Zhang Ming says local govt handicapped by short-term, high-interest debt, & unaffordable responsibilities
Chinese Academy of Social Sciences economist advises Beijing to share revenue or shoulder more entitlement, restructure debt before swapping debt with SOE shares, & make contingency plans.
Local government debts in China—their causes and solutions—have been a subject of internal debate for months, and has frequently been featured on The East is Read.
In a recently published piece, Ting Lu, Chief Economist of Nomura Securities China, identified revitalization of the real estate sector as a key measure to kickstart debt resolution in China. In another piece, Xu Gao, Chief Economist of Bank of China International (China), expressed the necessity for the central government to provide timely assistance to local governments. Remarks by Xu Shanda, former Deputy Director of the State Tax Administration of China, have also been published, highlighting three sources of hidden government debts currently unaccounted for in official statistics. Additionally, Luo Zhiheng, Chief Economist and President of the Research Institute at Yuekai Securities, provided insight into the contributing factors to China's debt problems.
Today's piece by Prof. Zhang Ming is a compact yet informative read on China's ongoing debt narrative, a succinct and direct analysis of the three characteristics of China's debt issue, and nine solutions to navigate this financial quagmire.
Zhang Ming serves as Deputy Director of the Institute of Finance and Banking (IFB), Chinese Academy of Social Sciences (CASS), and Deputy Director of the National Institution for Finance and Development.
The following speech was originally delivered at the National School of Development (NSD) at Peking University on Sept. 9, 2023, and can be found in full-text, in Chinese, on the NSD's WeChat account. Another speech by Yao Yang, Professor and Dean of the NSD, from the same event, has already been published by Pekingnology.
The Characteristics of and Solutions to Local Government Debts in China
Today, I will be presenting in two sections: first, I'll discuss three characteristics of China's local government debts; second, I'll propose nine suggestions for managing the debt increase and resolving existing debt.
Three Characteristics
Reasonable Total Amount: The first characteristic of China's local government debt is that regardless of how implicit debts are calculated, the current full-caliber debt of the Chinese government is not considered “high” from an international perspective. According to estimates by the research team at National School of Development (NSD) at Peking University, the debt-to-GDP ratio of the Chinese government debt stands at 96%. According to the International Monetary Fund (IMF)'s estimate, this ratio is approximately 110%. In contrast, the debt-to-GDP ratio of the U.S. government is 120%, and Japan's is as high as 260%.
Unreasonable Structure. The second characteristic of China's local government debt is its seriously unreasonable structure, marked by an excessively high proportion of short-term and high-yield debts. In the U.S., federal government debt comprises three-quarters of the total government debt, while local government debt constitutes one-quarter. Conversely, in China, central government debt forms only one-fifth of the total debt, with local government debt accounting for the remaining four-fifths. More significantly, the cost of China's local debt is notably higher. The current yield on China's ten-year government bonds ranges around 2.5% to 2.6%, whereas the average cost of local debt stands at about 6%, with the term of the debt being shorter. Urban investment bonds typically have a term of 3-5 years, and the debt term for platform companies in third and fourth-tier cities is even shorter. Hence, to bolster the sustainability of government debt, initiatives should be undertaken to transition short-term, high-cost debts into long-term, low-cost debts.
Heterogeneous Debt Among Provinces. For instance, at present, Shanghai, Guangdong, and Beijing have virtually no implicit debts. These three regions have previously excelled in controlling local government financing vehicles (LGFVs) borrowing and have successfully addressed the last batch of implicit debts through special exchangeable bonds in recent years. However, in many provinces in central and western China, market estimates of their implicit debts are significantly understated. This heterogeneity demands varied solutions tailored to the different circumstances of each province.
Suggestions on Controlling Debt Increase and Resolving Existing Debt
Controlling Debt Increase
Controlling debt increase is the prerequisite for resolving existing debt. Failure to effectively manage the increase, even if it leads to a temporary resolution, will likely result in the resurgence of debt issues in a few years.
In terms of controlling the increase in debt, I put forward the following four suggestions:
Rebalancing Revenues and Responsibilities between Central and Local Governments through Reforms. Given the permanent decline in local land sales, steps should be taken to approximate a balance in revenues and responsibilities for local governments, accounting for transfer payments from the central government. Over the past two decades, local governments have chiefly depended on land sales to mitigate the disparity in revenues and responsibilities. However, with the structural shift in China's real estate market, selling land has become challenging. Indeed, during the three years' of the COVID-19 pandemic, LGFVs borrowed funds not only for infrastructure construction but also, to a degree, for ensuring the basic operation of local governments. Without a rebalance of revenues and responsibilities, debt issues may persist. Appropriate measures include:
Decentralizing revenues, enabling local governments to retain a larger share of the value-added tax (VAT) or introducing new taxes, albeit without significantly elevating the overall macro tax burden on residents.
Centralizing responsibilities, with the central government assuming a greater share of social welfare expenses like pensions, healthcare, and services for individuals with disabilities.
Addressing the Mismatch in Term and Return for Local Governments' Infrastructure Financing. Moving forward, the provision of regional public goods, such as large-scale infrastructure construction, should primarily be financed through the issuance of national bonds by the central government and general bonds by provincial governments. Lower-tier cities should be restricted from utilizing market financing methods to secure funds for infrastructure projects. A significant contributor to the high local government debt has been allowing LGFVs in third- and fourth-tier cities to leverage market financing for infrastructure projects. These projects, characterized by long construction cycles, substantial investments, and a low turnover rate of funds, inevitably result in a mismatch in terms and returns.
Revise the Performance Assessment System for Local Governments. At present, the emphasis on GDP assessment for local governments considerably outweighs that of debt assessment. With the execution of the first two suggestions, future evaluations can correlate local government GDP growth rates with debt levels, modifying the incentive mechanism that drives local governments to borrow exclusively for development. By adjusting the performance assessment system, excessive borrowing behaviors of local governments can be effectively curtailed.
Promote the Transformation of LGFVs. Should the first three suggestions be implemented, the relevance of LGFVs as mere financing platforms would be reduced. Under this premise, it's advisable to encourage the transformation of LGFVs. For those possessing quality assets and operating liabilities, consideration could be given to transitioning them into local state-owned enterprises (SOEs). Conversely, those without quality assets and existing solely for financing purposes should be phased out.
Resolving Existing Debt
Regarding the resolution of existing debt, I propose the following five recommendations:
Initiate a New Round of Nationwide Local Government Debt Audits. Despite two previous audits, local governments were unclear about the real objective of reporting debt levels during past debt resolution processes, thus the tendency to underreport debt amounts. To ensure truthful disclosure, it must be unequivocally communicated to local governments, before this audit, that this will be the final initiative using central resources to aid in local government debt resolution. If they choose not to disclose the debt, any hidden debt will have to be tackled by them in the future. Only through this approach can local governments be encouraged to accurately report their debt situation. Through a new round of debt audits, local debts can be classified into three categories:
Debt incurred solely for delivering public goods (such as infrastructure)
"Three Guarantees" (guaranteeing the payment of salaries, normal operations of governments, and the basic wellbeing of the people) expenditures serving quasi-fiscal functions during the past three years of the pandemic
Operating liabilities and other debts.
Distinct resolution methods are necessitated for these three types of debts.
For Debts Incurred for Providing Public Goods and "Three Guarantees" Expenditures during the Pandemic, Debt Swap Should be Applied. If provincial governments have the capability, they can issue general debt for the swap; otherwise, they can rely on the central government to issue national bonds for this purpose. To avoid moral hazards, a higher reliance on national bonds than general debt during the debt swap will trigger more pronounced penalties and restraint mechanisms. This recommendation can help mitigate the mismatch of term and return caused by local provision of public goods.
For Operating Liabilities and Other Debts, Local Governments Should Assume Responsibility for Resolution. Currently, two primary methods are available to local governments: the first entails resolving debts by selling assets. Given the challenges with land sales now, local governments might consider leveraging the equity of local state-owned enterprises for debt resolution, as seen in recent instances with companies like Moutai, Baiyao, and Yanghe [all of which are large SOEs and stock market magnets]. The second method involves debt restructuring, where local governments negotiate with financial institutions to extend the term and reduce interest. Going forward, cases akin to Zunyi Road & Bridge Construction (Group) Co., Ltd. [which announced on Dec. 30, 2022, that the term of its 155.94 billion yuan (21.32 billion U.S. dollars) bank loans has been extended for 20 years, with only interest payments required for the first 10 years.] will undoubtedly be promoted on a large scale, enabling both local governments and financial institutions to share the losses incurred from previous debts. It's important to highlight that there's a sequence to be followed between equity-for-debt and debt restructuring. My suggestion is that debt restructuring should precede the equity-for-debt approach. Local governments would be hesitant to relinquish controlling stakes in premier enterprises like Moutai. If the main aim of transferring Moutai shares is to repay high interest, it doesn’t present a cost-effective solution for local governments. Only by restructuring the debt to lower interest and extend the term, with a focus on repaying primarily the principal, might provinces be potentially willing to adopt the equity-for-debt approach.
Resolving Debt through Economic Growth. Currently, China's economy is experiencing a notable deficit in overall demand, leading to a significant negative output gap, which is unfavorable for debt resolution. If China's current economy were likened to a bicycle, it would need to maintain a certain speed to ensure stability and agility. Hence, the government should assertively enact counter-cyclical macro policies, bolster market confidence through structural reforms, and rapidly align the economic growth rate closer to its potential rate, to address local government debt in a more secure and sustainable manner.
Promptly Develop Crisis Response Plans: Under the existing framework, the likelihood of a systemic or regional financial crisis in China is relatively low. However, should localized or contiguous defaults arise, and platform defaults impact local commercial banks, a question emerges: should the response come from the provincial government, the central government, or a collaborative effort from both? Regardless of the scenario, detailed risk management plans for various situations should be formulated as soon as possible. Once a risk emerges, it can be addressed methodically according to the plan, instead of waiting for the situation to worsen and then hastily convening meetings to find solutions.
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