China's growing mountain of debt
Zhang Monan says even as financing for local governments grows in size and variety, they still struggle to repay debt and support spending. It's time for China to get its fiscal house in order
In the coming years, China's government will have to confront significant challenges to achieve stable, inclusive and sustainable economic growth. But, with mounting fiscal and financial risks threatening to derail its efforts, policymakers must act quickly to design and implement prudent policies.
The most significant medium- and long-term threat lies in the system of implicit guarantees that Beijing has established for local-government debt. In the wake of the global financial crisis, local governments borrowed heavily from banks to support China's massive stimulus programme, amassing 10.7 trillion yuan (about HK$12.5 trillion using exchange rates then) worth of debt by the end of 2010.
China's leaders hope to control potential risks stemming from local-government investment vehicles by limiting bank lending. The balance of bank loans to these vehicles increased only slightly last year, to 9.3 trillion yuan (HK$11.6 trillion), from 9.1 trillion yuan in 2011. And the China Banking Regulatory Commission has called on banks to retain last year's loan quotas for this year, and to ensure that the overall balance of loans to such instruments does not exceed the 2011 year-end total.
But these financing vehicles obtained a massive amount of financing last year by issuing bonds and trust loans. This includes 250 billion yuan in local-government bonds, 636.8 billion yuan in urban-investment bonds, and technical co-operation trust-fund projects totalling 501.6 billion yuan, representing year-on-year increases of 50 billion, 380.6 billion and 247.9 billion yuan, respectively.
Even with these funds, however, local governments have struggled to make ends meet. Tax reforms have caused their share of national fiscal revenue to decline steadily, from 78 per cent in 1993 to 52 per cent in 2011. Over the same period, however, their share of total government expenditure rose from 72 per cent to 85 per cent.
The need to fill the gap has forced local governments to depend on land sales. But land-related income has plummeted over the past two years, from 32 per cent of total revenue in 2010 to 20 per cent last year. Measures mandated by Beijing to control surging real estate prices will continue to reinforce this trend, increasing pressure on local-government revenues.
The risk stemming from local-government debt is exacerbated further by massive amounts of non-explicit debt acquired through arrears, credits and guarantees. When a local government is no longer able to service its debt, the central government will have to place its own fiscal capacity at risk by assuming the responsibility.
China's financial stability is also under threat, as lenders turn to unofficial channels to circumvent tighter regulations on the formal banking system. Perhaps the biggest risks stem from China's rapidly growing shadow banking system.
Shadow banking can be conducted through trust loans (extended by trust companies), entrusted loans (company-to-company credits brokered by financial institutions), bank acceptances (company-issued drafts or bills that are endorsed by banks), and corporate bonds (debt securities issued by companies directly to investors). These instruments' combined worth reached 5.9 trillion yuan last year, led by corporate bonds (2.3 trillion yuan).
New lending by trust companies - which rose by more than 400 per cent last year - is generating significant solvency risk in China, given that it is frequently extended to higher-risk entities, including real-estate developers and local-government investment vehicles. A spike in defaults could destabilise the entire financial system and trigger an economic downturn. And trust loans tied to these financing vehicles ultimately enjoy the same implicit guarantee from the central government as official bank loans.
Regular banks, too, are trying to evade new regulations by ramping up off-balance-sheet lending. Indeed, it is increasingly common for banks' off-balance-sheet lending to exceed newly issued balance-sheet credit. In 2011-2012, such lending grew by 1.1 trillion yuan, reaching 3.6 trillion yuan (23 per cent of total bank financing), while balance-sheet lending increased by only 732 billion yuan.
But the former is usually implicit and uncertain, making it vulnerable to default.
More generally, the rapid expansion of credit risks is increasing inflationary pressure and fuelling the formation of asset bubbles. But when the monetary authority tightens credit too quickly, asset prices become more volatile, resulting in more non-performing loans and triggering economic shocks.
China's government must implement prudent macroeconomic policies now to minimise escalation of these risks. Long-term fiscal stability will require policies that account for the growing disparity between fiscal revenues, which are suffering from slowing growth in gross domestic product, and expenditure, which will be driven up by structural tax cuts and increased social-welfare spending.
In order to manage growing pressure on public finances, China must establish highly efficient public-budget and fiscal-restraint systems. To this end, the government must tighten financial supervision, improve budgetary management and enhance the operational efficiency of fiscal policies.
China also needs a new financing model for infrastructure projects. The current system relies heavily on these local-government investment vehicles and fiscal expenditures. But local governments cannot continue to rely on revenue from land sales to repay their debts or support current spending. More stable financing channels and stronger enforcement of operating standards are essential to support rapid urbanisation.
As prudent fiscal and financial policies gradually stabilise China's economy, monetary policy must remain neutral. Loosening monetary policy would increase significantly the risks stemming from local-government debt and shadow banking, while tightening monetary policy would fully expose those risks, posing a serious systemic threat.
With the right balance of vision and caution, China's leaders can tackle the build-up of fiscal and financial risk. If they fail to act decisively, China's leadership of the future global economy will hang in the balance.
Zhang Monan is a fellow of the China Information Centre, a fellow of the China Foundation for International Studies, and a researcher at the China Macroeconomic Research Platform. Copyright: Project Syndicate