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China reform bodes well for local government debt

The plan resulting from the third plenum could tackle soaring debt levels at local and regional governments, says Kim Eng Tan, a senior director and analytical manager of Asia-Pacific sovereign ratings at Standard & Poor’s.

China's new leadership appears to be taking decisive steps to tackle soaring debt levels at local and regional governments (LRGs). The recent plenum of the Communist party culminated in a reform blueprint that Standard & Poor's Ratings Services believes could lower the financial, economic, and fiscal risks to sovereign creditworthiness if it's implemented effectively. That's partly because the reforms may significantly reduce the incentives and need for LRGs to aggressively borrow.

The plan aims to achieve strong breakthroughs in key reforms by 2020. But we anticipate much earlier progress in some of these areas. In our view, the central government's emphasis on controlling risks associated with the rapid increase in LRG debt in recent years could help to speed up implementation.

Local government debt has spiraled alarmingly since the onset of the global financial crisis. We estimate that broad LRG debt reached Rmb 14 trillion (about US$2.3 trillion) by the end of 2012. However, the National Audit Office (NAO) may reveal an even higher figure when it announces its most recent findings. In 2009 alone, broad LRG debt increased more than 60%, according to the NAO. Financing arms of local governments raised much of the debt, which included increasingly risky types of borrowings – ie, those with high costs and short maturities.

We believe the risk to the sovereign credit rating on (AA-/Stable) arising from these debt burdens is likely to moderate over the next three to five years as the reform initiatives kick in. However, much hinges on the central government's ability to reduce the dependence of economic growth on LRG investments. Additional factors would include the local authorities' commitment to beefing up their transparency and accountability over debt levels, which includes providing stronger justification for new borrowings.

Greater accountability will reduce borrowing appetites

We expect the heads of LRGs to become more cautious towards borrowing. One reason for that is the central government's plan to partly assess officials' performances on how much debt their authorities have incurred. The current performance appraisal scheme strongly emphasizes economic development, with little regard to how it was financed. This sometimes meant aggressive spending on urban infrastructure and facilities – such as roads, subways and parks – mostly funded through debt. Few officials, if any, were held personally responsible for the heavy debt burdens, which successive leaders then inherited.

The effectiveness of this new measure in combating excess debt levels will depend on how much weight it contributes to overall performance assessments. An earlier attempt to include social welfare and environmental indicators into local officials' appraisals didn't seem to achieve a significant change in behavior. That's partly because of the continued dominance of economic and employment measures in overall assessments.

The focus is now on repaying the principal, not just interest

The proposed introduction of multiple-year budgeting could also help moderate LRG borrowings, in our view. Anecdotal evidence suggests that some local officials care only about interest payments and not about the need to repay the principal at a later date. Many LRGs choose to delay the inevitable by rolling over a large proportion of their debts on maturity. Consequently, some governments have borrowed much more than they can comfortably support.

The blueprint proposals imply that local officials must take into account principal repayments in coming years when they decide to borrow. Under the medium-term budgetary framework, officials will need to prove that debt-financed investments could generate fair economic returns or future government revenue. Such a requirement should discourage aggressive borrowings or borrowings for uneconomic projects.

Transparency should improve debt management

Comprehensive budgeting and fiscal transparency among LRGs would help the central government meet its interconnected targets of guarding against aggressive LRG borrowing and better directing the allocation of funds. The blueprint suggests that the governments should more frequently tap the bond markets to finance urban infrastructure projects. These moves would likely strengthen internal and market discipline over LRG borrowings.

The lack of fiscal transparency has led to unproductive spending or overspending among some LRGs because of weak financial management or corruption. Under the new reforms, governments with weak credit profiles or intending to undertake relatively unproductive projects will likely face higher funding costs and reduced access to borrowing channels than their peers. This should scale back their borrowing capacity.

Public financial accounting will aid investment decisions

The central government's aim for LRGs to report comprehensive financial statements would alleviate a long-standing headache for investors struggling to gauge LRGs' financial health. Weak debt disclosure sometimes stems from concern among local officials that the financial strength of their LRGs could be misread. If these LRGs disclose only their debts, some investors may conclude they are over-indebted.

This could have negative implications for the governments' image and borrowing capacity. Under a comprehensive financial reporting system that consolidates LRGs' various assets – such as net investments in state-owned enterprises – many governments would likely be more comfortable with enhancing their fiscal transparency, in our view.

Rationalised inter-government arrangements

The central government's aim to cut “unfunded mandates” would reduce the LRGs’ funding shortfall and the related excuses for LRGs to borrow heavily, in our view. Under unfunded mandates, the central government asks local authorities to carry out some policy initiatives, but doesn't provide them with sufficient funds to do so. In 2008, for example, LRGs were pushed to provide a large proportion of the funds needed for the RMB4 trillion stimulus package that the central government introduced in response to the global financial crisis. At that time, LRGs grabbed the opportunity to borrow for their own projects, contributing to the hike in LRG debt in 2009.

Success will hinge on market-oriented reforms

Many other measures and initiatives under the blueprint suggest LRG debt could be reined back in the coming years. For example, a new alert system will warn central and respective local governments when LRG indebtedness crosses a certain risk measure.

But over the next three to five years, it's still possible that the central government will allow LRGs to borrow heavily to make large-scale investments. That scenario may materialize if market-oriented reforms proceed too slowly to achieve the central government's GDP growth target through the vibrancy of the private sector and by keeping state-owned enterprises at arm's length from LRGs. Robust growth remains a top priority for China's new leadership at a time when the economy has started to lose steam after a blistering decade.

Overall, the taming of LRG debt will pivot around the success of market-oriented reforms.

The author of this article, Kim Eng Tan, is a senior director and analytical manager of Asia-Pacific sovereign ratings at Standard & Poor’s.

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