A dangerous dependency

China’s local governments have become addicted to using land to pay down old debts as well as raise new collateral, warns Peiyuan Lan.

China’s state-driven Keynesian model of economic growth has meant the state is both the biggest debtor and the biggest creditor in China’s infrastructure projects. While the official government debt-to-GDP ratio is 68 per cent, if all prefectural city investment enterprise debts were added into the mix, the ratio would increase to 90-95 per cent, a much higher ratio than the United States and the European economies when they were at a comparable stage of industrial development.

China’s infrastructure investments account for around 19 per cent of GDP while the ratio is only 5 per cent in Japan, 4.7 per cent in India, and 2.6 per cent in both the United States, and the European Union.

Since the 1990s when the banking system was reformed, Local Government Finance Vehicles (LGFVs) have become the primary institutional means for municipal, prefectural, and township governments to access ostensibly market-based financing. However, the lack of accountability for these state loans has meant a ballooning of local government debts while the banking system’s chronic non-performing loan (NPL) books—accounting for which was a core reason for the 1994 bank reforms—are only getting worse.

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While the economy boomed, everyone simply looked the other way. Communist Party GDP targets were to be met no matter the means. However such capital misallocation introduces permanent total factor productivity restraints. Given LGFVs mostly live on the capital gains of converting rural land to urban land, and the apartment blocks built over them, local governments have become addicted to using land to pay down old debts as well as raise new collateral.

However as urbanisation nears completion, the industrial economy is slowing, and the central government is turning to social policy to plug structural holes in the rural population. Land is therefore the quick fix for a finance system where the government is both vendor and buyer.

China’s 2015 Budget Law made government bailouts for new city investment enterprise debts illegal, although the law did allow local governments to issue municipal bonds directly for the first time. Recently, the central government has begun scaling up the magnitude of its debt-for-equity swaps, which will run through 2017 and will amount to 14.7 trillion yuan.

The development of a viable local government bond market to mimic the United States or Europe is being hampered by many factors; chief among them is the short bond period on Chinese debt. Local government bond periods are 6-7 years, while city investment enterprise bonds mature in around 1-6 years. Maturities for municipal bonds in the United States are often around 15 years.

According to the Ministry of Finance, the stock of local government debt was RMB 16 trillion at the end 2015, of which LGFV debt was around RMB 6 trillion. This is despite a State Council Directive requiring that local governments no longer raise debt through city government investment enterprises and LGFV channels.

Meanwhile, Public Private Partnerships (PPP) have been slated to create a new source of private capital. Since 2013, the State Council, the National Development and Reform Commission (NDRC), and the Ministry of Finance have issued over 40 PPP regulatory documents. In 2015, the NDRC approved a PPP project with RMB 5.9 trillion investments in total, including transportation, municipal facilities, and public services. Private capital invested RMB 3.7 trillion in public infrastructure in 2015, a 29 per cent year on year increase.

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However, the PPP model has encountered many difficulties. The most obvious one is that local governments and private investments have divergent interests in deciding project returns. Local governments are unwilling to grant lucrative construction contracts to private enterprises and forego the revenues themselves. But private enterprises standing alone in the market tend to focus on absolute returns and refuse to invest in the low profit-making projects that local governments put on offer.

Hence the old public infrastructure financing model still dominates, and reforms are yet to yield any significant results. Considering the declining profitability and mismatch between short-term loans and long-term projects, city investment enterprises’ capacity to repay debts is questionable, while the local government loan book continues to mushroom.

Net bonds issued by LGFVs in the year to September 2016 reached RMB 1.07 trillion, more than 2015’s RMB 946 billion. With LGFVs continuing to borrow at these rates, the Chinese financial infrastructure is dicing with a new form of risk. LGFVs are subject to the volatility of land markets, meaning the government is effectively a real estate speculator. If China does not take any measure to alleviate LGFV debts, spillover effects will impair banks’ underlying assets and may trigger financial crises and sovereign debt crises in China’s trading partners.

More local government transparency is needed, including introducing a competitive mechanism to improve the efficiency of investments. At the same time, the central government in Beijing needs to break the chain between local governments and city investment companies, and ensure that suboptimal lending practices in urban coastal cities are not being backstopped by the income taxes of the hinterland’s vast working poor.