Waiting for a Chinese local debt disaster

Posted by Tracy Allowayon Jun 29 16:11.

Standard Chartered analyst Stephen Green has been on the trail of China’s local debt saga for ages now.

Monday was a big day for him.

China’s National Audit Office released figures showing its municipalities owe a whopping Rmb10,700bn ($1,650bn) in debt, equivalent to about 27 per cent of China’s economy and outstripping the central government’s officially declared debt balance of less than 20 per cent of GDP.

Yet Green figures the NAO estimate is actually a low-ball figure. To take into account informal liabilities, you need to add another Rmb4,000bn. Those would be liabilities that might not be legally enshrined, but when push comes to shove, the authorities will probably need to take responsibility for them.

If you include the extra RmB4,000bn, you get total public debt that looks more like this:

Specifically, it would be about RmB 28,198bn worth of formal and informal public debt combined at the end of 2010, according to Green’s estimates — or about 71 per cent of China’s GDP last year.

Now, that looks bad. But as StanChart notes, China is also generating a lot of tax revenue at the same time. Compared to, say, Italy or Greece, who have high debt and low growth, China is in a much better place.

Of course, that doesn’t mean the local debt problem isn’t, well, a problem. Reports are already coming in that China’s local government investment vehicles (LGIVs) are beginning to default, apparently.

Note how the problem has been solved to date — and what’s now changing:

Reports of LGIVs in Yunnan province and Shanghai telling their banks that they can only repay the interest, rather than capital, on their loans signal the beginning of a wave of difficulties, we believe. There are likely thousands of anxious bank branch officers, LGIV CFOs and local government officials out there. We assume that the LGIV loans are mostly bullets, and 3-5 years in term, so the pressure for repaying principal has not yet hit. But it will begin in 2012-13. The interest burden of around 6% on local government/LGIV debt is much higher than the 2% that the MoF is currently paying on outstanding central government debt. If one assumes that local governments and their vehicles have total debt of CNY 14.7trn (as we do…), and that all of it is bank debt, then the interest due this year will be around CNY 880bn (USD 134bn). This is a tremendous amount of money, equivalent to 21% of local government tax revenues in 2010. (This would be a big number even if we had clear evidence that local finance bureaux had budgeted for these payments, which we do not.) Land sales around the country continue to do much better than many had feared, and should be providing precious cash flow. But interest payments will mount up, the credit markets will become less welcoming (quotas for debt issuance by LGIVs are being squeezed), and banks are under instructions to stop extending credit to LGIVs (although they still appear to be doing so), so it is no longer easy to take out new loans to repay old loans. At some point, the legacy will have to be recognised

As we have explained before, there is a game associated with how LGIV loans go bad and/or get resolved. No one wants to be the first in the country to have a LGIV blow up in their district. As a result, whenever a LGIV is unable to cover its interest, a small meeting will likely be held between the LGIV, the bank and the local government to find a way to resolve the issue. Loans will be extended; new collateral offered; assurances made. As the pressures build, such meetings will become ever more difficult. We assume that at least CNY 4-6trn of LGIV loans – and possibly much more – will ultimately not be repaid by the projects, and this shortfall will need to be addressed. In addition, the central government will have to assume the CNY 5.7trn of local government debt. At some point, the central government will have to enter the field – it cannot have rumours circulating about hundreds of LGIV defaults undermining confidence in the banking system. However, the end game is tricky because:

You might be wondering, at this point, whatever happened to the great $464bn bailout of Chinese municipal debt, reported by Reuters late last month. Unfortunately the bailout appears to have been nothing more than a Ministry of Finance research paper, according to Green.

Which means something else might soon have to be discussed.

Related links:
China’s uncollateralised, cash flow-less, local government loans – FT Alphaville
China’s great central economy, and big local problems – FT Alphaville
So tell us Mr Chinese official, do you have a debt problem? – FT Alphaville
Introducing Alphachat, the FT Alphaville podcast – FT Alphaville

This entry was posted by Tracy Alloway on Wednesday, June 29th, 2011 at 16:11 and is filed under Capital markets. Tagged with , , , .

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