For the past few days, I have been travelling in China, working my way from the mega metropolis of Shanghai to regional cities like Guilin. I have been impressed by the country’s new airports and high-speed railway lines. At the same time, the empty buildings that I glimpsed from the window as we zoomed through the countryside made me wonder who is paying for all this.
Chinese local government debt, a cooling property market and excess industrial capacity are the three biggest risks facing the world’s second largest economy.
Of the three risks, burgeoning local government debt has the potential to inflict the most pain on the economy. China’s banking system -- both the official and shadow sectors -- have large exposure to the profligacy of the local governments. Many of these local fiefdoms have stretched their budgets to breaking point.
It is important to spell out what we know about local government debt. According to the National Audit Office, the total outstanding debt for local government in 2008 was 3.2 trillion yuan, or $600 billion. Only two years later, it had increased to 10.7 trillion yuan. By June 2013, it had soared to 17.89 trillion yuan.
So Chinese local government debt increased by around 560 per cent between 2008 and 2013. This does not even include the 1.25 trillion yuan worth of local government debt that was issued by the central government. So, all up, local government debt is now close to 20 trillion yuan or $3.8 trillion.
However, the size of the debt pile doesn’t reveal the whole story.
Given the magnitude of the Chinese economy, especially the $4 trillion ‘war chest’ of foreign exchange reserves, it might be easy to brush off concerns about local government debt.
However, a number of factors help put the severity of the local government debt problem into perspective. There is a mismatch in maturities, the debt exposes the country’s banking system and local governments are heavy reliant on land sales for revenue.
Unlike many other municipal governments in developed countries, Chinese local governments below provincial levels are not permitted to raise debt. Consequently, local governments have turned to so-called financing vehicles to raise money and it's estimated there are now around 11,000 of them.
They have sourced most of their funding from Chinese banks. These state-owned financial institutions are responsible for providing 50.8 per cent of all local government debt, 71.6 per cent of explicitly guaranteed debt and 61.9 per cent of implicitly guaranteed debt.
Because Chinese banks have been clamping down on excessive exposure to local government debt lately, many local governments have been forced to borrow from the shadow banking sector, which typically charges 10 percentage points more than banks.
So Chinese banks are heavily exposed to the local government debt both through formal lending as well as off balance sheet activities.
Apart from an over reliance on the banking sector, local governments are also dependent on land sale revenue to balance their books as well as to service their ever-growing debt.
According to the National Audit Office, 35 per cent of total local government revenues come from the sale of land, up from 20 per cent in 2010, making them heavily reliant on the real estate sector. In some provinces and cities, land revenues account for more than half of the government’s income.
At the end of 2012, 11 provinces and 316 cities pledged 3.49 trillion yuan worth of land sales revenues to repay their debts, accounting for 37.23 per cent of the total outstanding debt.
In short, local governments are increasing reliant on a rapidly-cooling real estate sector to balance the books. The country is experiencing a nationwide decline in housing prices, with even the once red-hot property markets of major first-tier cities witnessing price falls.
Like troubled American investments before the global financial crisis, Chinese local governments are relying on short-term loans to finance their long-term investments. For example, more than 50 per cent of total outstanding debt is due within the next three years. This year they’ll need to cough up enough money to repay almost 22 per cent of the total outstanding debt.
In addition, the growing debt burden is getting worse in some parts of China. For example, there were three provinces, 99 cities, 195 counties and 3,465 towns with debt-to-GDP ratio greater than 100 per cent, according to the National Audit Office.
This increases the risk of an outbreak of a regional financial crisis that could ultimately spread to the rest of China. If such a regional crisis were to occur, the central government would likely be forced to become the lender of the last resort and to bail these local governments out.
Though the total size of Chinese local government debt seems manageable, certainly below the 60 per cent debt-to-GDP ratio stipulated under the Maastricht Treaty, it is the sustainability of rapidly increasing debt that is in doubt. A slowdown in GDP growth and declines in land sales revenue means that China’s government debt problem is a lot more worrisome than before.