China is granting local governments greater autonomy by allowing them to swap up to $160 billion in outstanding loans for lower-interest, slow-maturing government bonds.
The program will provide a crucial buffer against local government debt crises in 2015 and beyond.
The initiative may reduce economic stress in the near term but fails to address the largest contributor to China’s crisis: corporate debt.
A significant evolution is underway in how China manages its rising levels of local government debt. On May 14, the Chinese government announced that by September, it would complete the first phase of a new plan that allows local governments to swap outstanding loans for low-yield, slow-maturing local bonds. Under the plan, localities would have a steady and stable repayment path for the more than $3 trillion in local government debt accumulated during the past six years of rapid, post-financial crisis spending. It will also have the added benefit, Beijing hopes, of lowering local government debt-servicing costs, thus freeing up tens of billions of yuan in liquidity in the short run. For now, local governments will be able to exchange only a small portion of outstanding loans (about $160 billion) for local bonds, but if successful, the program will likely expand substantially in the years to come.
The debt swap plan comes at a crucial time for China’s economy. In recent years, the country’s slowing growth rate has steadily eroded the local governments’ abilities to service outstanding debts, much less sustain the level of investment needed to keep the economy humming. By allowing localities to swap 50 percent or more of maturing outstanding debts this year, the new plan will provide a much-needed buffer against local government debt crises in the near term — and beyond, if the program expands as Beijing intends. Although the plan is a welcome departure from the Chinese government’s previous ad hoc methods of managing local government debt maturation, it fails to address the most pressing problem: outstanding corporate debt.
At the end of 2014, Chinese businesses owed more than $16 trillion, accounting for 61 percent of China’s total outstanding debt and equal to nearly 180 percent of the country’s gross domestic product. That compares with $3.38 trillion owed by local government financing vehicles (LGFVs), the means through which local governments raise virtually all of their cash.
The idea of allowing local governments to issue their own bonds is not new to China. Until recently, central government leaders consistently rejected the idea of granting localities greater autonomy. For most of the 2000s, the central government opted to keep virtually all financing under the control of a handful of major state-owned commercial banks and their local affiliates. When the global financial crisis forced Beijing to rapidly ramp up spending and investment after 2008, the central government refused to allow localities to issue their own debt and created a legal framework for LGFVs to operate and draw capital from state-owned banks, ultimately falling under the central government’s control.
In 2008, when the country was facing a potentially destabilizing economic crisis, the decision to bind local government finances to the state-owned banking system via LGFVs was reasonable. Beijing was worried that economic imbalances between coastal and inland provinces could fuel political instability and fragmentation. From the vantage of 2008, LGFVs seemed to provide the central government a means to dramatically expand local governments’ spending capacity — local governments cover 85-90 percent of all government expenditures, including for infrastructure development and social services — while retaining a degree of control over how and when that money was spent.
This state-controlled strategy, however, began to break down after 2010, when Beijing attempted to ease lending to LGFVs. The decrease in loans from state-owned banks resulted in the creation of “shadow lending” tools thanks to a persistent demand from businesses and LGFVs. By 2013-2014, shadow lending — some of it in the form of off-balance sheet lending by state-owned banks themselves — accounted for an uncomfortably large share of China’s total outstanding debt and new credit creation. The new economic reality forced the central government to clamp down and correct the growing reliance on shadow lending, a process that partly explains the timing of the start of China’s real estate and broader economic slowdowns in early 2014.
Even in the face of declining economic growth, Beijing is loath to reverse the trend. For one, the slowdown — and the reform and restructuring it implies — is a crucial step on the path to rebalancing China toward an economic growth model grounded in private consumption, high value-added manufacturing and services. More to the point, the sheer scale of outstanding credit and industrial overcapacity, combined with the rapid deterioration in credit’s return on investment, means that reversing the current decline would require unsustainable levels of new spending. With little option but to allow the economy to falter, the Chinese government has instead turned its focus to managing the slowdown. Enabling local governments to repay their old debts while maintaining a baseline of spending is central to this effort.
Enter the new debt swap program. By exchanging higher-interest, fast-maturing loans for low-interest, slow-maturing bonds, Beijing aims to prolong but soften the pain of repaying those debts and free more cash for local governments to spend in the near term. In short, Beijing hopes that this new process of gradually granting autonomy to the local governments will cut down on a number of entrenched problems and force the localities to think more carefully about how they spend their money going forward. The simple fact that Beijing is proceeding with the creation of local bond markets suggests that the central government understands it no longer has any choice but to allow greater local fiscal autonomy. It is no coincidence that this process coincides with a sharp consolidation of the central leadership’s powers in other spheres of Chinese political and economic life. China’s leaders are aware that the country is moving toward a consumption-driven economic growth model. To mitigate future challenges posed by this transition, the government is moving rapidly to ensure maximum control over central party, government and security apparatuses.
The Elephant in the Room
The debt swap program has gotten off to a somewhat choppy start. In late April, Jiangsu province delayed an 81 billion-yuan ($13 billion) bond issuance, likely because of a lack of interest among commercial banks in purchasing the low-yield, slow-maturing securities. In response, the central government allowed commercial banks to use bonds bought from local governments as collateral for low-cost loans from the central bank, thus offsetting the impact of swapping higher-interest loans for low-interest local bonds on commercial banks’ balance sheets. As the program expands, bonds will become an increasingly viable alternative financing route, and the room for error will grow. In the near term, local government debt defaults remain a real risk, especially in areas where growth is slowing the most and LGFV reliance on shadow lending is highest. But the debt swap program provides a viable and likely stable blueprint for metabolizing the debts accumulated by local governments over the past decade or so.
However, this plan does not address the larger and more pressing issue of corporate debt, and no comparable plan for managing corporate debt exists. The corporate debt is more than four times the size of local government debt and is also that which sustains the vast majority of employment in China. For the time being, Beijing seems to be counting on the ability of service industries and agriculture, with financial help from the banking sector, to absorb the employment leftover from industrial consolidation — both government-driven and economically induced — and corporate closures. As the slowdown continues, the rate and scale of corporate debt crises is likely to grow substantially. Unemployment among manual laborers and manufacturing is also expected to grow. Although a plan to improve local government solvency and boost local governments’ liquidity could provide a buffer against social and political instability in the near term, the corporate debt must be addressed and eased to ensure China’s long-term prosperity.