19 November 2018

China’s local debt bomb, or is it?

China’s National Audit Office (NAO) released on Dec. 30 an audit report on local government finances, which reviewed the books of over 36,000 local governments, including more than 62,200 government agencies. This audit coverage is more than double the number of government agencies covered in the last national audit in 2011 and, presumably, is more accurate. The NAO report puts total local government debt (LGD) at 17.9 trillion yuan (US$2.95 trillion) at the end of June 2013.

The new data shows that the LGD was up by more than 67 percent from the 10.7 trillion yuan recorded in 2010, and up 50 percent from the LGD of 12.1 trillion yuan in 2012. In other words, the rate of accumulation of the local debt has gone ballistic in the past three years, a trend that is clearly unsustainable.

Using previous official data, we estimated that the risk-weighted Tier 1 capital ratio in the Chinese banking system stood at 10.6 percent at the end of 2012 when the LGD totaled 12.1 trillion yuan. This was still well above the 7 percent Basel III minimum requirement. Together with some recent data from the China Banking Regulatory Commission (CBRC), the new NAO report helps shed some light on the potential systemic risk, which has been an issue overhanging the Chinese stock market.

Non-performing loans (NPLs) in the banking system amounted to 539.5 billion yuan (0.96 percent of total loans) at the end of June 2013, with loan loss reserves standing at 1.5 trillion yuan. This implies a loss provision ratio of 278 percent. This was lower than the ratio of 298 percent at the end of 2012, according to the last audit report, but still high by international standards.

With this and other known data on bank exposure to LGD, potential loan losses and a bad debt recovery rate of 25 percent (as per CBRC data), we estimate that the 17.9 trillion yuan LGD would cut the banking system’s risk-weighted Tier 1 capital ratio to less than 7.0 percent from 10.6 percent. That is, the system’s risk cushion could have been eroded below the safety threshold, unless banks had increased their risk-weighted assets in the past year. But detailed risk-weighted asset data is not yet available at the time of writing.

The LGD’s rapid rate of increase has raised systemic risk sharply. The problem is serious, as the rate of LGD accumulation is not sustainable. But it is not yet fatal, thanks to 1) a closed capital account, 2) Beijing’s “implicit guarantee” policy, 3) ample financial resources that the central government can mobilize, 4) domestically-owned and RMB-denominated liabilities, and 5) an overall small debt burden (central government debt is about 22 percent of GDP; total government (including central, local and government agency) debt is about 53 percent; total economy-wide credit is about 190 percent of GDP, which is not excessive, considering China’s under-developed capital market).

Crucially, Beijing is not sitting on its hands. It has been moving slowly to address the LGD problem by keeping a tight monetary policy bias to force deleveraging and reining in local government borrowing from both the banks and shadow banks. In the near-term, the risk stems from the 24 percent contingent liabilities (or 4.3 trillion yuan out of the total 17.9 trillion yuan LGD), of which the NAO said the local governments would not be legally obliged to make repayments.

Separately, CBRC data released earlier also showed that wealth management products (WMPs) totaled 9.1 trillion yuan in the second quarter of 2013, with non-standard assets (i.e. the opaque and illiquid assets, especially those that have no secondary market, that are often seen as dodgy assets with little disclosure to investors) accounting for 2.8 trillion yuan. We estimated that WMPs amounted to 7.5 trillion yuan with 1.9 trillion yuan in dodgy assets as of the end of 2012. This would suggest that WMPs rose by 21 percent and dodgy assets by 47 percent in the first six months of 2013!

In the grand scheme of things, the problem does not look too alarming. The new data for the WMP and dodgy assets implies that they equate to some 16.3 percent and 5 percent, respectively, of estimated 2013 GDP. Granted, these are up from 14.3 percent and 3.6 percent of GDP, respectively, in 2012. But when compared with the substantial financial resources that Beijing can mobilize to contain any potential fallout from this problem (e.g. FX reserves amount to over 40 percent of GDP), they are manageable.

In a nutshell, Beijing has time to sort out the LGD problem. Together with rising shadow banking activities, which are in fact financial liberalization by stealth, the NAO audit result adds pressure on President Xi Jinping {習近平}, who was recently named the head of a Communist Party leading group for reform, to push through structural reforms. These will need to include reforming a fiscal system that starves local governments of tax revenues, which get only 40 percent of the total tax revenues collected but are responsible for 80 percent of the local spending.


Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

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