Recently, the China Banking Regulation Commission embarked on a pilot program to set up five local asset management companies in Guangdong, Zhejiang, Jiangsu, and Anhui provinces, as well as in the city of Shanghai. The companies will buy up bad debt from banks, trust companies, financial corporations, and financial leasing companies, in an attempt to clean up the banking and shadow banking systems in these areas. This action will help to make some important financial entities whole after they took part in over-exuberant investment in recent years, but it does not correct the fiscal imbalances between central and local governments that helped generate the problem in the first place.
First, some background. Currently, there are four national asset management companies, set up in the late 1990s to remove nonperforming loans from banks’ balance sheets. These are China Huarong Asset Management Company, China Cinda Asset Management Company, Orient Asset Management Company, and China Great Wall Asset Management Corporation. At the time, China was undergoing a massive privatization of its economy, and attempting to make banks more competitive and less involved in unprofitable policy lending. These national asset management companies were criticized as being ineffective in selling the bad debt, but they were successful in improving the status of banks’ balance sheets.
Fast forward to today. Local asset management companies are to be created, since the recent splurge in lending for fixed asset investment has resulted in some loan defaults in financial institutions starting at the beginning of this year. Because many local government financing vehicles and property developers have taken part in excessive borrowing to build up real estate and infrastructure, asset price declines, and the constant threat of a liquidity crunch have impacted these loans that are tied to local markets. Creating “bad banks,” or asset management companies, then, for regions with the heaviest amount of borrowing makes sense.
At the same time, as was the case with the national asset management companies, establishing “bad banks” does not change the fundamental incentives for financial institutions to take on such bad loans in the first place. In the case of the national asset management companies, the policy lending relationship between banks and state-owned enterprises remained to a significant degree intact, crowding out investment in smaller and privately owned firms. Similarly today, establishing local asset management companies does not change the problem of the revenue shortage from which local governments suffer, maintaining their incentives to spur growth through borrowing and short-run economic activities.
The problem that local governments face is not just a balance sheet crisis, but a fiscal crisis. Local governments obtain revenues through a fraction of the value added and corporate taxes collected in their jurisdiction, and all personal income taxes and business taxes. Extra-budgetary revenue has come mainly from land sales. All sources of income are insufficient, however, to cover expenditures, and not high enough to spur implicitly necessary growth.
The lack of sufficient local government revenue led governments to borrow to finance projects through local government financing vehicles, entities set up as corporations that, unlike local governments themselves, can borrow on the market. The 2008-09 fiscal stimulus package operated largely by pressuring local governments to spend on infrastructure, and in order to fund these projects, local government financing vehicles had to borrow big. Local government debt grew so large, that the central government announced that local governments would be able to issue bonds in order to cover the debt. Ten local governments, in Shanghai, Zhejiang, Guangdong, Shenzhen, Jiangsu, Shandong, Beijing, Qingdao, Ningxia and Jiangxi, were permitted to issue bonds in May 2014. The yields of these municipal bonds must be higher than the yield on central government bonds, which continues to pressure local governments to achieve sustained growth, setting up local governments for yet another round of debt-fueled growth.
To conclude, the basic central-local government fiscal relationship must be changed to reduce incentives for local officials to take on bad debt. This has been stated before but cannot be stressed enough. Allowing some over-indebted local governments to set up asset management companies has positive short-term implications, but in the long run, the fiscal shortfall will bring local governments back to a position of excessive debt once again. The solution would be for the central government to allot more local revenue to local governments, require a system of checks and balances to ensure the money is spent wisely, and reduce pressure to generate growth at all costs. Only then can local government debt become qualitatively and quantitatively healthier.