China must ready itself for bankrupt local governments
Winston Mok says Beijing should do more than audit local government debt - it should set up an agency to restructure debt, inject funding, and even allow some local administrations to go bankrupt
As epitomised by the announcement, soon after the world's largest building opened in Chengdu , that the world's tallest would be erected in Changsha , China has been expanding cities like no tomorrow. All these are part of the race among many Chinese cities to become "world metropolises".
Behind China's economic growth in last few years has been infrastructure and urban expansion, some of it of dubious economic Merit. In the process, some cities have borrowed beyond their means, and are struggling to make ends meet.
This week, China's National Audit Office - as instructed by the State Council - will begin a comprehensive review of all local government debts. Estimates of the debt range from 13 trillion yuan (HK$ 16.3 trillion) to 20 trillion yuan, or up to 40 per cent of gross domestic product last year.
It is unclear if these estimates cover all local government-affiliated borrowings, including those through investment companies, trusts and build-transfer schemes - whether legally guaranteed by local governments or not. The upcoming review will hopefully clarify the picture.
The debts of some cities are above 100 per cent of their GDP. Repayments are often contingent on land sales. Due to falling commodity prices, bad economic performances or slowed land sales, some local governments are insolvent on a de facto basis.
Hence local government debt is seen as a key economic risk by many economists in China. A recent survey indicated that close to 60 per cent of Chinese economists believe third-quarter economic growth will be adversely affected by local government debt, and most see the problem getting worse. So it is indeed prudent for Beijing to rein in the situation before it gets further out of control.
When local governments run into trouble, Beijing will be left holding the bag. In the planned reform of municipal finance, Beijing may consider putting in place a bankruptcy mechanism for local governments.
As a key force behind China's economic development in the past three decades, local governments have behaved like commercial enterprises. But the behaviour of some might have been shaped by moral hazard not checked by bankruptcy risks.
As de facto commercial enterprises, they may be delineated by Beijing as limited liability entities not underwritten by the central government. Beijing may draw a line and protect itself against unlimited exposure to unauthorised local Borrowing. In this way, lenders will become more prudent. Local governments will be more careful in extending guarantees. Without such guarantees, unauthorised borrowing may be reduced.
Local governments will not go under so easily, as much of the financing was done through platform (investment) companies rather than by local governments directly. To finance breakneck growth, local governments frequently resorted to platform companies for financing, where local assets - including land - are injected to raise funds.
Some of these borrowings are explicitly or implicitly guaranteed by the local government. If such platform companies become insolvent, they may go bankrupt just like any company. But in the process, the guarantees by the local government may be called in. If the local government cannot meet those obligations, it may in turn become insolvent.
In anticipation of such problems, Beijing could set up a central receivership board to assume control of insolvent local governments or platform companies. As stability is a top priority for Beijing, it certainly does not want to see local governments go broke on a massive scale. The proposed bankruptcy mechanism is meant to prevent this happening. Bankruptcy is only the final step after restructuring and receivership. The central receivership board may restructure debts and inject new funding. Beijing may use a few of these cases to make examples of reckless local governments.
To avert such crises, as suggested by the National Audit Office, a financial risk alert mechanism may be put in place.
In preparation for any issuance of municipal bonds, the local government must be credit-rated. As an extension of the upcoming review, Beijing may consider implementing an internal credit-rating system for local governments, and include it as a key measure for local cadres.
In the end, one would not run a business by focusing primarily on revenue growth - one could imagine the consequences. Yet that is precisely what is happening among many local governments of China. To generate the high growth required for the desired promotions, local leaders have taken on debt to be repaid by future generations of local administration, and ultimately the central government. One local leader was reported to lament that future leadership teams will just need to focus on one task: debt repayment.
Just like any business, one would need to look at cash flows and balance sheets. By putting in place a credit-rating system and bankruptcy mechanism, Beijing will be training local leaders to be responsible financial managers and effective general managers, not just aggressive sales managers.
Winston Mok is a private investor, a former private equity investor and McKinsey consultant. An MIT alumnus, he studied under three Nobel laureates in economics