Technical Assistance Consultant s Report Project Number: 45157 October 2013 Local Debt in the People s Republic of China: Local Government Financing Vehicle s Debt Management and Risk Control - Replacing Shadow Bank Financing with Local Government Bond (Financed by TA 7862-PRC, Sub-project 1.7) 中 国 地 方 政 府 债 务 : 地 方 政 府 融 资 平 台 公 司 的 债 务 管 理 与 风 险 控 制 Prepared by the Consultant Team of Study on Local Debt in the People s Republic of China: Local Financing Vehicle s Debt Management and Risk Control For Executing Agency: Ministry of Finance, People s Republic of China Implementing Agency: Ministry of Finance, People s Republic of China This consultant s report does not necessarily reflect the views of ADB or the Government concerned, and ADB and the Government cannot be held liable for its contents.
2013 Asian Development Bank 2013 年 亚 洲 开 发 银 行 All rights reserved. Published in 2013. 版 权 所 有 2013 年 出 版 Printed in the People's Republic of China. 在 中 华 人 民 共 和 国 印 刷 The views expressed in this publication are those of the authors and do not necessarily reflect the views and policies of the Ministry of Finance of the People s Republic of China (PRC) and the Asian Development Bank or its Board of Governors or the governments they represent. 本 出 版 物 中 所 述 为 作 者 的 观 点, 不 一 定 代 表 中 国 财 政 部 亚 洲 开 发 银 行 或 其 理 事 会 或 其 代 表 的 政 府 的 观 点 和 政 策 The Asian Development Bank (ADB) does not guarantee the accuracy of the data included in this publication and accepts no responsibility for any consequence of their use. 亚 洲 开 发 银 行 不 担 保 本 出 版 物 中 所 含 数 据 的 准 确 性, 而 且 对 使 用 这 些 数 据 所 产 生 的 后 果 不 承 担 责 任 Use of the term country does not imply any judgment by the authors or the Asian Development Bank as to the legal or other status of any territorial entity. 使 用 术 语 国 别 不 代 表 作 者 或 亚 洲 开 发 银 行 对 任 何 地 域 实 体 的 合 法 性 或 其 它 法 律 地 位 的 任 何 判 断
Sub-project 1.7 Synopsis of Final Report Local Debt in the People s Republic of China: Local Government Financing Vehicle s Debt Management and Risk Control Replacing Shadow Bank Financing with Local Government Bond 终 期 报 告 摘 要
Consultant Team 咨 询 专 家 组 WANG Mei (Lisa) Executive Deputy Director, National Economic Research Institute, PRC 王 梅 中 国 改 革 基 金 会 国 民 经 济 研 究 所 常 务 副 所 长 Project Officer 项 目 官 员 KHOR Niny 许 霓 妮 XU Sha 徐 莎 Economist, Asian Development Bank PRC Resident Mission 亚 洲 开 发 银 行 驻 中 国 代 表 处 经 济 学 家 Associate Project Analyst, Asian Development Bank PRC Resident Mission 亚 洲 开 发 银 行 驻 中 国 代 表 处 助 理 项 目 分 析 师
TABLE OF CONTENTS I. INTRODUCTION... 6 II. FUNDAMENTAL PROBLEMS OF LGFPCS... 6 III. MACRO REASONS FOR STATE COUNCIL NOTICE #19 NOT BE IMPLEMENTED EFFECTIVELY... 9 IV. PROPOSALS ON POLICY MEASURES AND SYSTEM REFORMS... 11
I. INTRODUCTION The local government financing platform companies (LGFPCs) the local government financing vehicle of the People s Republic of China (PRC) are the focal point of the PRC s current fiscal and financial risks. Since June 2010, when the State Council issued State Council Notice Regarding the Issues of Strengthening the Management of Local Government Financing Platform Companies(State Council Notice #19, 2010), cleaning up LGFPCs has made some progress, including detailed classification of LGFPC bank loans, assessment and characterization of their risks, putting a cap on their scales and so on. II. FUNDAMENTAL PROBLEMS OF LGFPCS However, many fundamental problems with the LGFPCs remain unsolved. These problems are: (i) Debt Financing of LGFPCs Is More Hidden and Costly Currently the total amount of bank loans of local government financing platforms (LGFPs), which includes local government financing platform companies, 1 is CNY9.3 trillion, representing an increase of 2% during the past two years. Its total scale has been under strict control. 2 However, since 2012, Shadow banking has become the main source of financing to the financing platforms. A significant jump of shadow banking financing took place during the first quarter of this year (see Figure 1). Shadow banking are those non-bank credit intermediary agents that convert savings into investments, with no or little supervision by financial regulators. They include trust companies, finance companies, leasing companies, small creditors, pawn shops and so on. According to an estimation by a China Banking Regulatory Commission report, by the end of 2012, the size of shadow banking financing reached CNY20 trillion; of which interbank loans, wealth management products and credit asset transfer was CNY8 trillion; guarantees, small credits, pawn shops, private equity funds was about CNY2 trillion; private lending (including entrusted loans worth CNY6 trillion and online ecredits) was CNY10 trillion. In addition, some local governments use methods such as BT (build-transfer), construction with contractor financing and illegal fund-raising to raise financing in disguised form. 1 Financing platforms include financing platform companies, local governments departments and their service units (shiye danwei). Financing platform is a concept used by China Banking Regulatory Commission; financing platform company is a concept used by National Audit Office and Ministry of Finance. 2 China Securities Journal, 2013.03.08, Shang Fulin: loans of local government financing platforms has increased only two percent over the past two years
Figure 1. Bonds and Trusts Used in Infrastructure Construction in First Quarter of Each Year (100 million) 8,000 7,000 6667 6,000 5,000 4,000 3,000 2,000 1,000 1412 1213 2126 0 2010 2011 2012 2013 Source: China Banking Regulatory Commission Report Replacing bank loans with shadow banking financing has resulted in at least three worrying problems: First, investment and financing activities of shadow banking are not entirely subject to regulation, and there is no sufficient monitoring statistics. As a result LGFPCs debt amount, their maturity and financed assets mismatches are more opaque. This further increases the difficulty of local government debt management and fiscal risk prevention. Second, the financing cost of shadow banking is much higher than that of bank loans. For example, the financing cost of trusts and entrusted loans is about 10%, BT financing up to 20%, and mass fund-raising up to 17.5%. All are much higher than the 7% cost of bank loans. This has led to an increase of the debt burden of the LGFPCs. Third, the financing source of shadow banking is still mostly banks. While the bank loans of the LGFPCs have been brought under control, the total risk exposure of the banking system to local government financing platforms and platform companies is still increasing. (ii) The Extent of Irregular Operation of the LGFPCs Is Still Serious Since 2010, cleaning up the LGFPCs has been pursued mainly through two approaches: First, depending on cash flow coverage ratio for principals and interests of loans, such as above 100%, between 70% and 100%, between 30% and 70%, and below 30%, the platforms (including platform companies ) loans are classified into four categories, full coverage, basic coverage, semi-coverage and non-coverage. By the
end of June 2012, according to China Banking Regulatory Commission s statistics, there were a total of 10,682 LGFPs (including LGFPCs) in the country. 70% of their bank loans were identified as full coverage, 20% non-coverage, and the proportions of basic coverage and semi-coverage were relatively low. Second, five conditions are formulated and LGFPs need to meet them before they can be classified as independent commercial companies, i.e., their label of LGFPs can be officially taken off. These five conditions are: (i) satisfy the modern corporate governance requirements and operate as commercial enterprise legal persons; (ii) the liability/asset ratio is below 70%; (iii) 100% cash flow coverage on principals and interests of loans, and every creditor bank of the LGFP characterizes the risk of its loans as full coverage; (iv) collateral of existing loans, loan terms, and repayment methods are verified and acceptable; and (v) there is no default record and the business is sustainable independently. By the end of June 2012, 1900 LGFPs, or 18% of the total, have been classified as independent commercial companies. In other words, these 1,900 label off companies can borrow bank loans as any other companies, not subject to the restrictions enforced on LGFPs. On the surface, 70% of the LGFP loans have full cash flow coverage, which seems to be a pretty good situation. In addition, 18% of the LGFPs are classified as label off. But the credibility of these figures should be discounted. The actual quality of these full cash flow coverage and label off financing platform companies are rather questionable. This is because there has been no substantial improvement in the management system of LGFPs. Whether they are local government financing platform companies or label off companies, most of them are still mixing government administration with commercial business, not following rules and regulations, with inadequate information disclosure and operating in a black box. This can be seen from the audit results of 223 LGFPCs under 36 local governments launched by the National Audit Office in 2013 3. Among the 223 LGFPCs being audited, at the end of 2012, 94 had assets worth CNY897.6 billion that cannot be or cannot be easily sold for cash, accounting for 37.6% of their total assets; there were five companies whose claimed registered capital of CNY 5.6 billion was actually not put in place; there were six companies whose assets were inflated by CNY37.1 billion. Among the 61 financing platform companies that had been classified as label off companies, 55 of them still bear debt for the government or continued to bear the obligation of financing the public projects; 18 financing platform companies used the label off as excuses to underreport government debt worth CNY247.9 billion, which were not subject to local government debt supervision. 3 National Audit Office, 2013.6.10, Audit result for government debts of 36 local-level governments
In summary, since the issuance of State Council Notice #19, methods of financing by LGFPCs have become more hidden and costly, and operations of platform companies not following rules and regulations remain a serious problem. Even after the issuance of No. 463 regulation by the Budget Department of Ministry of Finance, Notice Regarding Restraint of Local Government Financing Acts that Violates Laws and Rules, in December 2012, LGFPCs are still in a messy state that is hard to disentangle. III. MACRO REASONS FOR STATE COUNCIL NOTICE #19 NOT BE IMPLEMENTED EFFECTIVELY The reasons that State Council Notice #19 has not been implemented effectively are closely related to the changes of the PRC s macroeconomy since 2012. It can be seen from the two figures below that GDP growth had clearly fallen since the first quarter of 2012. Not until the third quarter of 2012 that economic growth had finally stopped decreasing due to strong rebound of infrastructure investment. Due to weak exports and excess manufacturing capacity, infrastructure investment plays an important role in maintaining the macroeconomic stability, but infrastructure investment is mostly undertaken by LGFPCs. This largely explains why LGFPCs were cleaned up in 2011 and their impulses of taking on additional debt were strictly suppressed, but in 2012 and the first quarter of 2013 they came back and continued taking on additional debt without due regard to costs and their number continued to rise. Figure 2. GDP Quarterly Growth Rate Figure 3. Fixed Asset Investment Quarterly Growth Rate 8.1% 30% 25% 20% 7.8% 7.8% 15% 7.7% 7.7% 10% 5% Manufacturing Infrastructure Real Estate 1Q 2012 2Q2012 3Q2012 4Q2012 1Q2013 Source: National Bureau of Statistics 0% 1Q 2012 2Q2012 3Q2012 4Q2012 1Q2013 According to the estimation of the author s model of local government debt, in order to ensure the realization of 7.5% GDP growth target annually from 2013 to 2015, infrastructure investments of CNY 9.3, CNY10.9 and CNY12.5 trillion would be
required in 2013, 2014, and 2015 respectively. Under the optimistic assumption that the size of local government debt by the end of 2012 was CNY13 trillion, the local governments correspondingly need to borrow new debt CNY4.5, CNY5.8 and CNY7.1 trillion per year from 2013 to 2015, and the balance of their indebtedness will reach CNY15.7, CNY19.4 and CNY23.9 trillion, respectively. Therefore, even under the optimistic scenario, local governments pressure of debt financing over the next three years will increase sharply, and the debt burden will be very heavy (see Figure 4). Figure 4. Debt and Repayment Burden of Local Government Outstanding Debt as % of GDP Interest Payment as % of Local Government Revenue 30.5% 34.0% Outstanding Debt as % of Local Government Revenue 121% 138% 25.2% 27.4% 24.4% 28.2% 102% 82% 93% 106% 21.2% 18.6% 2012 2013E 2014E 2015E 2010 2011 2012 2013E 2014E 2015E Source: Author s calculations Against this macroeconomic backdrop, if cleaning up LGFPCs relies solely on blocking these companies from taking on additional bank loans, it is obviously not enough. There is a need to adopt a combination of policy measures and system reforms to tackle the LGFPC problems.
IV. PROPOSALS ON POLICY MEASURES AND SYSTEM REFORMS To address the problems of LGFPCs, central government has to take a comprehensive set of policy reform measures while managing the need to maintain balance between stabilizing economic growth and controlling financial risks. The author recommends that, in order to fundamentally solve the problems of LGFPCs, central government should lower future macroeconomic growth target to 7%, while significantly increase the amount of local government bond issuance to about CNY3 trillion over several years. In the meantime, using this as a breakthrough point, central government should adopt a combination of policy reform measures. Six specific considerations are as follows: First, proactively moderate the economic growth rate from current 7.5% to 7%. This average annual GDP growth rate will ensure that the PRC's GDP per capita will double by 2020. At the same time, compared to 7.5%, a growth rate of 7% will effectively reduce the reliance on infrastructure investment, thus reducing debt financing pressure and financing impulse of local governments and their financing platform companies. Resources can then be allocated to other economic sectors whose demand had been depressed. Second, starting in 2014, substantially increase the local government bond issuance over several years by the Ministry of Finance on behalf of local governments to RMB 3 trillion, whose coupon rate will be below 4%. Use this bond issuance to refinance or replace LGFPCs debt, shadow banking and other financing channels. This means to use explicit direct debt to replace implicit indirect debt. If local governments can increasingly enter into a transparent channel where local government bonds are issued in a public and legitimate manner, the costs of financing would be reduced. This will also help reduce the overall social financing costs. At the same time, some local governments with good credit can be chosen as pilots to issue bonds directly based on their own credit. This would prepare for the time when the needed policy and system reforms are in place and local governments are all allowed to issue their own bonds. Correspondingly, central government should consider the following policy reform package: (i) Try to assess credit rating of local governments. Carrying out credit rating for local governments is a logical and substantial precondition for allowing local governments to issue bonds on their own (at present, the pilots are not real, because there is still an implicit guarantee by the central government to repay principal and interest of local government debt). According to Moody's research, major considerations for local government rating work include: i) Institutional framework: how central and local governments credit risks are related? ii) Economic fundamental: is actual condition of economic development sound and
sustainable? iii) Budget structure and management: balance and flexibility of revenue and expenditure; iv) Debt situation: debt burden and repayment capability; v) Structure and dynamics of government: what are the priorities and what are the pressures? (ii) Preparation and disclosure of local governments balance sheet. Through the preparation and disclosure of government s balance sheet, one can find out what the governments actually own, and analyze the structure of governments assets and liabilities, ratio and duration, and reveal governments debt risks. In addition, one can determine how much assets of each local government can be readily sold for cash. Some assets are part of the essential public services, and treating them as those that can be sold for cash would bring a false sense of security. Also, one can determine what assets can be sold for cash through which specific financial instruments (such as asset securitization). This will provide a realistic understanding of the debt repayment capability of local governments. In addition, when the stock of infrastructure investment increases significantly, the corresponding operating and maintenance costs should not be neglected. (iii) Establish a unified government debt management system. Governments at all levels should establish detailed debt budgets and revenue-expenditure plans. Local governments who have excessive use of debt or illegal uses of funds should be held accountable and those responsible should be severely punished. According to the following matrix, different approaches can be employed to manage different local government debt, and to formulate specific debt reduction measures. Table 1. Local Government Debt Management Matrix Low Level High per capita Debt Pilot for debt issuance Low per capita Adopt strict quantitative debt control measures High Level Debt Formulate specific measures Increase transfer payments, and to reduce debt and limit new strictly limit new debt debt Source: Mei Wang 2007. China s Local Government Debt Management. World Bank Working Paper. (iv) Revise the Budget Law. Currently in the PRC, the Budget Law does not allow local governments to issue bonds on their own, but gives implicit consent to local governments to raise financing through their back door platform companies in ways that are not following rules, are opaque and costly. This defeats the purpose of the Budget Law, makes effective risk prevention impossible, and
causes local governments to actually lose control of debt management 4. Amending the Budget Law to allow local governments to borrow legally is therefore imperative; at the same time, regulatory and supervisory systems of local government borrowing should be dynamically optimized to ensure prudential and responsible borrowing. Third, encourage the development of public-private partnership (PPP) mechanisms to attract private investments. According to the returns and nature of the projects undertaken by LGFPCs, they can be divided into three categories, namely non-commercial urban infrastructure projects, commercial urban infrastructure projects and quasi-commercial urban infrastructure projects. Those non-commercial projects can be undertaken by the governments; those commercial ones can be undertaken by commercial entities with no restrictions, and those quasi-commercial projects can be provided either by the governments or by the commercial entities. Correspondingly, market-oriented reforms in public utilities should be accelerated, the introduction of competition mechanism should be in parallel with the reform of property rights system, an independent regulatory institution should be established, and the relationships between governments and enterprises be sorted out. British telecom industry, power industry and gas industry were privatized since the 1980s and 1990s. Reform measures of the government of the United Kingdom include the elimination of administrative regulatory barriers which limited new entrants into the industries, improvement of laws, establishment of an independent government regulatory agency, establishment of special consumer organizations, and emphasize supervision by societies. Due to competition, the prices of electricity and water actually fell instead of rising, and the quality of services continuously improved. International experience in this regard can be used for reference. Fourth, actively promote the required fiscal reform. (i) Improve the intergovernmental fiscal system. Since rationalization and clarity of local government authorities are still not in place, and expenditure and revenue assignments are seriously mismatched, local governments overly rely on revenues of land sales, implicit debt financing and transfer payments, and only have limited autonomy, which make the accountability system pointless. Therefore system reforms that reasonably and clearly define expenditure responsibilities, and that match defined expenditure responsibilities with available financial resources are essential. In addition, improvement of transfer payment system and making it more transparent and standard are also very important. The 4 Mei Wang, Let Local Government Bond Replace LGFPC Bond. Cai Jing, No. 31, 2012.
fixed transfer payments should be reduced and the proportion of general transfer payments should be increased. In addition, local governments should increase their own sources of revenue, such as levying property taxes in order to accelerate the improvement of local tax system. (ii) Establish an open and transparent budget management system. Only on this basis, can a local government debt management system and a local debt issuance mechanism be established. Only under the premise of full disclosure of information can the National People's Congress and taxpayers effectively exercise their supervisory functions, prompting local governments to cautiously and responsibly raise debt. And only on this basis, meaningful credit rating and market-based local government debt issuance can be carried out, allowing interest rates to truly reflect different levels of risk. Fifth, carry out the required reforms of government. (i) Improve and implement local government performance standards. Previous performance standards GDP, tax revenues, employment, investment, social stability and family planning provided a powerful stimulus for overinvestment and irresponsible borrowing. Although these performance criteria have been modified to increase the proportion of people's livelihood and public services, when promoting government officials, economic growth still seems to be the main factor of consideration. Local government officials can be awarded due to the number of investment projects and related indicators, but the debt raised for these investments and the appropriateness of the debt structure attract no scrutiny. Virtually no punishment is associated with irresponsible borrowing 5. In 1993, the U.S. government promulgated the Government Performance and Results Act; in 1997, the British government promulgated the Local Government Act which clearly defined local government performance evaluation mechanisms and regulations; in 2002, the Japanese government promulgated the Government Policy Evaluation Act. Compared to these countries, the PRC had practically done no work in government performance evaluation at the national level, and government performance evaluation is based only on the central government's reporting requirements and normative documents within the Party. There are no authoritative, stable, legalized and institutionalized criteria. Although performance evaluation has already been emphasized, in practice it is basically stuck at the local government level, and there are no uniform evaluation rules. Reform of government performance evaluation mechanism is a system wide undertaking involving multi departments, and legislation at the national level is very important and should be vigorously promoted in order to lead the 5 Mei Wang, 2007. China s Local Government Debt Management. World Bank Working Paper.
government performance evaluation to a scientific, institutional and standard basis 6. (ii) Improve the ability to govern. Local governments need to improve capabilities in many aspects, including the ability of selection, monitoring and management of public projects. At present, various public utility projects that have been built saw their final construction costs exceeding what were necessary by an average of about 20%. 7 Raising the sophistication of the feasibility studies, implementation of a comprehensive quality management and multiple auditing system is imperative. The 2013 National Audit Office report shows that toll revenues of expressways began to decline, and expressways debt repayment pressure was still relatively high in a number of areas. In 2012, eight provincial-level governments repaid debt worth CNY45.385 billion by borrowing new debt, of which four provincial-level expressways ratio of borrowing new debt to repay old debt exceeded 50%, and three provincial governments had overdue debts worth CNY1.715 billion. This clearly relates to the deficiencies of the initial feasibility studies in terms of quality and seriousness. In addition, attracting private capital needs expertise and in-depth understanding of the market. Management of PPP projects requires high capability in terms of rule-making and execution on the part of the governments. Currently in municipal public utility construction field, Chinese-style tendering is widespread, and many bidding are often mere formality, which leads to construction costs significantly exceeding what are necessary. 8 Sixth, take the necessary measures to address financial risks. (i) In February 2012, the Ministry of Finance and China Banking Regulatory Commission issued Notice Regarding the Issuance of Management Method of Bulk Transfers of Non-Performing Assets of Financial Enterprises, which allows provincial governments to set up asset management companies and dispose financial non-performing assets under the jurisdiction of the provinces. Even though detailed operational rules have not yet been issued, Jiangsu Provincial Government is already in the process of setting up its asset management company. Besides asset management companies such as the Great Wall, Cinda, Huarong, and the Orient, establishment of local asset management companies provides new buyers for non-performing loans of local financial institutions, 6 XueLian Chen, 2010, No. 1, Breakthrough and Limit of Local Government Performance Evaluation Reform. Theory and Reform. 7 Yingchun Wang, June 13 2013, Public Utility Urgently Needs Multiple Reforms. China Securities Journal. 8 Ibid.
which is conducive to a more reasonable sale price of non-performing assets; some small scale non-performing assets, which the big four asset management companies are not interested, would have a potential way out. However, the relevant supporting reform measures cannot be ignored, for example, those that prevent moral hazards, and prompt financial institutions and LGFPCs to operate responsibly. In addition, at the macro level, developing a rational security market and a merger and acquisition market is also essential. (ii) Strengthen regulation over shadow banking. Let off-balance sheet business be visible, and require provision of the necessary capital reserves. Measures should be taken to help banks increase their risk awareness, gradually change their operation and reduce issuance of wealth management products with mismatching maturities. Seventh, continue to clean up LGFP and LGFP companies. This would take a long time, and the experience of international special purpose vehicles is worth learning. Among them, standard corporate governance, transparent project operation, professional management and good information system are common experiences of successful special purpose vehicles. In the short term, each investment project should be managed separately and have individual account and independent accounting. Each line of financing should be linked to a specific project. In the long term, it is necessary to distinguish between commercial and non-commercial financing platform companies, make them transparent and cut off their fiscal dependence on local governments, thereby reducing the potential fiscal management risks. It is a positive step that Ministry of Finance recently established a mailbox for complaints about illegal debt financing by local governments on its website.