What the PIGS in Eurozone, California in the United States, and a small village in Western China might have in common? Each of them share a single currency with whole lot of others, and they are all indebted.
These days, we all think that the Chinese own the world. China is the second largest holder of US government bonds after Ben Bernanke, with huge foreign exchange reserve, and rich folks going out to buy stuff from Louis Vuitton to luxurious homes in Hong Kong. However, apart from inflation and asset bubbles, there is just another aspect of the Chinese economy which is rather worrying, and all these problems seem to be closely related.
The talks on local government debts problems have only surfaced in the media occasionally over the year, and overall it did not attract too much of attention as crises in Europe, second round of quantitative easing, and inflation and asset bubbles in China seemed to have occupied most people’s limited cognitive resources in their consciousness.
To have a glimpse of the Chinese local governments’ public finances, we look at the government revenue and expenditure breakdown. It shows that while the central government has increasing surplus, the local governments are running ever larger deficits.
Photo: National Bureau of Statistics
This graph shows that while the central government has a very good surplus, local governments are deep in red ink, so the country as a whole is only roughly balanced in public finances. But this is not the entire story. The problem of local government debts is rather hard to track because the statistics are incomplete or unreliable or both, just like many other statistics by the Chinese government. It is hard to track also because some of the loans taken by the local government were not entirely legally (albeit widely use), so these numbers certainly do not normally appear in official accounts.
Local governments are hugely in debt, and they financed the deficits via “local government financing vehicles (LGFVs)”. To put it simply, these vehicles are companies set up by government or government related institutions. Government may inject assets, for example, land, to these vehicles, and they would raise money either by land sales or bank loans. The money raised can then be used for various projects, such as infrastructure and public facilities, and creditors, mostly banks, expect the revenue from these projects will be able to repay the loans. In many ways, these vehicles are quite similar to the special purpose entities established by US banks to keep things off-balance sheet, as the debts raised via these financing vehicles are not included in official accounts (so they are off-balance sheet, so to speak), but often times the local government may provide guarantees, implicitly or explicitly.
Truth be told, these sort of financing arrangements have allowed local governments to improve infrastructure and promote economic growth. But the rate of increase in debt is mind-boggling, and increasingly people are worried that these investments are more likely to be loss-making such that the loans can never be repaid. How much of loans to these vehicles are currently outstanding? There are no firm conclusion of the exact numbers (just as many other Chinese government statistics, these numbers are simply incomplete, unreliable, or both), and estimates diverge widely. Debt raised by LGFVs exploded after the China announced the 4 trillion Yuan of stimulus after the Great Financial Crisis. Some of the latest figures Chinese media cited is 7.66 trillion Yuan at the end of the first half of this year, and some earlier reports suggested that the outstanding debt increased by some 70% in 2009. Victor Shih at Northwestern University estimated early this year that local governments debts amounted to 11.4 trillion Yuan, with an additional 12.8 trillion Yuan of unused credit lines. The National Audit Office surveyed that 307 vehicles in 18 provinces, and found that government debts amount of 2.78 trillion Yuan in these sample of vehicles.
To put this into perspective, the GDP of China in 2010 is forecasted to be 38.95 trillion Yuan (current price) by the IMF. If we take the 7.66 trillion number of LGFV debt, that would be 22.5% of the total GDP, together with the forecasted outstanding government debt of 7.457 trillion Yuan, the consolidated debt-to-GDP ratio would roughly be 38.8%. If you use Victor Shih more pessimistic number, the consolidated debt-to-GDP (not counting unused credit lines though) would be 48.41%.
Yes, it does sound like nothing at the moment compared with the United States or Europe, but should the debt figure continued to increase quickly, the debt-to-GDP ratio would soon become less than comfortable. There is also an interesting twist here. In a previous article, I suggested that to contain inflation and asset bubbles, China will have to tighten monetary policy and control credit expansion to a point that recession might be inevitable. At the same time, we now see the poor fiscal conditions at the local governments level. Local governments rely not only on bank facilities, but also land sales to fund their investments. To fund these investments and support growth, local government raised debt from banks and sell land. If the real estate markets were thriving, this would bode very well for local governments, so for the local governments, it is in their interests to have high real estate prices. So the Chinese authority is in a dilemma, as they do not want home prices to rise quickly, but at the same time fear a home prices collapse if they tighten too much.
If China really wanted to engineer a recession, it would be no normal recession. The collapse of real estate bubble will put the public finances of local governments in even worse shapes as they can no longer sell land at good prices to fund their projects and to repay banks. Even though consumers in China might not be very much in debt, the local governments are, and the collapse in real estate market will undoubtedly make banks’ credit quality deteriorate, eventually this will tighten credit, creating a really deep recession.
So will this local government debt problems exploded? In the near term, it seems not very likely, as the government has been at least trying to clean up the LGFVs, and the overall policy is geared towards tightening, so a further big expansion of debt looks unlikely at the moment, and the overall public finance should still look manageable. As long as the economic growth is robust enough to keep things going, the problem may will be pretty much a hidden one until when there is a real slow down of the economy.
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