By Michael Lelyveld
China has backtracked on plans to curb off-book loans and local government debt as concerns about the economic slowdown continue to mount.
Nearly eight months after the central government ordered authorities to stop borrowing through poorly-regulated “local government financing vehicles” (LGFVs), it has eased rules for LGFV funding to spur economic growth.
“The reforms are now being reversed because President Xi Jinping’s top priority is to shore up the economy,” Bloomberg News reported on May 28 after the National Development and Reform Commission (NDRC) cleared the way for more local debt backed by LGFV loans.
Last October, the State Council, or cabinet, told local governments to “no longer borrow money through LGFVs,” which were created as arm’s-length corporations to raise funds for projects, skirting legal bans on issuing municipal bonds.
The government is in the process of ending the ban with budget law changes, pilot programs for bond issuance and a Ministry of Finance debt swap plans.
But in the meantime, the economic slowdown has raised demand for more backdoor lending through China’s thousands of LGFVs.
On May 28, the NDRC state planning agency used its authority over state-owned enterprise (SOE) bond issues to lower the debt-to-asset ratios for LGFV guarantees, China Daily reported.
The NDRC also lifted debt limits for cities and counties from 8 percent of local gross domestic product (GDP) to 12 percent.
“The move is expected to spur a new wave of bond issues by LGFVs to meet a huge financing shortfall in infrastructure investment,” the official English-language paper said.
The new rules also boosted quotas for SOE bond issues that support investment in seven previously-identified “key sectors,” including clean energy, mining services and transportation, state media reported.
Rising local government debt
The about-face has raised concerns on several counts, most significantly because of rising local government debt.
In its last official accounting, the National Audit Office estimated the total of direct local government debts, guarantees and contingent liabilities at 17.9 trillion yuan (U.S. $2.9 trillion) as of June 30, 2013.
Since then, Mizuho Securities Asia has said the total may have reached 25 trillion yuan (U.S. $4 trillion), Bloomberg reported.
Debt estimates vary in part because local authorities have been borrowing through LGFVs without reporting the obligations on their books. Moody’s Investors Service called the practice “opaque local government leverage” in another China Daily article.
The new budget law was expected to help clarify the risks as LGFV debt is gradually converted and replaced by municipal bonds.
But the NDRC move suggests that the government has decided not to wait for the transition, despite concerns that LGFVs have relied on capital from the shadow-banking sector, where risks are even murkier.
The implication is that the central government is stifling its own reforms as it tries to slow the slippage in GDP growth by pumping up local stimulus projects with new injections of debt.
The NDRC order is a measure of the government’s concern with further economic weakening in the second quarter.
The shift in policy follows an official GDP growth rate of 7 percent in the first quarter, the smallest since 2009, as some provinces recorded rates as low as 1.9 percent.
Thomas Rawski, a China scholar and University of Pittsburgh economics and history professor, said the decisions reflect the immediacy of the government’s short- term concerns.
“What you’re looking at is conflict between short-term objectives and long-term objectives,” Rawski said.
The government may not have abandoned its goals of market reform and transparency, but these have been temporarily trumped by economic weakening.
“We’ve seen this before, that when short-term difficulties arise, they step back to tried and true methods that may not reflect the long-term objectives,” he said.
Rawski suspects that real growth in the first quarter was considerably lower than the official GDP rate, as evidenced by the slight 0.8-percent rise in reported electricity consumption and an 0.1-percent drop in generation from a year before.
Fixed asset investment rises
Last week brought further uncertainty as the government reported that fixed asset investment in May rose 9.9 percent from a year earlier, recovering only slightly from April. The official Xinhua news agency said the outlook remained “grim.”
Industrial output also strengthened marginally in May with growth of 6.1 percent year-to-year. Production at state-owned and state-controlled enterprises barely budged with growth of 2.2 percent, the National Bureau of Statistics (NBS) said.
Rawski sees similarities in China’s response to the global slump of 2008-09, when the government encouraged banks to extend easy loans as part of its 4-trillion yuan (U.S. $645-billion) stimulus plan.
“They’re responding in ways that have worked before, at least in the short term, and in expectation that they’ll work again, at least in the short term, and my guess is that they’re confident that they can avoid the dangers posed by this growing debt,” Rawski told RFA.
The difference this time may be that China has yet to deal with the debt problems created by its earlier stimulus program. The result may be piling debt on top of debt with little accurate accounting or assessment of default risk.
Since taking office in 2013, China’s government has insisted it will not repeat the mistakes of big stimulus policy, which avoided an economic downturn at the cost of wasteful infrastructure projects and pollution.
But with the u-turn on local government debt, the government’s “targeted stimulus” formula has taken another step toward the earlier approach.
One danger is that China’s “new normal” economic growth rate will continue to decline, despite the new debt that the government appears willing to allow.
Rising debt and falling growth could be the worst of both worlds, increasing repayment risks.
Troubling local debt levels
LGFVs are due to repay 698.7 billion yuan (U.S. $114 billion) on their notes this year, more than double the amount in 2014, according to Bloomberg.
Analysts and international financial institutions continue to view China’s overall debt levels as manageable, but the cloud surrounding local debt is troubling.
“I think the biggest risk definitely is the LGFV debt,” said Jianguang Shen, chief economist at Mizuho Securities, as quoted by the website www.knowledge.ckgsb.edu.cn.
Last month, state media reports also highlighted continuing growth of non-performing loans (NPLs) in the banking sector.
At the end of 2014, NPLs stood at 1.43 trillion yuan (U.S. $234.1 billion) as the bad loan rate rose to 1.6 percent from 1.49 percent the year before, Xinhua said.
On Sunday, Xinhua cited a Moody’s statement last week on the local debt issue in an apparent response to analysts’ concerns about bailout risks.
While higher levels of off-budget investment financing “pose a challenge to the Government of China’s … fiscal position, such debt levels are relatively moderate and can be absorbed over time by the sovereign’s balance sheet,” the rating agency said on June 12.
But a Bloomberg report appeared to reflect greater concern on the part of Moody’s following a limited sampling of 36 local authorities’ debt levels from a National Audit Office review.
“Both the amount of the debt among the sampled local governments and the limited scope of the report are credit negative for China,” Moody’s was quoted as saying.