$3.9 Trillion Of Local Gov Debt In China... And Counting

By Gordon G. Chang

Officials in Yangzhong in heavily indebted Jiangsu province are completing the “world’s biggest metal construction in terms of volume,” a 15-story “scenic pagoda” in the form of a local delicacy, the oddly shaped puffer fish.

And in my family’s hometown of Rugao, also in Jiangsu, you can find in the middle of a sprawling park the world’s tallest bronze statue of a mythical Chinese longevity figure.
Chinese officials, flush with cash, have in recent years indulged their passions to build structures bizarre, garish, and completely unnecessary. 

As Vice Finance Minister Zhu Guangyao said this month, “There are some projects, the so-called image projects, by local governments which have very little financial return and virtually no social benefits.” 

Since the end of 2008, China’s economy has expanded not because local governments were able to tax and spend but because they could borrow and build.
Yet can they also pay back? 

Since 1994, the country’s Budget Law has generally prohibited lower-tier governments from borrowing money, so they have circumvented this rule by forming more than 10,000 “local government financing vehicles” to take on obligations.
The LGFVs, as these conduit companies are known, had accumulated 10.7 trillion yuan in debt by 2010 according to official figures. 

Vice Minister Zhu this month said the amount of indebtedness may have risen “a little bit” since then.
Only “a little bit”? 

The National Audit Office will release its estimates of local government obligations next month, but nobody is waiting for the official number. 

In the last several days institutional analysts, almost as if acting in concert, have issued reports estimating the amount of the country’s local debt. 

Nomura’s Hong Kong office, for instance, in a September 24 report estimated that LGFV debt at the end of last year reached 19.0 trillion yuan, which constituted 14.7% of bank lending and equaled 37% of the country’s officially stated gross domestic product.
Other estimates are even higher. 

“I personally feel that the scale of local debt has already broken beyond 20 trillion yuan,” says Liu Yuhui of the Chinese Academy of Social Sciences. 

The noted researcher believes there are 9.7 or 9.8 trillion yuan of bank loans and 13 to 14 trillion yuan of obligations to shadow vehicles. 

The high end of Liu’s range—23.8 trillion yuan or $3.9 trillion—is remarkably close to the June 2010 prediction of Victor Shih, then at Northwestern University. 

Shih, whose groundbreaking work last decade highlighted the debt load of local governments, then noted in the China Economic Quarterly that LGFVs would accumulate 24.1 trillion yuan by the end of 2012 if they borrowed to the limit of their credit lines.
Apparently, officials did just that, inking loan agreements for every fen they could get their hands on. Unfortunately, they have not used the proceeds wisely. 

A September 26 analysis from Macquarie Capital Securities shows that LGFVs are devoting a larger proportion of new borrowings to pay off old ones: 29% of funds raised through bonds this year went to discharge existing debt, up from 8% in 2009.
There are other warning signs. 

Nomura notes that LGFV profitability “fell sharply” in 2012 as did operating cash flows. 

Moreover, LGFVs had, in Macquarie’s words, a “staggeringly low” return on assets: just 1.3% in 2012.
No wonder localities have had to give these vehicles fiscal subsidies to permit them to pay back loans. Moreover, governments have also injected assets into them for the same purpose. 

Nomura, however, notes that many of the assets have been of an illiquid nature. 

Therefore, it looks like they will be of little use when most needed, in a crisis.
The Japanese financial services giant also believes 70% of these local government vehicles are at risk of default, but it notes that its analysis probably understates the severity of the situation because it sampled only the better LGFVs, those that had been strong enough to issue bonds.
Not every analyst is overly perturbed by the massive run-up in LGFV debt, however. 

Take the famous Jonathan Anderson, now at the China-based Emerging Advisors Group. 

He tells us not to worry about the deterioration in traditional ratios as they “are less meaningful than they appear at first glance.”
And why is that? 

The credit boom that has troubled most everyone is only a “virtual” one. 

In a September 27 note entitled “Real Economics vs. China Economics,” he acknowledges that banks are lending very large sums but suggests that local government vehicles are leaving funds on deposit in the banking system. 

“In short, LGFVs have borrowed tremendously but they are holding a tremendous amount of cash in deposits as well.”
All of Anderson’s conclusions are logical—if you accept his premises. 

But why would LGFVs—or any other borrower for that matter—take out loans for the purpose of making deposits with their lenders and thereby incur negative interest spreads on a long-term basis? 

Moreover, his statement about LGFVs being cash-rich cannot be true in light of, among other things, the LGFV defaults that have already occurred.
The observation that LGFVs have been depositing substantial amounts of cash they borrowed, therefore, is about as wrong as it can be. 

There is, after all, a giant puffer fish sitting on an island in Jiangsu province that suggests LGFVs are, well, seriously under water.