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  • Apr 18, 2014
  • Updated: 6:55pm
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Local government financing needs revamp to avoid risk of excessive debt, analysts say

Central government urged to shoulder more of the loan burden at the local level as default risk looms amid a spending spree on infrastructure

PUBLISHED : Friday, 24 January, 2014, 10:21am
UPDATED : Saturday, 25 January, 2014, 5:07am

The fast growth in the mainland's local government debt has highlighted the urgency of a revamp of the country's seriously imbalanced fiscal system, under which the central government should shoulder more of the load, to ease the burden on provincial, city, county and township authorities, analysts said.

In the years ahead, Beijing also needed to build a rating system for local government credit, a foundation for launching long-awaited municipal bonds; narrow the gap between local governments' revenue and spending; and improve the transparency of their balance sheets, they said.

"The risks of default among some entities related to local governments will remain significant in 2014, especially if economic conditions weaken sharply," Standard & Poor's credit analyst Tan Kim Eng said.

Local government debt on the mainland reached 17.9 trillion yuan (HK$22.7 trillion) at the end of June last year, up 13 per cent from the end of 2012 and 67 per cent from the end of 2010, a National Audit Office report showed recently.

The mainland's gross domestic product grew at its slowest pace in more than a decade at 7.7 per cent last year. The expansion, while still robust by international standards, has already cooled significantly from a peak of more than 10 per cent in recent years.

The risks of default among some entities related to local governments will remain significant in 2014, especially if economic conditions weaken sharply
Tan Kim Eng, Standard & Poor’s

As economic growth slows further over the next few years, given the shaky global economy and domestic economic rebalancing, analysts warned some local governments might eventually go bankrupt if local fiscal revenues failed to keep up with the pace of the debt build-up.

The ratio of central plus local government debt to GDP remains low at 39 per cent, however, way under the international warning line of 60 per cent.

The net government debt-to-GDP ratio might be even lower, S&P said, estimating it at under 30 per cent in 2012, after deducting liquid assets held by governments at various levels from total debt.

Analysts mostly believe there is no near-term need to worry about systemic financial risks. Nevertheless, the debt situation remains a big concern as local authorities, which have been banned from issuing bonds directly while also facing tightened regulatory policies on bank lending, have relied heavily on land sales and sought help from the risky shadow banking system to finance their infrastructure projects.

The most imminent worry is liquidity risk, analysts say, as infrastructure projects launched by local authorities usually do not generate high near-term investment returns.

Nomura International's chief China economist Zhang Zhiwei said profitability at local government financing vehicles weakened in the first half of last year, with the median return on equity falling to about 1.9 per cent from 3 per cent in the second half of 2012, far below the 5.4 per cent median ratio for non-financial companies with A shares.

Zhang said that while the government had pledged fiscal reforms to provide more revenue to local governments as part of long-term plans to contain the risk of local government debt, some short-term actions could also be taken to avoid a broad-based default.

These might include selling some state-owned assets to cover losses at local government financing vehicles, allowing debt rollovers and restructuring, and continuing to provide subsidies to local authorities.

The risks and the corresponding measures to curb them would likely weaken infrastructure investment this year, slowing GDP growth to 7.1 per cent in the second quarter, Zhang said.

The National Development and Reform Commission predicted about 100 billion yuan worth of local government debt would come due this year.

In order to ease short-term tightness in liquidity, the agency said it would allow local government financing vehicles to issue new corporate bonds to cover part of the old borrowings to ensure projects could be completed.

Mainland leaders stressed at their Central Economic Work Conference last month that curbing and resolving the risk of local government debt would be one of the major tasks this year.

They pledged to include local government debt in comprehensive budgetary management and revamp the evaluation system of local officials by cutting the weight of GDP numbers in deciding their political careers.

People's Bank of China deputy governor Pan Gongsheng said doing so would be a top priority.

Allowing local governments to issue bonds directly rather than having the central government do the job for them as a proxy would make the local government financing system more regulated and transparent, Pan said.

In the future, city governments should be the main issuers of municipal bonds
Pan Gongsheng, People’s Bank of China

"In the future, city governments should be the main issuers of municipal bonds" as they were the main bodies that used the funds, he said at a recent conference.

Li Yan, senior analyst at Beijing-based China Chengxin International Credit Rating, expects the government to move "relatively fast" in rolling out municipal bonds or bonds supported by underlying projects, in an effort to cut reliance on borrowing through the shadow banking system.

"To repay the debt, county-level authorities have to rely on financing, with the bulk borrowed at high costs owing to regulatory curbs on bank lending, which has pushed up market interest rates," Li said.

Mainland leaders would also need to reform the fiscal system to smooth imbalances in the structure of revenue and spending, analysts said.

Some lower-tier governments were heavily indebted, the audit report revealed. As they lack the land and other resources that are concentrated in bigger cities, city and county-level governments in less developed regions are facing the greatest challenges in resolving their debt burden.

Of the outstanding local government debt, borrowings by provincial governments, which have the greatest fiscal resources among all levels of local authorities, accounted for just 29 per cent, while city and county-level debt accounted for about 69 per cent.

The percentage of local government debt that lower-level governments must repay using their own funds was also much higher than that for provincial governments, the audit report showed.

The ratio for city governments was 66 per cent and that for county governments was 78.5 per cent, compared with 34 per cent for provincial authorities.

 

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Indeed, '(t)he most imminent worry is liquidity risk', not insolvency risk.
Some local government financing paltforms including Shanghai, Yunnan, and Shanxi have encountered difficulties of principal repayment and requested to extend loan maturities.
Imitating the Stability and Growth Pact in the Eurozone, Beijing should immediately set up a public debt and deficit cap on the local governments.
Once the debt cap is established, some short-term measures, including selling part of the local government assets, securitizing debts (transferring nonperforming loans to the asset management companies at a discounted price and negotiating an extension of loan maturity), and wiping off by the central government, are needed to be taken immediately, in order to quickly lower the leverage rates below or close to the target rates.
Other measures, including issuing local government municipal bonds, levying property taxes, and rebalancing local government expenditure (public services, education, social security, medical services and healthcare, and environmental protection spent more by the central government), will be long-term solutions for a healthy and sustainable local fiscal position.
(From 'Strategic Priorities' by Yifan Hu)

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