Fork in the path

IFR IMF/World Bank 2021
12 min read
Paolo Danese

China's debt-funded expansion has been the envy of many over a number of years. But it now faces a stark choice: growth or deleveraging.

The ongoing collapse of a large, over-leveraged real estate developer in China is another test of the authorities' keenness to avoid contagion at all costs, and there is confidence Beijing will manage to avoid a "Lehman moment" for China.

Yet, the headline case serves as a reminder that China's growth recipe is still too reliant on debt, especially at a local government level. More tough choices loom for policymakers as they seek to keep the engine of growth steaming ahead.

The Covid-19 pandemic has not helped China's now decade-long efforts to find a new recipe for growth not as heavily reliant on debt-funded investments. Last year's stimulus measures, funded for Rmb1trn (US$155bn) through pandemic bonds, pushed China's overall debt-to-GDP ratio up by 23.6 percentage points to 270.1% at the end of last year, the fastest pace since the financial crisis, with local governments accounting for around a third of the increase, according to a research report by HSBC.

The State Council noted that as of July 2021, Rmb657bn in local government bonds had been issued, split between Rmb248bn for general bonds and Rmb408bn for so-called "special bonds", which finance infrastructure investments and are to be repaid from revenues from the underlying projects. These levels are far lower than the 2020 totals, when special project bond issuance was Rmb3.6trn, according to Ministry of Finance data, as a result of several steps taken to bring down borrowing by local governments and introduce transparency to their practices by regulators.

The implicit bet of the current model is that infrastructure and industrial projects, funded with local government borrowing through bank loans and the debt capital markets can continue to guarantee the type of growth rates for China which most developed countries can only dream of.

Those on the bullish side can point to some victories for that approach, such as the one of Hefei, which went from a backward inland city to a high-tech industrial hub over the past decade primarily by investing capital raised by local government financing vehicles (LGFVs). The city saw the rise of corporates such as electric vehicles company NIO, which is now building an entire electric vehicles-focused industrial park in the city through an agreement with local governments. The city joined the "trillion yuan GDP club", which now includes 23 cities in the country. Shanghai was the first among them, passing the milestone 2008.

But, local successes may prove costly from a wider point of view. China sees growing economic headwinds as it deals with the ongoing fallout of the Covid-19 pandemic and a trade war with the US. That means local governments find themselves squeezed between tighter borrowing rules and the need to continue to meet GDP growth demands from Beijing.

How we got here

China's approach to debt was shaped by the experience of developed markets, specifically the sub-prime mortgage bubble which triggered the global financial crisis of 2008. The Chinese government watched in horror as the Western financial system folded, and decided it would sign cheques no matter the size to keep its economy from crashing, a trend many central banks around the world would soon decide to follow.

So began China's addiction to debt-funded economic growth, which spurred countless infrastructure projects, from successful high-speed rail lines, which have become an image of China's rapid development abroad, to the less flattering images of "ghost towns" littered around the map. Some of these wasteful construction projects still languish, though there have been successes in repopulating some of them, according to international media coverage of places such as Kangashi town in Inner Mongolia or the Binhai New Area of Tianjin. The latter is a former ghost town that now hosts a population of over two million, according to state media.

That being said, there is no hiding from China's looming debt mountain. And LGFVs may well be the avalanche waiting to fall. These vehicles remain a focus for analysts for the simple reason that since the global financial crisis they have been the main source of off-balance-sheet financing for struggling local economies, as explained by Jing Liu, senior China economist at HSBC.

"It is important to remember that out of the Rmb4trn [GFC] stimulus package, the central government only took Rmb1.2trn out of its pocket, while local governments had to find their own funding," Jing said. "There were big restrictions on how to do that, too, since back then local governments were not allowed to raise debt directly."

While direct loans from banks to local governments made up the US$3trn in official additional funding that made up the stimulus package, there is a consensus around the fact that, through LGFVs, the actual borrowing at the local level far exceeded that amount.

"That led to the many infrastructure projects which allowed China to bounce back quickly from the crisis and give markets confidence to rally, even helping lead the rest of the world out of the crisis," Jing said.

Yet complacence around the use of these funding vehicles spurred a borrowing frenzy, which lasted until 2012 when the central government realised it needed to rein in debt and introduce transparency. At that time, the government held its first of many rounds of audits of local government debt, although those exercises have done little to slow down the trend, as the latest figures confirm.

That brings us back to Covid-era China.

"Local governments can now borrow from debt capital markets directly, the intention of the central government is to open the front door, to have that light shining through, and to close the back door [of LGFV financing]," Jing said.

Two of the steps taken are the loan-for-bond swaps programme and the consolidation of borrowing plans for local entities at the provincial level, forcing sub-provincial level entities to coordinate their fundraising efforts to fit within assigned quotas.

Jini Lee, Asia head and finance practice partner at international law firm Ashurst, notes another step taken is the introduction of the "traffic light system" which emphasises the fact that there is still enough credit differentiation among LGFVs to entice international investors.

"We are still seeing the better credits among the LGFVs coming out with new bonds and refinancing," said Lee. "With the traffic light system, those entities marked as green can come offshore for funding easily, the yellow ones can only issue offshore bonds for refinancing, while those in red are technically not allowed to issue new offshore bonds.”

That applies not just to the primary but the secondary markets as well.

"With more credit differentiation, we actually see foreign investors being more savvy of the opportunities, many of them may like the volatility and buy bonds that they see as oversold," said Lee.

Not enough

The steps are not only directed at the markets but at the people behind the institutions, too.

"Since 2018, local government officials need to be responsible for the debt levels in their region,” HSBC’s Jing said. "For top local officials, that translates into a lifetime responsibility. This is to curb the excessive borrowing seen in the past. Now, even the prudent officials worry about how to make sure the local government special bond payment schedule matches the cashflow from the projects."

It is therefore surprising that, despite across-the-board efforts, debt has continued to grow since 2017 at a rate between 12.5% and 14% per year, even accelerating in 2020 as the global Covid-19 pandemic hit.

That means there is a wave of LGFVs defaults waiting to happen, according to Samuel Kwok, senior director of APAC public finance at Fitch Ratings.

“Since 2017, we are of the view that LGFV defaults are likely,” Kwok said. “Recent credit incidents among SOEs, although not strictly speaking LGFVs, also reinforce our view towards increasing default risks among LGFVs. Local governments may become more selective in their support to LGFVs. More important policy-driven entities that are closely aligned with the government may benefit from more support, and vice versa.”

One way out from under the mountain of debt would be a new agreement around the division of tax revenue between local and central governments. The current model in China sees the central government collect most revenues and redistribute them from the more developed regions to subsidise growth in the less developed ones. A different split may help reduce reliance on debt, but that has not materialised.

“In recent years, the fiscal performance of local and regional governments have been impacted by a series of tax cuts and the pandemic, thus limiting the flexibility of the LRGs to fund further infrastructure spending,” Kwok said. “This lack of fiscal firepower means LRGs still are incentivised to use LGFVs as a conduit to raise debt and pursue infrastructure and urban development.”

Choices on growth

But even should such fiscal reform efforts succeed, they may ultimately amount to little without a decisive shift away from excessively high growth targets, according to Michael Pettis, economist and finance professor at Peking University.

"Successfully reining in the debt will be impossible unless Chinese growth consists mainly of what Beijing calls high-quality growth, which is driven by exports, consumption, and related business investment," said Pettis. "That growth can be achieved without growing debt."

However, Pettis noted that such growth could amount to perhaps 3% or 4% per year, with the rest likely made up of non-productive infrastructure investments funded by borrowings that will sooner or later need to be repaid. Which brings us full circle back to the real estate sector, which have both been on borrowing binge while simultaneously acting as one of the sectors driving economic growth year after year. Shutting off the debt tap for real estate developers too suddenly would make it impossible to hit the policy-mandated growth targets.

"If you want to end the moral hazard, you have to stop using the property sector as an engine of growth," Pettis said.

The current crisis may well be solved through state intervention, whether through mergers in the sector or bailouts from the banks, but squashing one bubble may only lead to yet another popping up elsewhere.

Even President Xi has made candid statements in this regard in a recent essay for Qiushi, an official party newspaper, published in July.

"I said that we needed to shift the focus to improving the quality and returns of economic growth, to promoting sustained and healthy economic development, and to pursuing genuine rather than inflated GDP growth and achieving high-quality, efficient, and sustainable development."

With top leadership on board, and the focus shifting away from unattainable levels of annual GDP growth, China could start getting a grip on its debt problems. But dealing with the mistakes of the past may prove painful.

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