Difficult debts
by Tom Holland
by Tom Holland

Zombie China assets threaten lenders

The real threat from uneconomic projects backed by mainland municipal authorities is that lenders will be saddled with these unviable assets

Last month Zhang Ke, the boss of accounting firm ShineWing, gave voice to fears shared by an increasing number of people.

China's local government debts were "out of control", he told the newspaper, and warned of a looming crisis.

What's got Zhang running scared is not the debts owed directly by China's municipal authorities, but rather the debts accumulated by local government-owned investment companies.

Local authorities are forbidden from borrowing directly in the capital markets, so back in 2009 when Beijing ordered an all-out stimulus effort to counter the effects of the international financial crisis, provincial, county and city governments set up thousands of companies to fund their infrastructure development projects.

Initially, these companies, or local government financing vehicles as they are often called, relied on bank loans to raise their money. Recently, however, they have broadened their funding sources, issuing corporate bonds, borrowing through trust companies and selling "wealth management products" to private investors in search of yield.

Estimating how much they have borrowed by these means is tricky. In a report published last week, analysts at the Hong Kong office of Malaysian-owned bank CIMB estimated that total Chinese local government debts, including those owed by their investment companies, hit 15 trillion yuan (HK$18.7 trillion) last year, or 29 per cent of China's gross domestic product.

Paying those debts back, or even just meeting the interest payments, is going to be difficult. CIMB's analysts looked at a sample of 809 local government investment companies, and found that only 31 per cent generate enough cashflow to cover their debt service obligations. Most don't even come close.

Yet CIMB is relaxed about the risks of a bad debt crisis. The bank's analysts argue that although local government investment companies are in terrible shape, the finances of the local governments themselves are relatively strong. According to CIMB, China's local governments ran a combined budget surplus of 3.3 trillion yen last year, enough to cover their interest expenses several times over.

As a result, CIMB argues that local governments have sufficient financial resources to bail out their investment companies should they get into trouble.

As a model, CIMB's analysts cite the example of Yunnan Road Development Investment Corp, which in 2011 warned lenders that it would not be able to repay its 100 billion yuan of debt.

In the end a default was averted with a behind-the-scenes deal which saw the Yunnan provincial government lend the company two billion yuan from its budget and inject fresh capital, while the creditor banks agreed to roll over their loans. According to CIMB, the loans were never marked as non-performing.

It is likely that similar deals, probably involving state share or land injections, could be used to prevent future defaults by indebted local government investment companies.

But while that would avoid embarrassing headlines, it would not solve the underlying problem. The trouble is that many of the projects backed by local government companies are uneconomic, and may never generate enough cash to service their debts. Injecting more non-cash-generating assets, rolling loans over, or issuing bonds to repay bank debts won't help.

So Zhang Ke was probably wide of the mark with his crisis warning. The real danger is not that there will be a debt crisis, but rather that China's lenders will continue to carry zombie local government assets on their books, hampering the development of the financial system and ultimately damaging the country's future growth prospects.

This article appeared in the South China Morning Post print edition as: Zombie assets scarier than local government debt crisis