Analysts Larry Brainard Chief Economist + 44 (0) 203 008 6092 lb@trustedsources.co.uk Bo Zhuang Economist +44 (0)203 1707 250 bz@trustedsources.co.uk For more information please contact Sales: sales1@trustedsources.co.uk +44 (0) 20 3170 7254 28 Apr 2010 Is China s local government debt a serious problem? China s local government debt is much higher than officially acknowledged but overall levels are still manageable China s ambitious stimulus package has fuelled concern that the rapid rise in local government debt may upset the stability of state finances and burden the banks with unmanageable non-performing loans (NPLs). We estimate that total public debt amounted to 56 per cent of GDP at the end of 2009, a figure at the low end of the range of similar ratios in other major countries. NPLs will undoubtedly increase in the next 2 3 years, a legacy of politically directed credit extended in 2009. Regulatory authorities in Beijing have now reasserted control over bank lending, and in our view rising NPLs will be unlikely to cause system-wide credit problems. Key judgments The extensive array of state assets more than offsets China s public debt. Banks are well positioned to manage increased NPLs associated with the rapid growth in credit during 2009. Problems, if any, will be limited to smaller local banks and rural cooperative credit institutions. Fiscal revenues will continue to expand at a healthy rate thanks to rapid economic growth. With foreign reserves of US$2.4 trillion and an ability to draw on high levels of household and corporate savings, China is one of the most creditworthy sovereign entities. Important information: Please see last page of this report for all disclaimer/disclosure information Copyright 2010 Trusted Sources UK Ltd. All rights reserved. www.trustedsources.co.uk 1
Core Case Now that China has successfully weathered the recent crisis, investors have turned their attention to longer-term risks that threaten sustained rapid growth. Foremost among such concerns is the rapid build-up of local government debt. This focus on local governments finances reflects the unprecedented expansion of bank lending that took place during 2009, much of it to their financial platforms. The large fiscal expansion announced in November 2008 required that local governments contribute a significant share of the total cost of infrastructure projects, typically about 25 per cent. Lacking their own sources of funding, local governments tapped bank loans for the bulk of such investments. The resulting surge in local government debt has recently become a hotly debated topic in financial markets. The debate was sparked by Professor Victor Shih of Northwestern University. He has claimed that the off-balance sheet liabilities of local governments alone could have been as high as Rmb11.4 trillion (US$1.7 trillion) in 2009, roughly 34 per cent of GDP. He has also estimated that additional local government debt will amount to Rmb12.4 trillion (US$1.8 trillion) in the next two years. These calculations lead him to conclude that China will face a large-scale debt crisis by 2011. We agree with Professor Shih that total domestic public debt, including contingent liabilities both explicit and implicit, is much higher than the 20 per cent of GDP figure often cited from government sources. But we disagree that the true public debt figures are as high as Shih suggests or that the country is facing a hidden debt crisis. We think that China will not face a large-scale debt crisis in the next 3 5 years because: The state holds a diversified mix of assets, including bank deposits, financial assets of highly profitable state-owned enterprises (SOEs) and land. Revenue growth from taxes and land sales and the potential of drawing on SOE profits provide the government with a considerable financial cushion enough to manage any prospective debt problems and to provide the government with substantial leeway in handling public debt. We estimate public debt to be at 55.5 per cent of GDP at the end of 2009. This estimate includes all contingent fiscal liabilities. As much of this debt represents bank lending, this figure highlights a higher level of risk for the banking system than is generally reckoned. Yet the overall public debt/gdp ratio is not out of line with other top-rated sovereigns such as the US, the UK, Germany and Japan, all of which have ratios above 60 per cent. Unlike many countries that have faced debt crises in the past three decades, China s public debt is mostly denominated in local currency. As a result China does not face problems in rolling over its debt: with high domestic savings, the government can easily refinance debt at relatively low interest rates. With the continuation of relatively rapid economic expansion, the government s fiscal revenues will probably grow steadily at double-digit rates, in the low teens. And although income from land sales is vulnerable to fluctuations in the property market, there are huge pools Copyright 2010 Trusted Sources UK Ltd. All rights reserved. www.trustedsources.co.uk 2
of untouched SOE profits that could be tapped to meet fiscal shortfalls. We believe that major Chinese banks are capable of managing the impact of rising NPLs associated with politically mandated lending during last year s boom. These banks have sufficient and diversified income streams, to enable the inevitable write-offs of NPLs over the coming 3 5 years. The institutions most at risk are the smaller local banks and rural credit cooperatives that will have to depend on provincial or higher-level support to surmount expected bad loan problems. Finally strong GDP growth will facilitate a reduction in public debt ratios as the denominator of the ratio grows. Public debt is very low China s public debt, including state bonds, stood at only Rmb6.0 trillion (US$878 billion) at the end of 2009, 18.5 per cent of GDP. This is one of the lowest debt ratios among both developed and emerging economies. Of this total Rmb1.55 trillion (US$227 billion) worth of bonds were issued by the Ministry of Finance (MoF) in order to establish China s sovereign wealth fund, the China Investment Corporation (CIC). This debt is offset by assets of the CIC. Deducting bonds associated with the CIC leaves Rmb4.5 trillion (US$659 billion) of total debt at the end of 2009, only 13.4 per cent of GDP. China s outstanding foreign debt totalled US$428.6 billion at the end of September 2009. Most of this was owed by the corporate sector, and the bulk was short-term trade-related debt. Only US$36.9 billion of the total external debt was government borrowings, only 4.2 per cent of total public debt and an even smaller fraction just 1.5 per cent of China s foreign exchange reserves. What about the unofficial debt? A comprehensive assessment of any government's fiscal soundness must take into account contingent liabilities beyond explicit government debt by including quasi-government and implicit debt. There are mainly four types of such liabilities in China: 1. Debt incurred by local governments 2. Non-performing loans incurred by state-owned commercial banks and policy banks 3. Legacy debt from the 1997 99 debt crisis held by the four asset management companies (AMCs) 4. Transition costs of pension reform Below we examine each of these debt categories. Local government debt Local governments in China are prohibited from running fiscal deficits and thus from incurring debt of their own by Article 28 of the Budget Law. Apart from bonds issued by the MoF on behalf of some provincial governments (Rmb200 billion [US$29.3 billion] in 2009 and another Rmb200 billion budgeted for 2010), local governments have taken on various types of liability in ways that get round the prohibition on borrowing. No one really knows the exact size of local government liabilities, although most of that would be debt incurred by Copyright 2010 Trusted Sources UK Ltd. All rights reserved. www.trustedsources.co.uk 3
local financial platforms (LGFPs). The LGFPs are in effect special-purpose vehicles that borrow from banks, typically with explicit or implicit guarantees to secure the loans. Of the announced Rmb4 trillion (US$586 billion) fiscal stimulus programme launched in November 2008, the central government has contributed only Rmb1.2 billion (US$176 billion) from its own budget for projects. Local governments were called upon to put up a similar sum in financing. Lacking the ability to raise taxes, they adopted various forms of "backdoor financial federalism", raising funds by means including setting up LGFPs to borrow from banks, encouraging land sales and development, and miscellaneous unofficial charges. The People s Bank of China (PBoC) in early 2009 publicly encouraged local governments to set up more LGFPs (if they did not already exist) to borrow from banks or the capital market. Half China s 8,800 LGFPs today have been created in the past 18 months to raise these funds, mostly through direct borrowing. This is in line with past policies that granted autonomy to provincial authorities in finding ways to boost growth. Once recovery gets underway, Beijing will again try to reassert its authority over local activity so as to put the provincial tigers back in their cages. But this could be a tricky practical task, particularly in the case of big and well-connected provinces such as Guangdong. Banks ended up providing most of the project financing, but with the understanding that the loans were guaranteed by local governments or Beijing either explicitly or implicitly. Therefore they viewed the LGFPs as de facto government risk much the same as lending to SOEs. Even if a project does not have a tangible repayment stream, the banks expect that the loan repayment will come from future local government subsidies to these entities or from security pledged against the loans such as equity in local state-owned companies, land or buildings. The PBoC, the China Banking Regulation Commission (CBRC) and the National Development and Reform Commission (NDRC) jointly reported in H2/09 that all local government debt totalled Rmb5.3 trillion (US$776 billion) as of May 2009. Professor Shih estimated the total debt of LGFPs to be Rmb11.4 trillion (US$1.7 trillion) at the end of 2009. This appears to be an overestimate. The most obvious reason is that the PBoC s total loan data show that new medium- and long-term loans (longer than 12 months) to non-personal sectors amounted to Rmb5 trillion (US$732 billion) last year. Thus new loans to LGFPs in 2009 cannot be as high as Rmb5 trillion because the increase in this loan segment includes other private corporate sectors such as property development. We believe that 70 per cent of the new medium- and long-term loans extended between June and December 2009 were directed to local government entities. This means that total local government debt could not exceed Rmb7.1 trillion (US$1.0 trillion), or 21.1 per cent of GDP at the end of 2009. The World Bank s Louis Kuijs cites a figure from the CBRC of Rmb 5 6 trillion (US$732 878 billion) in loans outstanding at year-end 2009, with another Rmb3 trillion (US$439 billion) in committed undrawn lines. Non-performing loans The problem of NPLs is significant, even if the exact details are murky. Before the global financial crisis hit in late 2008, Chinese commercial banks had largely cleaned up bad loans from the 1997 99 crisis via write-offs and transfers of bad debts to the four AMCs set up for the purpose of loan workouts. Relatively subdued lending growth and rapid economic growth Copyright 2010 Trusted Sources UK Ltd. All rights reserved. www.trustedsources.co.uk 4
during 2004 08 facilitated a reduction in the banks NPLs. According to the CBRC, total NPLs stood at only Rmb497.3 billion (US$72.8 billion) at the end of September 2009, or around 1.5 per cent of GDP. How much bad debt is likely to result from last year s Rmb9.6 trillion (US$1.4 trillion) in new loans? This will depend on how fast the economy grows in the next few years. It will be nowhere near to the level of the late 1990s when 40 50 per cent of bank loans were non-performing and overall bad debt was more than 40 per cent of GDP. Historical AMC-related debt and pension-related obligations Four AMCs were created in 1999 to take on and work out 1.4 trillion (US$205 billion) of NPLs transferred from state-owned commercial banks. Their mission was to maximize the value of the recovery of the assets. According to the CBRC annual report for 2006, these companies had processed 88 per cent of the overall assets by then. Total asset recovery for the AMCs averaged 21 per cent at the end of 2006. Assuming that the rest of the NPLs are unrecoverable, this implies that the total AMC-related debt still outstanding would be around Rmb1.1 trillion (US$161 billion), or 3.3 per cent of GDP in 2009. Of other potential public liabilities to be considered, the implicit pension liabilities which refer to the gap between current accumulated pension funds and future obligated payouts under current pension plans are the most significant. Below in Table 1 we summarize all liabilities, official and otherwise. Based on our assumptions and estimates when all contingent fiscal liabilities are factored in, total government debt in China is as high as Rmb18.6 trillion (US$2.7 trillion), or about 55.5 per cent of 2009 GDP. This number is likely to involve some double-counting and overestimation: for example, a substantial portion of LGFP debt was financed by policy banks, which is likely to produce an overestimation of policy bank NPLs. This 55.5 per cent figure is far higher than the reported official level, but it is below the EU ceiling and below that of most developed countries. Table 1: China s government debt as at year-end 2009 Rmb trillion Per cent of GDP Notes Official central government debt Local government debt 4.5 13.4 Excludes CIC-related debt of Rmb1.55 trillion (US$ 227 billion) issued in 2007 7.1 21.2 Based on the PBoC s estimate of Rmb5.3 trillion local government debt at the end of May 2009, to which we add 70 per cent of total medium- and long-term loans to LGFPs during June December 2009. Policy bank NPLs 1.0 3.0 Includes the China Development Bank, the China Eximbank and the Agricultural Development Bank of China. Commercial bank NPLs 1.2 3.5 As of September 2009 official NPLs were only Rmb497.3 trillion. We assume that another Rmb700 billion of non-local governmentrelated loans are bad loans. AMC debt 1.1 3.3 We assume a 21 per cent recovery rate. Copyright 2010 Trusted Sources UK Ltd. All rights reserved. www.trustedsources.co.uk 5
Ministry of Railway bonds 0.3 0.9 Bonds outstanding as of year end 2009 Pension liabilities 3.4 10 Implicit pension-related debts are hard to estimate. Apart from the Rmb2.6 trillion accumulated in the social pension fund, we estimate that the pension gap would be another 10 per of GDP under current government plans. These liabilities are generally long term in nature. Total 18.6 55.5 Sources: PBoC, MoF, CBRC and TS estimates. Do not ignore the government s assets and potential income streams Before becoming alarmed by the debt/gdp figure, one must examine the asset side of the government s balance sheet both at central and local levels. This exercise distinguishes China from many other countries. First, the Chinese government owns sizeable bank deposits. Outstanding government deposits at the PBoC stood at Rmb2.1 trillion (US$307 billion) at year-end 2009, or 6.3 per cent of GDP. Deposits owned by government departments and organizations in the commercial banks totalled Rmb3.0 trillion (US$439 billion), or 9 per cent of 2009 GDP. Second, according to the Ministry of Finance SOEs at the central and local levels possess net assets worth a combined Rmb16.4 trillion (US$2.4 trillion) at the end of last year, equivalent to 49 per cent of 2009 GDP. Among these the net assets of the 130 central government SOEs that come under the MoF State Capital Operating Budget reached Rmb9.2 trillion (US$1.3 trillion), or 27.4 per cent of 2009 GDP. We believe that problems of poorly run SOEs have been overstated because these same 130 companies alone made almost Rmb1 trillion (US$146 billion) in profit last year. Third, land is legally owned by the Chinese state. Although agricultural land is collectively rented out to farmers, non-agricultural land is in effect controlled by the government. The authorities can also take over agricultural land from farmers at a substantially lower cost than the market value. We shall not attempt to estimate the market value of the land, but it is clearly one of the most valuable assets in China. Statistics from government agencies show that revenue to governments from land sales during 2001 09 averaged 3.4 per cent of GDP. Copyright 2010 Trusted Sources UK Ltd. All rights reserved. www.trustedsources.co.uk 6
Chart 1: Land sales, 2001 09 Rmb trillion 1.6 1.2 0.8 0.4 Land sales (LHS) As a % of GDP (RHS) 6 5 4 3 2 1 Per cent 0 2001 2002 2003 2004 2005 2006 2007 2008 Sources: MoF, State Council and Ministry of Land and Resources. 2009 0 Table 2: China s government-controlled assets at year-end 2009 Rmb trillion Per cent of GDP Notes SOE net assets 16.4 49.0 Of which central SOEs 9.2 27.4 Includes 128 SOEs under State-owned Assets Supervision and Administration Commission, the China National Tobacco Corporation and the China Post Group. Government deposit at the PBoC Deposits of government entities at commercial banks 2.1 6.3 3.0 9.0 Non-agricultural land?? Total >21.5 >64.3 Sources: PBoC, MoF, CBRC and TS estimates. Other factors will also help China avoid debt indigestion In addition to the government s strong assets, China is likely to grow out of its debt problem in the future because of other factors: From a cash-flow perspective, total government fiscal revenue has been increasing steadily over the past 10 years. We expect that economic growth should support a sustainable low double-digit rise in fiscal revenue. At the same time SOE profits are boosted by their monopoly or quasi-monopoly position. The top 130 central SOEs made Rmb966 billion (US$146 billion) in Copyright 2010 Trusted Sources UK Ltd. All rights reserved. www.trustedsources.co.uk 7
pre-tax profits in 2009 alone. Under the 2010 budget, the MoF set a target of taking only Rmb42 billion (US$6.1 billion) in taxed profit from these companies, less than 0.5 per cent of the total profit for 2009. We believe that this almost untouched pool could easily be drawn upon if central government needed to do so in order to meet its debt obligations. Second, unlike in other emerging economies China s government debt consists predominantly of domestic claims, which means that it is not dependent on external creditors to refinance its debt. In the past, most emerging-market debt crises were consequences of an inability to pay foreign debt. With foreign reserves of US$2.4 trillion and individually held cash deposits of Rmb26.1 trillion (US$3.8 trillion), the government can easily refinance debt by issuing local-currency debt at a relatively low interest rate. Third, the surging liability of local governments has brought policy responses. In February the CBRC required banks to unpack packaged loans granted to LGFPs last year, to review the loan quality of each project, to secure a second source of payment or collateral wherever called for, to recall loans that were abused or loans without a clear purpose and to consolidate county and other lower-tier LGFPs at the provincial or municipal level. If current multiple levels of LGFPs are consolidated into a three-level system (central, provincial and municipal), the most vulnerable county- and township- level financing platforms are likely to be protected from the risk of default. These measures will not solve the local government debt problem instantly but they will restrain further reckless local government borrowing. Fourth, after the last state-owned commercial bank, the Agricultural Bank of China, was restructured into a shareholding company in 2008, Chinese commercial banks have substantially improved their handling of NPLs through stricter credit risk management and increasing provisions against loan losses. The provision ratio for commercial banks rose from nearly 20 per cent at the end of 2003 to more than 130 per cent at the end of 2009. At the same time the banks earnings from the substantial spread between controlled lending and deposit rates will give them enough resources to absorb defaults by LGFPs. Fifth, one of the major concerns in the market is, what happens if property and land prices start to drop and there is a chain reaction when banks start to recall their loans to local government? This is unlikely, because during bad times borrowers such as LGFPs are not required to mark their land or property assets to market. For this reason banks are unlikely to recall loans, as they want to maintain a good relationship with local governments. On the other hand Chinese depositors retain strong confidence in state-owned banks, which will ward off bank runs. This domestic confidence circle provides the government with more time to sort out the debt problem. Copyright 2010 Trusted Sources UK Ltd. All rights reserved. www.trustedsources.co.uk 8
Conclusion We believe that the Chinese government's targets to contain the size of local government debt and to mitigate the credit risks in the banking system are achievable. From a general perspective, the government debt burden is manageable. Tighter loan quota controls and rising interest rates will inevitably cause NPLs to rise over the next 2 3 years. In view of current low NPL ratios and the high provisions of banks against NPLs, we do not expect a widespread credit crunch that would affect the financing of many projects. The strong state asset position, the relatively underleveraged household sector, rising fiscal tax revenues and, most important of all, rapid economic growth provide China with the tools it needs to grow out of its debt burden. Copyright 2010 Trusted Sources UK Ltd. All rights reserved. www.trustedsources.co.uk 9
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