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    China Business
     Jul 14, 2010
China's local debts threaten crisis
By Olivia Chung

HONG KONG - China's local governments, which have increased spending under the central government's massive 2008 economic stimulus, have run up debts to levels that could pose a threat to the economy, according to some economists.

Eighteen provincial, 16 city and 36 county-level governments that were audited had accumulated debts of 2.79 trillion yuan (US$412 billion) by the end of last year, according to the National Audit Office.

About 9% of new debts in 2009 were invested in the central government's four trillion yuan stimulus package projects initiated from late 2008, and a considerable proportion of last year's loans were used to finance transport and other infrastructure facilities started before 2008, it said. The audit report said most of the 2.79


trillion of debt was used to fund infrastructure construction.

"The pressure from some government debt burdens is quite heavy, and poses a definite risk," audit office director Liu Jiayi said in the report. "New government debt must be strictly controlled to prevent financial risks from evolving into fiscal risks."

Seven provincial governments, 10 city and 14 county-level governments studied had overspent their incomes, with one provincial government having spent three times what it had available, Liu said in the report posted on the website of the audit office. The report did not name the governments, only saying the western region bore the higher levels of debts.

Of the total loans, about 60%, or 1.04 trillion yuan, were secured last year, with the rest dated from 2008 and before, the report said.

According to China's Budget Law, adopted in 1994, local governments are required to have balanced budgets. They are banned from issuing debt, securing bank loans or using government assets as collateral for loans. They can borrow only from the central government or other central authorities.

However, many local governments for years have used local investment companies as a way to bypass the law to borrow and fund their development projects, including infrastructure and real estate projects. Local governments inject land and cash into the investment companies to give it assets as collateral against loans from local banks.

About 8,200 financing vehicles have been set up by local governments, according to the China Banking Regulatory Commission (CBRC). But how much the local government-controlled companies have borrowed to date and how they use they funds are unclear.

The CBRC said in March that outstanding loans to these vehicles totaled 7.38 trillion yuan by the end of 2009, 20% of the country's total loans and representing a 70.4% surge from a year earlier. It also said some of the massive loans to government financing vehicles had become questionable, without disclosing the amount.

Victor Shih, a professor at Northwestern University in Illinois, estimated loans raised by local governments through financing vehicles between 2004 and 2009 reached 11.4 trillion yuan, representing more than one-third of the country's gross domestic product (GDP) of 33.5 trillion yuan in 2009.

About 7 trillion yuan of the total borrowing was borrowed for infrastructure spending and 4 trillion yuan for "other" purposes, according to Shih's study,

Shih said that if existing credit lines were fully drawn down, total local government borrowing could swell to 24 trillion yuan by the end of 2012, which would lead to a large-scale financial crisis.

A recent report by the People's Bank of China, the central bank, focused on worries over local borrowing in Tianjin municipality, near Beijing, where loans to local government entities doubled last year to 432.5 billion yuan. The municipality's GDP rose 16.5% last year to 750 billion yuan.

At the end of 2008, Beijing unveiled a 4 trillion yuan investment expansion plan and maintained a relaxed monetary policy as part of its efforts to combat the global economic downturn. The central government paid for only one-quarter of the stimulus plan while the rest came from state companies and borrowing by lower-level governments from state banks.

Mainland banks extended a total of 9.6 trillion yuan in loans to support the plan last year, almost double the minimum target of 5 trillion yuan.

Despite the concern, some economists believed the nature of the debt and amounts would not lead to local or national crises.

"Given that the increasing loans are related to the stimulus move launched by the central government and the higher levels of debt are borne in the developing region, the central government will definitely offer help to solve the problems," said Wu Xiaoling, a former central bank vice governor.

Guo Tianyong, a professor of finance at the Central University of Finance and Economics, said the nation's debt level was still prudent as it accounted for only 47% of gross domestic product.

Shi Hongxiu, a finance professor at the Chinese Academy of Governance, told Asia Times Online that this audit report was alarming because the mounting debt could pose a threat to macro-economic stability.

"The macro-economic instability stems from the ineffectiveness of our macro-economic management tools. For example, interest rates can be used by the governments as a way to help the economy operate at optimum levels. However, when [local] governments are involved in borrowing and investing through their investment vehicles, which are companies without much worry about repayment or inflation, the effectiveness of macro-economic policy will be impeded," Shi said.

"There is an even worse scenario. Unlike Western market economies, local governments in China have a duty to shore up growth. If the governments do not abide by the Budget Law and fund their pet projects to maintain growth regardless of the projects' future profitability, while state banks lend to government companies regardless of their ability to repay, the lending spree will backfire, with a soaring number of non-performing loans, and affect currency stability."

Shi referred to the early 1990s, a period of overheating in the Chinese economy, when soaring local government debt plagued banks across the mainland. Inflation rose to 21% in 1994 - its highest over the past 30 years - and much local debt ended up as non-performing loans, climbing to 40% of total credits in the state banking sector in the mid-1990s. This prompted the central government to tighten lending, resulting in prolonged deflation in the late 1990s.

Yi Xianrong, a researcher with the Institute of Finance and Banking under the Chinese Academy of Social Sciences (CASS), told Asia Times Online that the threat to the economy posed by the large debt burden was that a fall in mainland property prices might erode the value of the land that local governments' financing vehicles had posted as collateral against their borrowing, which could lead to a sharp rise in non-performing loans for banks.

Banks in Shanghai may face a combined loss of 5 billion yuan, or 8% of their pre-tax profits in 2009, if property prices drop 30%, the Shanghai bureau of the China Banking Regulatory Commission said last month.

Wharf (Holdings) chairman Peter Woo Kwong-ching said earlier that mainland property sales and prices could drop as much as 30% this year due to the central government crackdown on property speculation. However, while property sales volume has plummeted, prices so far remain stable.

Realty prices in 70 major cities nationwide rose 12.4% year-on-year in May, compared with a record 12.8% rise in April, figures from the National Bureau of Statistics showed. The month-on-month increase was 0.2% in May, compared with 1.4% in April.

Chinese banks may need to set aside 283.1 billion yuan as bad loan provisions over the next two years, which may reduce Chinese lenders' net profit, according to the 2010 Blue Book for China Finance, the annual report on China's financial development compiled by CASS.

"Loans extended to local financing vehicles, which are implicitly backed by the unstable fiscal revenue of local governments, accounted for about 10% of the total lending extended by listed Chinese lenders at the end of 2009," the report said.

China Development Bank, the nation's state-run lender for public works, bears the highest exposure to such loans, which account for 69% of its total loan portfolio, the report said.

In mid-April, the state cabinet announced moves to cool the housing market, including raising the minimum down-payment to second-home mortgages to 50% and imposing an extra 10% interest rate on second home loans.

However, Lian Ping, chief economist at the Bank of Communications, did not believe China's mounting debt would pose a European debt crisis as the country's financial system is fundamentally different from that of Europe.

"The governments of European countries usually have to maintain high government deficits to support their bloated social welfare systems, and the additional spending to combat the financial crisis added a further burden to their government finances. In China, even after the local debt is taken into account, the scale of public debt is limited," Lian was quoted as saying by China Daily.
Beijing now closely watches the increasing debts of local governments, as the problem has the potential to turn soar years later. In a circular to local governments and ministries, the State Council last month asked officials to categorize debts issued by local financing companies and banning certain public assets from being injected into the investment vehicles. It ordered local governments to improve management of such investment vehicles and told banks to limit lending to them.

Wu Zhong, ATol's China Editor, writes:
The Chinese government has annual fiscal revenue of more than 30% of the GDP, strong foreign reserves (US$2.45 trillion as in March), and manages state-owned enterprises and banks with assets totaling 115 trillion yuan, so that its assets still far exceed its current debts (both of the central and local governments), Shi Hongxiu at the Chinese Academy of Governance argues, according to Xinhua.

Moreover, with a high savings rate, the country has large bank savings (61.20 trillion yuan at the end of 2009, of which 26.48 trillion yuan was households savings), so if there is a need the government could issue more bonds at any time to easily raise funds at home.

Even so, the large scale of local government debt has to a great extent tied Beijing's hands in applying more flexible macro-economic control measures.

For instance, to ease growing public anger over skyrocketing housing prices, Beijing has issued toughly worded orders to cool down the market. But because local governments have pledged land resources to borrow bank loans, they need to keep land prices high so that banks will not recall their loans.

Again, it is generally agreed that China needs to increase interest rates to curb inflation as consumer prices soared 3.1% in May, but any interest rate increase would increase the financial burden of debt-laden regions.

Thus, instead of using the traditional monetary instrument to fight against inflation, the National Development and Reform Commission now is assigned a new job: to control people's expectations of inflation. It is not clear how it can do this, beyond banning the media from reporting any forecast about possible price increases in consumer goods.

For Premier Wen Jiabao, who will step down in March 2013, how well he handles the problem of state and local debt is a huge challenge to his wisdom and reputation.

After the Asia financial crisis starting in 1997, Wenís predecessor, Zhu Rongji, tremendously expanded budget deficits for infrastructure investment. By 2002, a year before the end of his term, the accumulated state debt reached 2.5 trillion yuan. By comparison, China's five-year plan for 1996-2000 set the goals of bringing down the budget deficit in 2000 to under 10 billion yuan and accumulated state debts to under 300 billion yuan.

Some Hong Kong newspaper thus nicknamed him "The Deficit Premier". Zhu obviously was upset by this. At his last press conference as premier at the National People's Congress annual session in March 2002, Zhu said: "A Hong Kong newspaper granted me an honorary title of 'The Deficit Premier'. I never accept any honorary title or degree ... [With the deficit budgets] what we will leave to the next government are not just debts but 2.5 trillion yuan worth good-quality assets, which will ... contribute to future economic development in the country ... So, sorry, I cannot accept the title of 'The Deficit Premier', which I have to return to the sender."

In the past seven years or so of Wen's premiership, China's deficit and government debts have spiraled. One may wonder what he will have to say in justification before his retirement. Will he be able to proclaim, like Zhu, that what he will leave to the next government are good-quality assets rather than bad debts?

Olivia Chung is a senior Asia Times Online reporter.

(Copyright 2010 Asia Times Online (Holdings) Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)

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