China has rolled out its most wide ranging fiscal reforms since 1994. Why does the central government want to rein in local and regional government (LRG) debt?
The rapid growth in LRG debt over the past five years has increased the risk to China's fiscal health and to the stability of the financial sector. The reforms aim to put public finances on a more stable footing, partly by slowing down the growth of LRG debt.
LRG debt stood at Rmb11 trillion (US$1.8 trillion) at the end of June 2013, according to the National Audit Office. That implies an average annual growth rate of well above 20% since 2008, compared with the annual growth in nominal GDP of about 13.5%. The debt level is equivalent to 20% of GDP.
The slowdown of China’s property market highlights the importance of curbing LRG debt growth. Property-related revenue — a key source of funds for LRGs’ debt payment — is likely to be sluggish over the next two to three years, as we expect slower growth in housing sales in China. Some LRGs have already seen contraction in those revenues.
What are the key reform features?
Comprehensiveness and transparency. The central government plans to revamp most components of public finance, covering public accounting, budget planning and execution, debt management, taxation and intergovernmental relations. It places strong emphasis on greater fiscal transparency, aiming to reduce off-budget activities and increase public disclosure.
For example, the central government requires LRGs to compile balance sheets based on accrual accounting, to produce three-year rolling budgets, starting from 2015-2017, and to implement risk-based debt controls and reduce borrowing through financing companies. LRGs have made some progress in the implementation of these measures.
Can the reforms check the growth of LRG debt?
We believe so. These important policy changes should press LRGs to rationalize their spending and reduce their capacity to aggressively borrow.
China also plans to draw a clearer line between LRGs and entities related to them. Off-budget LRG borrowing will be gradually phased out. Government-related entities, especially financing companies, have been the main vehicles through which local governments have borrowed off-budget for public projects, such as roads and subways.
Many financing companies also undertake commercial projects (such as property development). It may be difficult to clearly separate their borrowings for commercial activities and those incurred for policy purposes. This situation compromises fiscal discipline, and has contributed to the rapid growth of LRG debt and contingent liabilities.
How sharply will the growth in LRG debt slow over the next three years?
We expect growth to slow markedly from the annual average of more than 20% during 2008-2013. However, debt growth is still likely to be close to the pace of nominal GDP growth over the next three years (ie, about 10%).
The continued growth of LRG debt reflects the central government's need to further economic development even as it tries to impose greater fiscal discipline. Many new infrastructure projects required to sustain strong economic growth will still be public projects and financed with LRG debt.
If the recent reforms aim to stop LRGs from borrowing through government-related entities, why are more LRG-owned enterprises issuing or intending to issue international bonds?
We don't believe that this trend indicates any easing of the financial constraints on LRGs. Most of the LRG-owned enterprises that are issuing international bonds are commercial businesses, such as Shanghai Bright Food (Group) Co Ltd and Shandong Yanzhou Coal Mining Co Ltd. We believe the central government allows issuances from commercial businesses partly because it imposes greater transparency and market discipline on the issuers.
The issuers are tapping the offshore bond markets mainly for overseas acquisitions. The enterprises are likely to prefer offshore issuances because of the lower funding costs. Local government-related entities undertaking public projects are starting to tap the offshore bond market as well, such as Nevertheless, overseas borrowing of these state-owned enterprises (SOEs) is a minor source of their funding. Overall restrictions on LRG-related credit growth remains tight.
Should investors be concerned about the creditworthiness of individual LRGs?
Some investors believe that Chinese LRGs differ little in credit quality because the central government is likely to support the bonds. Even if these assumptions are true today, future developments could change the situation. The central government is increasingly wary of moral hazard issues. Consequently, it's seeking to dispel expectations of sovereign support for debts related to LRGs and public agencies. Achieving this objective may mean LRGs and other public entities could default on debt payments.
The creditworthiness of individual LRGs has important implications for government-related entities. The central government is unlikely to extend its support to individual entities that local governments own unless systemic risks emerge. Consequently, the credit risks of these entities could heavily depend on the creditworthiness of their LRG owners. The National Audit Office showed high variance in overdue LRG-related debt across provinces by the end of 2012. The auditors also indicated that it is more challenging for some LRGs to service their debt than peers.
How will the reforms affect the real or perceived creditworthiness of LRGs?
The overall credit profiles of LRGs may strengthen if fiscal reforms improve the operating environments or fiscal management of individual LRGs. For instance, the tax reform and refinement of intergovernmental relations may make LRGs' revenue better match their expenditure as the reforms deepen.
Greater disclosure may reveal that some LRGs have more liquid assets than previously known to external parties. This could improve the perceived creditworthiness of LRGs. The central government has focused on measuring LRG debt over the past few years. The prospective disclosure of LRGs' balance sheets will provide a more comprehensive picture of their financial profiles.
The increased fiscal transparency under the reform will also enable us to narrow down our view on the creditworthiness of more LRGs. This will, in turn, enable us to assess their potential support to local government-related entities. For instance, the publication of the audit reports on LRG debt earlier this year allowed us to assess the creditworthiness of several more provincial governments. However, timely information about fiscal deposits is still lacking for about a third of the provinces, which makes rating these governments challenging. Weak disclosure about debt and fiscal deposits at sub-provincial LRGs are also key constraints on credit assessments.
If there is a property market correction, could reforms help prevent Chinese LRGs from defaulting?
We don’t think public finance reform could deliver a quick cure to the LRG sector’s high revenue exposure to China’s property sector. However, by tapping fiscal reserves and assets for sales, we believe LRGs are likely to tide over a relatively weak property market over the next two to three years.
Nevertheless, some sub-provincial government financing companies may fail, as a property market correction could weaken their revenue and the capacity of their LRG owners to support them. Sub-provincial governments tend to have greater revenue exposure to the property sector than provincial governments, while the former have less assets to sell than the latter (see Chart One). In contrast, many SOEs controlled by provincial governments are listed companies, making it easier for those governments to sell some stake in SOEs to supplement liquidity and support their financing companies if necessary.
The author of this article is Liang Zhong, director of sovereign and international public finance at Standard & Poor’s Ratings Services.