonds, the application process is long and there are very few maturity options. In 2011, the total quota of bonds for all local governments was 200 billion yuan, but local governments spent a total of 5.25 trillion yuan. The quota increased to 250 billion yuan in 2012, but local government spending increased to 6.16 trillion yuan.
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