Local government debt piles in China continue to grow but there are signs that the government is starting to take a tougher line. This may weigh on China’s economic growth outlook in the second half (H2) of 2017.
Ministry of Commcerce (MOFCOM) data show that local government debt totaled RMB 15.32 trillion ($2.2 trillion) at the end of 2016, four times the RMB 3.7 trillion recorded in 2006 and equivalent to approximately 25 percent of China’s total 2016 GDP.
But these numbers likely understate the true figure by about RMB 10 trillion ($1.47 trillion) because they ignore new forms of debt raising, such as public-private partnership debt, according to Wang Tao, chief China economist at UBS.Enjoying this article? Click here to subscribe for full access. Just $5 a month.
How did China get to this state? Here are five main causal factors:
China’s unbalanced tax system: Local governments keep 50 percent of taxes collected but are responsible for about 80 percent of local expenditure, putting them under pressure to find additional funding sources, according to Xun Wu, an MIT researcher.
The scourge of moral hazard: The Chinese government’s obsession with stability and its control-heavy economic policy approach has created a moral hazard culture, where local officials issue debt believing the central government will step in if anything goes wrong.
Target-chasing government officials: Local people have to meet centrally determined economic growth targets and often resort to debt-funded vanity investment projects to attract attention to themselves and secure promotions. While this may make for good growth numbers, it doesn’t necessarily translate into wise investments, with a string of image or “face” projects cropping up, such as government buildings at a rural community being modeled on the Kremlin or puffer fish shaped towers costing $11.4 million in Jiangsu province.
Infrastructure outlays: Building roads, airports, and subways is a favorite form of legacy project for local officials and an excellent way of channeling government money into state-owned enterprise coffers. Though China needs new infrastructure, many projects fail to generate the necessary returns to repay debt funding because of poor design or project choice, according to research by Oxford University researchers Atif Ansar, Bent Flyvbjerg, Alexander Budzier, and Daniel Lunn.
Illegal debt-raising: A recent study by China’s National Audit Office found that not only had total local government debt risen 87 percent since 2013 but local officials in 16 provinces had raised a total of RMB 53.719 billion ($7.84 billion) illegally through tactics such as using forged or unenforceable land deeds as collateral.
These five factors have been playing out for years, but it seems that the Chinese government has recently taken a harder line to reduce leverage in the economy by introducing new forms of oversight by central government departments, banning local governments from guaranteeing debt issues, and enforcing caps on total debt raises.
These tighter government controls, plus investor concern at the sheer size of the outstanding debt outstanding, are pushing up interest rates, with coupon rates on local government financing vehicle (LGFV) debt rising by as much as 200 basis points since late 2016. One issue by a LGFV sold at 7.8 percent, the highest rate since December 2015, according to Financial Times research.
This is raising the possibility of an impending default with Moody’s and Lianhe – two of the largest agencies offering ratings on local government debt – expecting defaults to emerge over the coming months.
But a full-scale, national default is highly unlikely. It would cause chaos in China’s banking system because many of China’s main banks have been buying up huge volumes of local debt during the past year, and it would choke off investment in the economy just at a time when the Chinese government is looking to local governments to support the economy and pursue its urbanization agenda.
However, a limited default may play a useful function in the lead-up to the Chinese government’s 19th Party Congress by exposing and punishing poor management by local officials. That would provide Xi Jinping a means to further tighten his grip as he begins another five years in charge.
But looking at the bigger picture, the scale of the debt problem plus the Chinese government’s steps to discipline debt raising and push deleveraging will put pressure on local governments, just at a time when they are providing solid momentum for the economy.
Locally administered infrastructure project spending has helped drive a rebound in infrastructure spending — up 21.1 percent in H1 2017 — that has supported the economy so far this year. The crackdown in funding, plus the impact of ongoing tight monetary policy, will likely weigh on growth in H2 2017.
That’s why Mizuho Chief Economist Shen Jian Guang is forecasting a slowdown in growth to 6.6 percent -6.7 percent year-on-year in H2 2017, compared with 6.9 percent in H1 2017, due to the impact of a continued, tight monetary policy. I’ll be looking at how China’s government enforces its new debt rules and their impact on the economy in future posts.