Tuesday, February 09, 2010
China's 8,000 Credit Risks
Beijing's stimulus has spawned thousands of special government investment funds holding billions of dollars in off-balance-sheet debt.
By VICTOR SHIH
OPINION ASIA FEBRUARY 8, 2010, 10:47 A.M. ET
As the world struggles to recover from the most severe economic slowdown in a generation, China seemingly has accomplished a miracle. Growth registered at almost 9% last year, yet the government debt-to-GDP ratio still stood around a modest 20% as of December 31. Has China enjoyed the proverbial free lunch?
Far from it: The Chinese government has financed much of an enormous stimulus package through thousands of investment entities created by local governments. If Beijing doesn't soon recognize this problem and put a stop to it, banks in China, which have provided the bulk of the funding, may soon face delinquent loans that rival even China's enormous fiscal and foreign-exchange capacity.
After Beijing announced a $588 billion stimulus package in late 2008, local governments enthusiastically rolled out plans to invest more than $4 trillion over the following few years. These were far from idle pipe dreams. The central authorities permitted and even encouraged local governments to borrow heavily from banks to finance infrastructure projects. Because Chinese law forbids banks from lending directly to government institutions, these governments set up some 8,000 investment companies, according to official figures. Banks lending to these entities class the outlays as "enterprise loans."
Beijing is no longer sure how much money local investment entities have borrowed from banks and raised from bond and equity investors. The amount, however, must be large. In September, the Chinese press, citing government sources, suggested that these entities have borrowed $880 billion. In a January interview with the Twentieth Century Business Herald, a Chinese newspaper, the vice chairman of the Finance and Economic Committee of the National People's Congress, Yi Zhongliu, revealed that local investment entities borrowed some $735 billion in 2009 alone.
These are mere guesses, however. A National Audit Agency audit conducted late last year uncovered so many problems with the data that Premier Wen Jiabao ordered another large-scale audit of local investment entities. Until a thorough audit is completed and the results announced to the public, no one really knows the total scale of local borrowing.
To obtain an independent estimate, I collected data from thousands of sources, including regulatory filings, bond-rating reports and press releases of government-bank cooperative agreements. I estimate local investment entities' borrowing between 2004 and the end of 2009 totals some $1.6 trillion. The data are far from perfect because borrowing by low-level government entities and lending by small banks are difficult to track. Nonetheless, my evidence suggests that the scale of the problem is much larger than previous government estimates. At $1.6 trillion, the local debt is roughly one-third of China's 2009 GDP and 70% of its foreign-exchange reserves.
Although local budgets are limited, regional governments can sell land to raise money to pay interest and ultimately principal. Indeed, local authorities across the country sold land worth $233 billion in 2009, benefiting from the real-estate upsurge in the second half of the year. For local investment vehicles to fully repay interest and debt through the sale of land, however, the real-estate boom must continue for years to come, sustaining high demand for land. Worse, banks have already pledged more than a trillion dollars in additional credit lines to local investment entities. If the central government does not restrict bank lending to them, these entities will go deeper into debt, thus either requiring the sale of much more land or the creation of a pile of nonperforming loans.
The central government is already ordering banks to slow lending to local investment vehicles. However, stronger actions are needed to forestall disaster.
First, the government needs to order banks to stop lending to all new or newly started investment projects undertaken by local entities. This also would slow the overall amount of lending and constrain rising inflation.
Second, since county governments are in the poorest fiscal shape and have the least ability to repay banks, the central government should take over the debt of almost all of the county-level investment vehicles. Although this will increase China's debt-to-GDP ratio significantly, the total would still be low by international standards.
A sudden contraction of lending to local investment vehicles will generate a wave of nonperforming loans, but a greater reliance on market mechanisms can easily solve this problem over the next few years.
First, banks will fully recover the debt of the healthiest local entities, which may account for half of total local debt. For the remainder, the government needs to allow banks to directly sell subprime or distressed loans to both foreign and domestic investors. Beijing need not fear that China's listed banks will sell their nonperforming loans at below-market prices, as these banks report to shareholders. Banks, in conjunction with investment banks and distressed-asset investors, should also explore ways to securitize local debt for sale to both domestic and international investors. The latter in particular would have a healthy appetite for yuan-denominated security, anticipating a currency revaluation soon.
Beijing's mantra of "reform and opening" rings increasingly hollow in recent years as a larger share of financial resources is poured into the state sector. However, a timely, bold and market-oriented intervention to resolve the local-debt problem would once again put China on a path of reform.
China's 8,000 Credit Risks
Beijing's stimulus has spawned thousands of special government investment funds holding billions of dollars in off-balance-sheet debt.
By VICTOR SHIH
OPINION ASIA FEBRUARY 8, 2010, 10:47 A.M. ET
As the world struggles to recover from the most severe economic slowdown in a generation, China seemingly has accomplished a miracle. Growth registered at almost 9% last year, yet the government debt-to-GDP ratio still stood around a modest 20% as of December 31. Has China enjoyed the proverbial free lunch?
Far from it: The Chinese government has financed much of an enormous stimulus package through thousands of investment entities created by local governments. If Beijing doesn't soon recognize this problem and put a stop to it, banks in China, which have provided the bulk of the funding, may soon face delinquent loans that rival even China's enormous fiscal and foreign-exchange capacity.
After Beijing announced a $588 billion stimulus package in late 2008, local governments enthusiastically rolled out plans to invest more than $4 trillion over the following few years. These were far from idle pipe dreams. The central authorities permitted and even encouraged local governments to borrow heavily from banks to finance infrastructure projects. Because Chinese law forbids banks from lending directly to government institutions, these governments set up some 8,000 investment companies, according to official figures. Banks lending to these entities class the outlays as "enterprise loans."
Beijing is no longer sure how much money local investment entities have borrowed from banks and raised from bond and equity investors. The amount, however, must be large. In September, the Chinese press, citing government sources, suggested that these entities have borrowed $880 billion. In a January interview with the Twentieth Century Business Herald, a Chinese newspaper, the vice chairman of the Finance and Economic Committee of the National People's Congress, Yi Zhongliu, revealed that local investment entities borrowed some $735 billion in 2009 alone.
These are mere guesses, however. A National Audit Agency audit conducted late last year uncovered so many problems with the data that Premier Wen Jiabao ordered another large-scale audit of local investment entities. Until a thorough audit is completed and the results announced to the public, no one really knows the total scale of local borrowing.
To obtain an independent estimate, I collected data from thousands of sources, including regulatory filings, bond-rating reports and press releases of government-bank cooperative agreements. I estimate local investment entities' borrowing between 2004 and the end of 2009 totals some $1.6 trillion. The data are far from perfect because borrowing by low-level government entities and lending by small banks are difficult to track. Nonetheless, my evidence suggests that the scale of the problem is much larger than previous government estimates. At $1.6 trillion, the local debt is roughly one-third of China's 2009 GDP and 70% of its foreign-exchange reserves.
Although local budgets are limited, regional governments can sell land to raise money to pay interest and ultimately principal. Indeed, local authorities across the country sold land worth $233 billion in 2009, benefiting from the real-estate upsurge in the second half of the year. For local investment vehicles to fully repay interest and debt through the sale of land, however, the real-estate boom must continue for years to come, sustaining high demand for land. Worse, banks have already pledged more than a trillion dollars in additional credit lines to local investment entities. If the central government does not restrict bank lending to them, these entities will go deeper into debt, thus either requiring the sale of much more land or the creation of a pile of nonperforming loans.
The central government is already ordering banks to slow lending to local investment vehicles. However, stronger actions are needed to forestall disaster.
First, the government needs to order banks to stop lending to all new or newly started investment projects undertaken by local entities. This also would slow the overall amount of lending and constrain rising inflation.
Second, since county governments are in the poorest fiscal shape and have the least ability to repay banks, the central government should take over the debt of almost all of the county-level investment vehicles. Although this will increase China's debt-to-GDP ratio significantly, the total would still be low by international standards.
A sudden contraction of lending to local investment vehicles will generate a wave of nonperforming loans, but a greater reliance on market mechanisms can easily solve this problem over the next few years.
First, banks will fully recover the debt of the healthiest local entities, which may account for half of total local debt. For the remainder, the government needs to allow banks to directly sell subprime or distressed loans to both foreign and domestic investors. Beijing need not fear that China's listed banks will sell their nonperforming loans at below-market prices, as these banks report to shareholders. Banks, in conjunction with investment banks and distressed-asset investors, should also explore ways to securitize local debt for sale to both domestic and international investors. The latter in particular would have a healthy appetite for yuan-denominated security, anticipating a currency revaluation soon.
Beijing's mantra of "reform and opening" rings increasingly hollow in recent years as a larger share of financial resources is poured into the state sector. However, a timely, bold and market-oriented intervention to resolve the local-debt problem would once again put China on a path of reform.