Solving China's local government debt problem

During the global financial crisis, Beijing unleashed one of the largest fiscal stimulus packages in the world, worth about four trillion yuan. Though it saved China -- and Australia -- from recession, one serious side-effect of the spending binge has been the build-up of massive local government debt.

China's National Audit Office revealed late last year that local government debt had surged 20 per cent every year for the last three years. The collective debt of local governments had increased nearly 3.9 trillion yuan ($A720 billion) to 10.6 trillion yuan by June 2013. Many governments have borrowed heavily using so-called local government financing vehicles, because they are not allowed to raise funds directly from banks and investors.

How to deal with this debt problem is one of many challenges confronting Beijing this year, and the Ministry of Finance is finally letting local governments issue their own debt and be responsible for it. In characteristically Chinese fashion, the new policy is being tried out in a few handpicked provinces and cities. The Party has chosen the 10 most prosperous cities and provinces along the eastern seaboard -- including Shanghai, Guangdong, Shenzhen, Jiangsu, Shangdong and Beijing -- to trial the program.

This is a quantum leap forward from the previous system. Though Beijing has been trying to get local governments to look after their own debts since 2009, the Ministry of Finance is still responsible for repaying debts on behalf of the local governments. Consequently, many local officials believe they can never go bankrupt.

Under the provisional regulation, Beijing will strictly control the amount of debt that local governments can issue. In addition, local governments may not roll over unused quota for the next year.

In terms of maturity, Beijing has abolished the three-year municipal bond in favour of longer five-, seven- and 10-year maturities. The move is designed to change the current local government financing model in China, which is to borrow short-term debt to finance long-term infrastructure needs.

Chinese credit rating agencies have already started working on the creditworthiness of the municipal and provincial governments that are allowed to issue debts in their own rights.

Allowing Chinese local government to issue their own debts is an important step towards resolving the country’s escalating local debt problem. However, Beijing needs to build up a legal, financial and reporting structure to support the move, otherwise the new policy could potentially make the problem even worse.

At present, China does not have legislation that governs the issuance of local government debt. Existing laws only deal with central government and corporate debt, so local government debt is trapped in a legal purgatory without clear definition.

Chinese local officials often act and behave like local emperors when it comes to making decisions about infrastructure investment. In 2012, more than 50 per cent of their local revenues came from sales of land and real estate investment. Consequently, many of them are addicted to borrowing heavily to finance investment projects.

A policy proposal put forward by finance professors from China Europe International Business School recommends Beijing enable local legislatures -- which are merely rubber stamp parliaments at the moment -- to scrutinise local government officials.

Most importantly, Beijing needs to change the deeply ingrained perception that local governments can never go bankrupt. China’s local bankruptcy laws only apply to companies, not government entities. Local government officials have been enjoying their debt binge for too long, and investors have been shrugging off the risk in the belief that Beijing will step in to bail them out when things turn ugly.

China’s bankruptcy laws must cover local government if the problem of moral hazard is to be averted. Beijing has been carefully allowing corporate debts to default in order to teach investors a lesson in risk management. It needs to do the same for local government.

Allowing local governments to be responsible for their own debt is an important first step, but creating a transparent and creditable local government debt market will be a herculean task for Beijing, and time is not on its side.