China designs programme to determine size of local government debt burden
China has begun a program designed to clarify the size of its local government debt burden and reduce its financing costs. Swapping cheaper bonds for more expensive loans is an important step toward creating a healthier fiscal system.
But it is equally important to understand what this program will not do – it isn’t a bailout, it won’t lead to local government defaults and it isn’t a Chinese version of quantitative easing (QE).
The accumulation of local government debt was the result of three policy choices made by the Communist Party.
First, in the 1990s, power over local revenue collection and spending was recentralized in Beijing, in an effort to reduce unnecessary local spending.
Second, when the Global Financial Crisis struck in 2008 and tens of millions of workers were laid off as demand for China’s exports collapsed, the Party undertook the world’s largest Keynesian stimulus, accelerating construction of public infrastructure projects in order to reduce unemployment.
Third, the Party chose to fund that huge stimulus via loans from the Party-controlled banking system. All of this led to a dramatic rise in local government debt.
The new swap program is the Party’s latest effort to manage this debt.
The mechanism is to convert existing loans from banks and trust companies into bonds, as this will improve the Party’s ability to track local government debt, and will reduce financing costs. This is not a bailout as the Party will remain responsible for the debts. At the same time, I do not expect the existing debt to be abandoned by the Party in this process, so it will not lead to local government defaults.
Although some of the mechanical aspects of this loans-to-bonds swap may appear similar to QE measures deployed by the European Central Bank, this is not QE. China’s banks do not lack liquidity. Household bank deposits, for example, are equivalent to about US$8.8 trillion, which is greater than the combined GDP of Russia, Brazil, India and Italy. Corporate bank deposits are even larger.
Bank lending is constrained by Party policy, via a loan quota to which all banks must adhere, not by liquidity. While total credit outstanding is rising by more than 10 per cent year-on-year, the Party has been steadily guiding this growth rate lower, in line with gradually slower GDP growth. And QE is the last resort of a central bank that has no room to reduce interest rates, which is clearly not the case in China. This is why China’s central bankers have frequently stated that they are not engaging in QE.
There is little reason for investors to spend a lot of time trying to master the details of the swap program. The program is in its early stages, few details have been released and new programs like this typically go through significant change as policymakers observe the obstacles encountered during the trial run.
Some people will view these changes as signs that the Party is losing its nerve, while the reality is that the changes are more likely to reflect the Party’s pragmatic approach to new programs. The initial swap is to cover about 1 trillion yuan (US$161 billion) of existing local government debt, with a reported 1.86 trillion yuan of local government debt coming due this year.
A key positive of this evolving swap program is that it is likely to persuade more investors that there is little risk of default by local governments. This risk has always been negligible because there is no separate municipal political, legal or financial structure, so it is a mistake to apply a US framework to China’s municipal finances. This is why, after a decade of double-digit growth in loan-financed public infrastructure construction, there has not been a single default.
The impact of the swap program on China’s banks is unclear, but is likely to be modest. Because loans with higher interest rates will be swapped for bonds at lower yields, it is possible that bank profitability will suffer. But it is also likely that the swap process will free up a significant share of the loan quota to be lent instead to private firms, at even higher interest rates, mitigating the impact.
Banks will continue to grant new loans and roll over existing debt as the swap process unfolds because the swap program is not intended to stop Party financing of public infrastructure.
The peak in infrastructure investment has passed but the Party still plans to build a lot more subways, wastewater treatment plants and other projects. Despite the incredible pace of construction in recent years, the total length of China’s railway network is only half of that in the US, and of the 150 Chinese cities with a population of more than 1 million, only 22 have operational systems for subways or other rapid transit.
Andy Rothman is an investment strategist at Matthews Asia