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A deeper look at China local government debt

Standard & Poor’s says that China's creditworthiness could deteriorate if indebtedness continues to grow rapidly.

China's National Audit Office (NAO) recently released a report revealing a spike in China’s local and regional government debt (LRG). Despite the steep levels of debt outlined in the report, we believe that fiscal support for China's sovereign creditworthiness hasn't materially weakened. However, China's creditworthiness could deteriorate if indebtedness continues to grow rapidly.

What was the scope of the NAO's investigation? How did it differ from the 2011 audit on debt levels at the end of 2010?
In December 2013, the NAO's investigation revealed that the Chinese government amassed total debts of Rmb19.1 trillion (US$3.1 trillion) by the end of 2012. The NAO also reported that government debt further rose to Rmb20.7 trillion by the end of June 2013.

The investigation covers significantly more debt and borrowers than the similar audit conducted for 2010. The earlier investigation only counted debts related to LRGs at the provincial, city (or prefectural), and county level. The 2013 audit was China's first stock-take of general government debt and contingent liabilities stemming from the borrowings of government-related entities. The 2013 report also included sub-county LRG-related debts and the borrowings of the central government, its agencies, and certain related companies.

In addition, the 2013 audit expanded the coverage of contingent liabilities. For instance, in the latest report, the NAO included as contingent liabilities the local government-related entities borrowings for build-transfer projects that were not classified as LRG debt.

Is the large amount of government debt that the NAO reported a near-term threat to the sovereign credit ratings on China?
We believe that the previously undisclosed portion of general government debt is unlikely to sufficiently weaken China's fiscal profile for a rating downgrade, given that we view the central government's debt level as low under our criteria.

By the NAO's definition, government debt amounted to 36.7% of GDP in 2012. Net debt levels are likely to be lower than 30% of GDP after deducting the liquid assets of governments at various levels and the government-related enterprises whose debts are included in the NAO audit. The Chinese government holds sizable fiscal deposits. At the same time, Chinese companies typically hold significant cash on their balance sheets because of the frequent changes in credit policy. The Chinese public sector also faces relatively low funding rates.

These factors suggest that fiscal support for sovereign creditworthiness isn't materially weaker than the reported numbers indicate. Furthermore, the NAO's debt numbers include a sizable amount of debt that is not normally considered general government debt.

However, sovereign creditworthiness could deteriorate if indebtedness in China--including LRG-related borrowing--continues to grow rapidly. Apart from the weaker fiscal attributes, this trend would also weaken financial stability and threaten longer-term economic and fiscal stability.

How big a systemic risk is LRG debt to the Chinese banking system?
We have long viewed local government debt levels as a major risk to the financial soundness of the Chinese banking sector, given the size of the exposure, generally weak stand-alone credit profiles of borrowers, and the persistent ambiguity of government policy in addressing this issue. The banking sector has so far reported very low credit losses from this segment. But that's mainly because of regulatory forbearance in the rollover of loans and the borrowers' massive alternative borrowing in bonds and trust loans, among other channels.

We expect 30% of the banks' exposure to eventually turn sour, if the government doesn't extend any extraordinary financial support to the borrowers. In addition, the insatiable funding needs from local governments and their financing companies have been crowding out many small and mid-size enterprises and households from the credit markets and pushing up funding costs. Such spill-over effects may have a far-reaching and undesired impact on the banks' loan quality, in our view.

Nonetheless, we don't see an imminent risk of a systemic crisis from local government debt. The banking sector has structural strengths that include good operating profitability, solid funding and liquidity profiles, and moderate financial leverage. In our view, the major banks could therefore withstand a severe deterioration in loan quality. We also believe the central government has the capacity and willingness to forestall a banking crisis stemming from the local government debt issues. For example, the government recently addressed the refinancing risks for local government debts by granting such borrowers greater access to the domestic bond market.

Are local government defaults likely to increase sharply in the next few years?
We don't expect LRGs to default on their bonds in the next few years. The central government gave provincial government bonds effective guarantees. Further, LRG sector debt has largely stabilized relative to operating revenue, in our view. In addition, we believe LRGs could have strong enough cash positions to support debts maturing in 2014 if we factor in the fiscal deposits of the central government. However, LRGs' arrears to contractors and, in some cases, overdue bank loans may increase significantly. That would be particularly true when economic conditions are weak.

We also view defaults on the bonds of LRG financing companies to be unlikely in 2014. Amid perceptions of growing financial risks in the country, the central government appears to be wary of destabilizing sentiment through major disruptions, such as a default among these companies. In 2013, the central government instructed provincial governments to be responsible for LRG-related debt in their jurisdictions. This suggests that provincial governments are likely to lend greater support to sub-provincial LRGs and their financing companies in times of financial need.

As market sentiment stabilizes, the central government may not be as concerned about the potential impact of defaults among the financing companies. Attention may then shift toward inculcating financial discipline among LRGs. This may make it more difficult for LRGs to roll over debt, which they have done for the past two years--as suggested by a spike in projected LRG-related debt that will mature in 2014 and 2015. The inability to easily roll over debt will weaken some of the support of LRGs for their financing companies, whose default risk may therefore rise.

Is government debt likely to continue to rise steeply in the next few years?
Another surge in LRG debt is unlikely over the next few years due to the widespread recognition of the risks to financial and fiscal stability from the aggressive growth of LRG debt since 2009. The central government appears to be taking decisive steps to guard against soaring LRG debt, as shown in the more thorough audit of 2013. The government has also stepped up disincentives for reckless LRG borrowing by incorporating debt levels as a performance metric in assessing the effectiveness of the governments.

The measures that the central government has implemented so far have spurred some progress. After China's large stimulus package in response to the 2008 global financial crisis, growth in LRG debt fell back in line with growth in operating revenue more quickly than after the 1997 Asian financial crisis.

While unlikely, another credit-driven government investment boom cannot be ruled out entirely in the next few years. A boom could happen if an economic shock that threatens employment and social stability hits China in the period. We believe that while policymakers are concerned about financial and fiscal risks, they are likely to be even more sensitive to the risks of social instability that could result from an abrupt economic slowdown.

The author of this article, Kim Eng Tan, is Senior Director for Asia-Pacific Sovereign Ratings at Standard & Poor’s.

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