Heading off a China-style Subprime Mortgage Crisis

By Caixin editor Hu Shuli

Warning of local governments’ high exposure to bad debts, the credit agency Fitch recently downgraded China’s long-term local-currency rating from AA– to A+. Officials should take note: the downgrade underlines how closely international markets are watching developments in the country.

Local government debt is nothing new, but the amount has been modest—until recently. The government’s pursuit in 2008 of a 4 trillion yuan stimulus package has pushed debt levels sky-high. The continuing growth of the shadow banking system is also a source of hidden risk.

Just how big is the debt? The National Audit Office says local governments had 10.7 trillion yuan of debt at the end of 2010. The National People’s Congress budget report, meanwhile, said principal repayment of local government bonds last year totaled 200 billion yuan. Some experts estimated a rise last year of 1 to 2 trillion yuan. Even based on conservative estimates, local government debt may now exceed 12 trillion yuan.

This debt is worrying, not only because of its size. Worse, it is not transparent and we don’t know how it will be handled. Particularly of concern is the tendency of Chinese officials to let political expediency override economic sense.

The extent of the risk from local government debt has been a topic of hot debate. When, where, and how it may destabilize the system is in fact hard to predict, given the opacity of government operations. Some analysts are worried about the sluggish growth of government revenues. Meanwhile, many people both in and outside the government say the risk of default is low because the central government would pick up the pieces if things go wrong.

This view is mistaken. The central government is not obliged to guarantee local government debt. Besides, with the country’s economy slowing and the growth of fiscal revenues similarly easing, the central government may in fact have no ability to bear the burden of debt in case of a systemic meltdown. The debt will instead be monetized, and the people will have to foot the bill. This is China’s own subprime mortgage crisis in the making.

Even if no crisis is likely to happen soon, we cannot allow the debts to build. There are many problems with the system. By allowing the proliferation of local government financing vehicles (LGFVs), the government is breeding another group of “state enterprises” that monopolize the country’s financial resources, crowd out the smaller players, and make the financial market even more distorted.

Furthermore, such investments promote inefficient growth based on an old model of development that the country would do well to abandon.

The government must rein in the growth of LGFVs if the economy is to grow sustainably. Authorities should curb the amount of debt, audit the system, and check the debt structure of local governments and their solvency. Given the danger of moral hazard, the central government should also stop local governments from intervening in small-scale defaults. Their interference would see the automatic extensions of loan deadlines, and some state-owned enterprises may end up paying the debts of others. We’ll end up with not only companies that are “too big to fail,” but also, ridiculously, those that are “too small to fail.” This would only feed the debt balloon.

Letting some companies go bust would, in fact, improve the market pricing of risk premium, the interest rate structure, and the bond rating system.

The media plays a key role in the monitoring of local government debt, and it must be allowed to do its job. Some local governments have tried to stonewall media inquiries on the pretext of safeguarding the financial environment. The opposite is in fact true. Without the media raising awareness about potential problems, the system would face graver dangers.

In addition, the financial regulatory system must be overhauled. Each segment of the financial sector is separately regulated, but today many businesses offer integrated financial services, and it’s time the regulatory environment catches up. The central bank should lead the new regulatory regime, and facilitate co-operation and information sharing, such as with the China Banking Regulatory Commission. This would ensure better policy co-ordination and more effective supervision.

Reforming the government financial structure remains the best way to minimize risk from local government debt. It is a pity that last year’s budget law amendments did not expressly allow local governments to issue bonds; allowing the independent and legal issue of local government bonds should be the next step forward. To this end, local governments must open their books to public scrutiny, and their balance sheets must meet legal standards. This would allow residents to make an informed decision about whether or not to buy government bonds.

At the end of the day, the government’s role must change. Governments at all levels should stop promoting construction projects, and turn their focus from meeting growth targets to providing public goods and services. This includes upholding rule of law and protecting the environment. Only in this way can a China-style subprime mortgage crisis be averted.

Banking, Debt, Local Government