Anthony Chan of Alliance Bernstein looks at China’s hidden debt and asks it portends a new sub-prime crisis in the region
Is there a new sub-prime debt crisis building in China? Both the markets and the media have been rife with speculation since early this year over the possibility a massive – and hitherto hidden – lending bubble may be building in the world’s most dynamic economy. At the heart of the issue are the liabilities built up by China’s vast number of provincial and local governments as the country has spent its way out of the credit crunch.
These bodies – ranging from the 34 provinces, autonomous regions and centrally administered municipalities down to about 40,000 township communities – have borne the brunt of the country’s infrastructure revolution. Fixed asset investment by local government came to around Rmb17.4trn ($2.5trn) last year, or more than 11 times the amount spent by central government and nearly three times the normal budgetary expenditure of local authorities. This fixed asset expenditure, which is financing the road, railway and energy projects that are transforming China, soared in 2009 as Beijing encouraged infrastructure spending as part of measures to keep the economy moving.
Limitations
But local revenues have never come near to meeting these costs and, owing to an oddity of Chinese law, local authorities are strictly limited in what they can borrow themselves. Their response has been to establish separate holding companies to manage big infrastructure projects and borrow the money required to finance them. At issue now is exactly how much these 8,000-odd “local government funding vehicles” (LGFVs) have borrowed.
Official estimates put the total amount outstanding by the end of 2009 at some Rmb6trn to Rmb7trn ($0.9trn to $1trn). But these figures have been open to question for some time.
Scepticism has grown since 2009, when LGFV debt more than doubled as central government encouraged infrastructure spending in the wake of the credit crunch. Now, a US academic, professor Victor Shih of the Northwestern University of Illinois, has added fuel to the fire by suggesting local government debt is more like Rmb11.4bn ($1.7trn), or nearly double the level acknowledged by Ministry of Finance officials.
Liabilities
Shih conducted on-the-ground research in China to dig out the off-balance-sheet liabilities of local governments, as well as the contingent liability to central government of public entities such as development banks and the Ministry of Railways. If added to other borrowing, Shih’s estimate for China’s total domestic government debt comes in at a weighty 96% of expected GDP by 2011 or 2012, which would be about four times the official estimate. In a worst-case scenario, he argues China may face a large-scale debt crisis two years from now.
While we are not in a position to dig in the same corners as Shih did to compare notes, we can nevertheless highlight a number of important points to provide some perspective on the issue.
Wake-up call or false alarm?
First, as well as the total outstanding local government debt of Rmb11.4trn at the end of 2009 (34% of GDP), Shih’s study adds credit lines agreed between local governments and banks estimated at another Rmb12.8trn ($1.9trn, 38% of GDP). His assumption they will be fully drawn on in future greatly inflates China’s current debt problem. If we exclude these future credits, the public debt would stand at about 59% of GDP (that is, 96% minus 38%) – much better than Shih’s worst case, although, of course, still pointing to a great deal more risk in China’s banking system than generally thought.
That brings us to our second point, which is China’s public-debt-to-GDP ratio does not look too extreme when compared with the ratios of Asia’s other A-rated issuers of sovereign debt. Korea, Taiwan and Malaysia, for instance, are all in the 40%-50% of GDP range. And, even at 59%, China would fare better than BBB-rated India where domestic public debt-to-GDP is likely to top 80% this year.
Minimisation
Third, in our view, China’s strong economic growth, high domestic savings, fiscal strength and huge government assets (such as foreign exchange reserves) will help minimise the macroeconomic disruption of the debt problem. Indeed, strong growth will not only improve the debt-to-GDP ratio, but the economic reforms that go with it should lead to structural change that will also help minimise the systemic risk of existing bad debts.
For foreign investors of course, the main impact of this issue will be felt through China’s listed banks. Here we think there are other reasons to be cheerful. The three government-controlled “policy banks” – China Development Bank, Agricultural Development Bank of China and Export-Import Bank – have a disproportionately large share of the debt and, by all accounts, the lowest-quality portion too. This means any fallout from bad loans is likely to fall more heavily on them than on their listed counterparts.
Worrying
Certainly, we do not want to unduly minimise the importance of the LGFV debt problem. Perhaps its most worrying feature is there are no reliable estimates of its size. It is also troubling the Government has been tardy in getting to grips with the issue. Even so, we think the markets may be over-reacting. These loans are long term, with no repayments for the first few years, so any bad debts will take a while to come through. Even then, the impact is likely to fall disproportionately on the state-controlled banks. Indeed, unlike during the US sub-prime housing crisis, there is no evidence LGFV debt is being sliced up and sold on to other investors as separately-tradeable bonds. By the time any problems finally surface, we believe a combination of government action, more balanced lending policies and economic growth should have diluted the effects of LGFV loans.
The bottom line is, China probably has more financial and economic strength to weather a real crisis than any other major nation. So while the country faces a long-term problem with local government over-indebtedness, it is one it can and ultimately will deal with. It may not necessarily be done in a way that pleases the markets, but it is unlikely to become China’s version of the credit crunch.
Anthony Chan is Asian sovereign strategist at Alliance Bernstein
