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1 中 银 国 际 固 定 收 益 研 究 BOCI (Steve Wang) + (852) (Qiong Wu), CFA +(852) (Vivian Zhang) +(86) (Lucy Liu) +(86) x8025 Rates, Currencies & Credits Special Research Report : Brewing risks from local government debts: The Chinese case vs. U.S. crisis Both China and the U.S. have a local government debt problem, despite for very different reasons. Chinese banks are major holders of local government debts in the form of loans, while individuals and fund managers are the major risk takers of U.S. local government debts in the form of municipal bonds. A tightening monetary policy, severe cooling measures on real estate market by central government and a suspension of direct bond issuance from local government finance vehicles are the main causes for China s local government debt trouble. The U.S. local government debt crisis is largely caused by a structural imbalance between the falling income and property tax receipts and the rising costs of government sponsored pension and Medicare entitlements. A prolonged slow economic recovery marked by a sustained high unemployment rate and falling real estate market have simply compounded this U.S. problem. Chinese local governments largely rely on revenues from central government fund transfer/support & taxes/charges related to corporate activities, in contrast to their U.S. peers relying on individual and consumer-related taxes and charges. 采 1 This report only represents analysts personal viewpoints, which don t necessarily represent those of BOCI Group and any of its affiliated entities.

2 Chinese local governments spend significantly a smaller portion of their budget on key spending items such as public education, services & welfare than their U.S. peers do, while appear to bear responsibilities to fund more areas of social and public services and assistances., Chinese local government debts are mainly used for fixed asset investment such as public facilities, infrastructures, transportation & land reserves, while their U.S. peers use most of their debt funding for public services and welfare., The reopening of local government bond market, successful negotiations with banks on loan rollover, extension, exchange or refinance and the easing of land purchase requirement to rejuvenate land sales are near-term solutions for the Chinese debt trouble, but U.S. will need some structural moves in areas such as lowing costs of their public and social entitlement programs and making public education systems more cost efficient to meet the challenge. A sustained fast economic growth will ultimately help local governments to grow out of and away from their current debt problems. China is expected to continue to grow at a rapid pace, but U.S. has a lot to try to right its course. 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采 采

3 Brewing risks from local government debts: The Chinese case vs. U.S. crisis Local governments in both the U.S. and China are facing some serious debt problems today, despite for different underlying reasons. In the U.S., the potent mixture of a prolonged below-par economic recovery, a stubborn high unemployment rate and a long-slide of home prices, all rooted in the financial crisis of , have severely hurt the U.S. local governments fiscal health. Some local governments are experiencing increased budget gaps while at the same time facing elevated financing costs. The record levels of economic stimulus by the U.S. federal government and an unprecedented monetary easing and liquidity injection by the Federal Reserve have so far been ineffective in turning their fortune. In China, the story is of a different version. The monetary tightening since early 2010 by the central government on concerns of an overheated economy, particularly of a real estate bubble, has severely curbed new debt funding and refinancing activities of local governments. This happened right after an explosive growth of such debts since the financial crisis. At the same time, land sales, which have been a major revenue source for Chinese local governments, have fallen dramatically. The combination of increased hurdles of access to bank loans and bond market and much slowed land sales has stirred up anxiety on the credit quality and refinancing ability of many local governments. Issues under the spotlight Although the U.S. local government debt crisis (or more precisely the muni bond crisis) has been in headlines for sometime since 2008, concerns on Chinese local government debts only emerged as a recent international focus recently when China s National Audit Office (NAO) released an extensive and detailed audit report on Chinese local government debts in June Indeed, other Chinese government agencies, such as China Banking Regulatory Commission and the central bank PBoC, had separately made their own assessment on the local debt issues in the past, but the NAO assessment is considered the first comprehensive analysis specifically targeting the topic. NAO reported a total outstanding of RMB 10.7tn ($1.625tn) in local government : GDP 27% 1 1) 3

4 debts/liabilities as of the end of last year, which accounted for 27% of China s GDP. They are classified into three categories (see Fig. 1): 1) Direct debts, for which local governments are directly responsible for debt repayments, are approximately RMB 6.71tn or 62.62% of the total debts/liabilities. 2) Contingent debts, for which local governments have provided guarantees, are about RMB 2.34tn or 21. of the total. 3) Other debts or implicit liabilities, for which local governments don t have contractual obligations but may have to offer assistance on repayment if needed, are about RMB 1.67tn or 15.5 of the total. Excluding implicit liabilities, the combined direct and contingent debts/liabilities represents 22.7% of China s GDP (see Fig. 2). In the U.S, local government debts are nearly all in the format of municipal bonds ( munis ) or direct debts. As of the end of last year, the outstanding amount of the U.S. muni bonds was at $2.92tn or a 20% of the U.S. GDP % 2) ) / Fig. 1: Outstanding of China s local government debts as of 2010 贷 ovt gu 转 rentees 21.80% 费 mplicit 邦 irect debts debts % However, U.S local governments are facing sizable implicit liabilities that are stemmed from the government pension and Medicare entitlements and programs. Such implicit liabilities are estimated to be around $3.5tn by academic quotes, representing 24% of the U.S. GDP. In China, government pension and healthcare programs are still under development and have not been built into a rigid entitlement system. Liability estimates in this regard are currently unavailable. Chinese local government debts underwent a rapid growth during its relatively short history 2 / Fig. 2: A few facts on local government debts: China vs. U.S. /China /U.S. History Borrowers 2010 Size of local govt debt at the end of GDP % of GDP in Local government debt started in 1979 Provincial, city and county governments RMB tn ($ 1.626tn), including direct debts and contingent debts of RMB 9.05 tn GDP 22.7% Direct debts and Contingent debts represent 22.7% of China s GDP / Source: NAO GDP GDP 20% In 1812, New York City issued 1st officially recorded municipal bond. State and city governments and their agencies () $2.925 tn of munis ( direct debts ) 20% 20% (only include munis) / Source: NAO, NSB, SIFMA, BOCI 4

5 3 ( ) / Fig. 3: Local government debt outstanding ($ tn) and growth rate: China local government debt vs. U.S. munis / Chin 转 / 企. 能. % 贷 邦 利 ( 美 地 能 ) % 贷 邦 利 ( 美 地 能 ) % 60% 50% 40% 30% 20% /Chin 转 / 企. 能 % % / Source: NAO, SIFMA, Bloomberg, BOCI /note: the growth rates of and are average growth rate in each period (see Fig. 3). The growth rate has been above 20% per annum since 1997 and peaked at high levels of 48.25% and 61.92% in the years of 1998 and 2009 respectively, when government installed stimulus efforts at the times of Asian financial crisis of and the global financial crisis of The high debt growth largely mirrored the high growth of Chinese economy and a continuing expansion of China s domestic capital market. In comparison, the mature U.S. muni market growth has been growing at less than 10% a year over the data period. In general, Chinese local government debts have relatively shorter maturities. Of the total outstanding, 53% of the debts are due in 3 years and nearly 70% in 5 years. A simplified average of the maturity profile published by the NAO report gives us a rough average maturity of Chinese local government debts at about 4 years, as compared to the average maturity of U.S. munis at 15 years. Among the various types of borrowing entities/vehicles of the Chinese local governments, vehicles called local government finance platforms (LGFPs) are a major borrowing group. Their debt issuance made up 46.3 of the total local government debt outstanding, as at the end of In particular, direct lending by commercial banks to LGFPs have surged over the past few years, from approximately RMB 1.7tn of total outstanding at the beginning of GDP 24% % % 61.92% % 53%370%

6 4 : / Fig. 4: Local government debt holders: China vs. U.S. Bonds B 转 nk lo 转 ns held by 79% b 转 nks* Bonds 4% held by Chin 转 funds* 1% Bonds held 邦 ebt to 可 thers by 费 金 能 co* upper govt 10% 2% 4% 持 unds 32% 费 金 邦 入 37% 企. 能. B 转 nks 10% 费 金 能 16% 可 thers 5% / Source: NAO, SIFMA, BOCI 2008, based on an estimate by PBoC, to about RMB 4.97tn as estimated by the NAO report. Who are the major debt holders? Chinese local government debts have some other significant distinctions from U.S. local government debts with respect to debt holders. In China, bank loans are the major form of local government debts, making up 79% of the total, while the rest of local government debt is in the form of bonds. (see Fig. 4). In other words, banks are the dominant investors/debt holders of Chinese local government debts. They hold 79% in loans and approximately 4% in bonds. In contrast, U.S. local government debts are nearly all in the form of muni bonds (20% in general obligation bonds and 80% in revenue bonds); individual investors (37%) and funds (32%) are the dominant debt holders. Banks only hold 10%, even less than the holdings by insurance companies (16%). Nevertheless, U.S. muni Investors enjoy federal tax exemption. Considering the high concentration of local government debts in the hands of Chinese banks and the generally weaker credit qualities of LGFPs than the overall quality of the banks loan portfolio, concerns over banks high exposure to these risk assets have become increasingly a focus of the financial market, given their latest local fiscal deteriorations. Where are the roots of these debt problems? Fiscal deterioration is one of the main causes. As Fig. 5 shows, Chinese local governments % 4 79% 4% 20%80% 37% 32%10% 16% 6

7 5 : / Fig. 5: Local government revenue and expenditure history: China vs. U.S. ($ billion) a) /China 1,200 1,000 / 美 evenue / 保 xpenditure b) /U.S. 3,000 2,500 / 美 evenue / 保 xpenditure 2,000 1,500 1, 金 A 金 A / Source: Ministry of Finance, US Census Bureau have been experiencing a rapid fiscal growth in recent years and enjoyed an overall surplus or balanced budget until last year, when expenditure exceeded revenue, though by a relatively small margin. This fiscal deficit was largely the result of increased infrastructure spending and decreased income from land sales. In the U.S., local governments started to see fiscal shortfall in 2008 (the latest data point we can find) in the latest deficit cycle. Reduced tax collection from both individual incomes and real estate properties on the back of the economic downturn should be the main cause. China s LGFPs are in particular facing a high

8 repayment risk in today s much tightened credit environment. China Banking Regulatory Commission (CBRC) estimated that about 23% LGFPs debts may see repayment problems. Assuming the total LGFP debt outstanding was RMB 8.47tn as published by NAO, we estimated that Chinese banks exposure to problematic local government debts could hit RMB 1.95tn, or 4% of the total bank loans at the end of Although this is a somehow manageable percentage, a wholesale default of such a block in a worst-case scenario would nevertheless significantly impact the health of banks balance sheet. At this point, however, we have little historical data that would allow us to establish an expected default rate for the Chinese local government debts. In the U.S. case, the local government debt problem is mostly tied to the country s economic outlook and to the solution of the structural imbalance between the growth of tax receipts and the growth of public welfare and entitlement payouts. Fortunately, history shows that the default rate of U.S. munis has been low. For example, Moody s study shows the cumulative default rate of U.S. munis during was only % on an annual basis, compared to the 0.675% default rate for Aaa-rated corporate bonds. Reading the fiscal tea leaves for solution clues The revenue and expenditure profiles of Chinese local governments are significantly different from those of U.S. local governments, which means the potential solution for their respective local debt problems could be quite different. The key revenue streams of Chinese local governments are central government fund transfer and support (44%), VAT/business taxes (22%), followed by real estate related taxes (9%), corporate income tax () and misc government charges/fees () (See Fig. 6). In other words, revenue contributions from the central government and corporate-related activities are critical to Chinese local governments (see Fig. 6a). In contrast, the revenue of U.S. local governments has a more balanced profile among the items of misc charges/fees (22%), federal government support (1), sales taxes and gross receipts (17%), property taxes (16%) and individual income taxes (12%) (see Fig. 6b). Obviously, local taxes and receipts related to individual activities are the dominant part of their overall revenue. 23% % % Aaa 0.675% 44% /22% 9% 6 6a 22% 117%16% 12%6b 8

9 / Fig. 6: Local government revenues in 2008: China vs. U.S. a) /China / Centr 转 l govt tr 转 nsfer 8 入 A 农 & business t 转 xes 7 美 e 转 l est 转 te rel 转 ted t 转 xes 6 Corp income t 转 xes 5 Ch 转 rges & misc. revenue 4 费 ndividu 转 l income t 转 xes 3 可 ther t 转 xes 2 可 thers 1 4% 2% 3% 9% 23% 45% b) /U.S. Ch 转 rges 转 nd misc. revenue 7 持 ed support 6 1 能 转 les 转 nd gross receipts 5 17% 利 roperty t 转 xes % 费 ndividu 转 l income t 转 xes % 可 ther t 转 xes 2 6% 可 thers 1 9% / Source: Ministry of Finance, US Census Bureau 23% In regard to expenditures, Chinese local governments appears to have a more evenly distributed outlay profile and also cover more areas and fronts, as compared to their U.S. counterparties (see Fig. 7). Although China s main expenditures are similar to those of the U.S, led by education (17%), public services (15%) and public welfares (13%), the total share of these three areas in the Chinese case makes up only 45%, as comparing to the 65% total share in the U.S. Additionally, Chinese expenditures on industry & financial related affairs make up of the total, as compared to 2% in the U.S., signaling the strong focus and effort by Chinese local governments to promote local industrial and business developments. One category that seems to find no counterparty in the U.S. is the agriculture development affair, which makes up of the total expenditures. Given that agriculture still contributes 10% of China s total GDP as of 2010 (only approximately 1.2% in the U.S.), most of Chinese local governments have dedicated budget lines to economic activities in this area. Uses of the proceeds from borrowings are also quite different between the two cases. Chinese local governments spend heavily on fixed asset investment, with more than 60% of their debt spending in public facilities/infrastructures and 7 17%, 15% 13% 45% 65% 2% % ( 1.2% 60%

10 / Fig. 7: Local government expenditures in 2008: China vs. U.S. a) /China 保 duc 转 tion 11 利 ublic services 10 利 ublic welf 转 re 9 可 thers 8 Agricultur 转 l development 7 Community 转 ff 转 irs 6 Business & fin 转 ff 转 irs 5 利 ublic s 转 fety 4 地 e 转 lthc 转 re 3 农 r 转 nsport 转 tion 2 保 nvironment 转 l protection 1 7% 5% 3% 3% 17% 15% 13% 13% b) /U.S. 保 duc 转 tion 10 利 ublic services 9 利 ublic welf 转 re 8 利 ublic s 转 fety 7 地 e 转 lthc 转 re 6 农 r 转 nsport 转 tion 5 Community 转 ff 转 irs 4 可 thers 3 保 nvironment 转 l protection 2 Business & fin 转 ff 转 irs 1 6% 5% 4% 2% 2% 14% 21% 30% / Source: Ministry of Finance, US Census Bureau public transportation. Debt spending in the public services, such as education and healthcare, are relatively smaller.(see Fig. 8) In the U.S., a larger portion of funds from muni issuance are dedicated to public services. For example, roughly 34% of total U.S. muni issuance in went to education and healthcare, far more than that of Chinese local governments debt spending of 9.54% in education, healthcare & affordable housing. Sources of repayment are also different. The NAO report has found that, as at the end of 2010, 3 of total Chinese local governments direct debts are somehow tied to incomes from land sales. In the U.S., repayment of general obligation bonds are tied to local government s overall taxes and receipts, and that of revenue bonds rely on revenue streams from the funded project. Besides, U.S. munis tend to have longer maturities with amortized principle payment, which is in contrast to the Chinese 34% 9.54%

11 8 / Fig. 8: Local government use of borrowed funds: China vs. U.S. * 农 美 金 能 利 24% 利 ublic f 转 cilities/ 费 n fr 转 36% / 还 转 nd reserves 保 du,he 转 lthc 利 ublic 11% 转 re/ 转 fford 转 b 持 转 cilities 农 美 金 能 利 le housing 企 tilities 2% 13% 10% 地 ousing 13% 3% Agricultur 转 l 邦 入 利 级 农 地 e 转 lthc 转 re 5% 11% 可 thers 企. 能. Chin 转 11% 可 ther 贷 ener 转 l 保 金 入 利 urpose protection 27% 保 du 3% 23% / Source: NAO, SIFMA /Note: In the U.S. case, issuance data in were used to calculate the use of proceeds. local government debts that are mostly in bullet form at relatively short maturities. Different pills for different patients Indeed both China and U.S. are facing serious issues in the local government debt front, but their respective solution to the problem may be significantly different for their unique natures. In our view, central government will play a critical role in handling and solving the Chinese local government debt problem. Chinese local government debts are mostly accumulated during the past few years of economic stimulus and held largely by domestic banks. At the same time, local governments have long enjoyed a strong fiscal support from the central government and been an integrated part of the execution branch of central government s policies. Also, don t forget that key state-owned Chinese banks are major holders of local government debts and thus have big stakes in this problem. More specifically, the central government can carry out a number of policy and market measures to meet the challenges. Resuming the application process for local government bond issuance (including for the newly developed offshore RMB bond market) should be a top priority. Direct bond issuance by LGFPs has been basically shut down after a period of under-regulated boom. The reopening of this segment of China s domestic bond market is 11

12 expected to be accompanied by a more streamlined and stringent regulatory framework and criteria. While an upgraded regulation on this market will help to weed out unqualified or poorly documented bond issuance, allowing local governments to have continuous access to the capital markets will help them to ease their refinancing burden and uncertainty, whether it s for their bank loans or outstanding bonds. The point is particularly important given the relatively short maturities of Chinese local government debts and their high maturity concentration in the next two years. Also, a further developed local government bond market should help the governments continue to reduce their heavy reliance on bank loans by using more bond market mechanism to meet their funding needs. Regulators could also accelerate the development of China s securitization market, in particular a covered bond market, to open up more channels for their funding needs. This market could offer local governments a new way to monetize government-invested assets such as highways, real estate properties, utilities or well-defined future tax/fee receipts. The central government may also ease the capital and payment requirements on land sales, particularly for commercial and non-luxury or retirement housing developments, so as to rejuvenate land sales and increase fiscal revenue for local governments. Local governments can boost their balance sheet and fiscal health in other ways. They can list or even privatize some of the government-owned enterprises. Extending the debt maturity profile is also an effective approach to lessen the debt burden. This can partly accomplished through successful negotiations with banks on loan extension, rollover, exchange or refinancing. Credit enhancement through improved collaterals, insurance guarantees or central government assistance/guarantee programs can further help local governments to expand bond issuance. Local governments can also improve their fiscal situations by the traditional practices of cutting expenditures, especially in the areas of administrative expenses and industrial/commercial subsides, and expanding tax receipts, such as property tax, rental tax, alcohol/tobacco taxes, etc. For U.S. local governments, they will have to make some structural changes, in addition to any necessary fiscal rebalances, to solve their debt crisis. These changes include reducing /, /, /,,, 12

13 public pension and healthcare outlays and entitlements and making public schools, the biggest cost item in a local government s budget, to be more accountable for public taxes and finance for better cost efficiency on per student basis. Federal government may need to take a more active role in assisting local governments to ease their debt burden, while at the same time local governments could seek more revenues from higher gasoline and luxury consumer taxes and seek savings in the general public services and healthcare areas. Economic growth is the bottom line After all, a sustained and fast economic growth is the ultimate solution to the local government debt problem for both China and U.S. Tax receipts, asset valuations, enterprise incomes and new revenue streams are all dependent on the health of both local and state economies. China's sustained strong economic growth continues to set a sharp contrast to the poor recovery pace of U.S. economy. The troubled yet young Chinese local government debt market will have to prove its durability and progress to maturity. Its current troubles and imbalances during development are probably better classified as a growing pain, rather than a fundamental fault. We believe that if the Chinese economy can maintain its fast growth trajectory, coupled with the further development of China s financial market and regulatory environment (such as the development of a genuine municipal bond market), this growing pain should be able to find an orderly resolution without a dramatic shakeup of China s financial system and economic path. On the other hand, the U.S. local government debt problem needs a near-crisis solution with dramatic actions at both governmental and public levels. Even a full recovery of U.S. economy, although seems still remote as of today, will only ease some of the pains but will not solve the problem once and for all. Containing and reducing outlays from entitlement programs and obligations, slowing down expenditure growth, improving cost-base of public education and healthcare systems, and lowing regulatory and legal costs for corporate enterprises are all the additional medicines that U.S. local governments may have to take or swallow to achieve a long-lasting solution. 13

14 DISCLOSURE The views expressed in this report accurately reflect the personal views of the analysts. Each analyst declares that neither he/she nor his/her associate serves as an officer of nor has any financial interests in relation to the listed corporation reviewed by the analyst. None of the listed corporations reviewed or any third party has provided or agreed to provide any compensation or other benefits in connection with this report to any of the analysts, BOCI Research Limited and BOCI Group. Member companies of BOCI Group confirm that they, whether individually or as a group (i) do not own 1% or more financial interests in any of the listed corporations reviewed; (ii) are involved in making a market in the securities of China Petroleum & Chemical Corp.; (iii) do not have any individual employed by or associated with any member companies of BOCI Group serving as an officer of any of the listed corporation reviewed; and (iv) do not have investment banking relationship with any of the listed corporations reviewed within the preceding 12 months. This disclosure statement is made pursuant to paragraph 16 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission and is updated as of 22 July Waiver has been obtained by BOC International Holdings Limited from the Securities and Futures Commission of Hong Kong to disclose any interest the Bank of China Group may have in this research report. 14

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