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Chinese local government debt returns to spotlight

Standard & Poor’s analyses the risks posed by China’s local government financing platforms.

Concerns about local government debt in China have intensified yet again. Many have expected nonperforming loans at banks to soar post 2009, when lending growth took off. In late 2009, local government-owned companies known as financing platforms became the centre of attention as a major source of credit risk to banks. Chinese local governments at all levels used local government financing platforms to carry out public projects such as urban infrastructure and utilities. Kim Eng Tan, senior director of sovereign and international public finance ratings, examines the risks associated with these debts.

Why are local government financing platforms singled out as a major source of credit risk for banks?
On a stand-alone basis, the credit quality of local government financing platforms is generally weaker than that of the banking sector’s overall credit portfolio. Some of these companies are little more than vehicles to raise debt for public projects. They rely heavily on government transfers, typically proceeds from public land sales, for debt servicing. And even some that have viable commercial operations (including companies in industries such as water utilities, urban transport and power generation) have weak financial health. A number of such companies that Standard & Poor’s Ratings Services examined in past years were in the low speculative-grade rating categories on a stand-alone basis.

Owner-imposed non-commercial objectives often impair the profitability of local government financing platforms. For instance, local governments encouraged many of their financing platforms that own power companies to increase production to offset reduced generation at central government-owned power stations as coal prices soared this year. They had taken similar steps when coal prices increased in 2008. The local governments expect such steps to stabilise economic activity. But these measures have led to severe losses at local power companies compared with smaller losses and even marginal profits at centrally owned power companies.

Why have local government financing platforms become a concern only in the past few years?
While local government financing platforms have been in existence for several years now, they accounted for only a small portion of commercial banks’ loans until 2009. Since then, the credit risk that these companies pose to the commercial banking system has rapidly increased. This is because commercial bank lending to these local state-owned enterprises (SOEs) surged in 2009 as the central government implemented its economic stimulus package.

These entities had traditionally relied mainly on policy bank credit (especially from the China Development Bank) to carry out public infrastructure projects. Until the recent economic slowdown, the central government’s control over project approval, and from 2007, the credit quotas on commercial banks and restrictions on local government land sales constrained local government financing platforms’ access to commercial credit. From late 2008, however, commercial banks rapidly increased lending to these entities as government controls eased. Since the end of 2009, commercial bank loans have overtaken the policy banks as the main source of credit for these companies.

We believe that the creditworthiness of local government financing platforms has deteriorated significantly since 2008 due to their increased borrowing. Assuming little or no government support for these companies, the risks of lending to them are now higher than before 2009 even as their importance to commercial banks has grown.

Do the recently reported problems at local government financing platforms herald the beginning of a large wave of defaults?
We expect nonperforming loans attributable to local government financing platforms to increase in the next few years. Most loans to these companies are three- to five-year term loans. Some of them could have been structured as long-term project loans where principal repayments begin upon project completion. As more project loans come due in the next few years, some local government financing platforms could face problems repaying their debts without new financing or government support. In a stress scenario, the banking sector’s cumulative nonperforming loans (across all borrowers, not just local government financing platforms) could reach 10% during the next three years if government support to these local SOEs is not forthcoming.

The central government’s tightening of credit policy to counter inflation appears to have brought forward the day of reckoning for some local government financing platforms. On the China Banking Regulatory Commission’s instructions, some banks have stopped financing projects that are in progress when loans are not backed with adequate collateral. As a result, the cash flows of a few highly leveraged firms have come under pressure. A highway company in Yunnan, for instance, has been reported by the local media to have threatened to default on its bank loan because of this.

Banks’ credit losses are likely to mount despite local government support to local government financing platforms. We do not, however, expect the major national commercial banks to record full-year losses. Our expectation reflects Chinese banks’ relatively wide interest spread (mandated by policy to help support financial stability) compared with that of other banking systems in the region and our baseline projections of strong and stable economic expansion. In addition, the central government’s top priority is still to maintain stability. It could, therefore, reverse some of its monetary tightening measures if it believes that local government financing platforms failures could weaken financial stability.

Why would big national banks face less credit risk than smaller banks?
While local government financing platforms are an important source of credit risk, we believe that the major national banks are significantly less exposed to them than smaller banks. Local governments have little influence over the major national banks’ lending decisions. In 2009, some of these banks reinforced their independence by requiring their branches to seek main branch approval for all loans to these entities. In contrast, smaller banks are subject to significant local government influence in the regions where they operate. One indication of this is that the five banks that showed the largest proportional growth in lending to local government financing platforms were regional commercial banks and a policy bank.

The big national banks are also in a position of being able to choose more creditworthy clients. Their dominance in the Chinese banking sector allows them to extend much larger loans at more flexible terms compared with their regional competitors, making them preferred banks for corporate borrowers. Consequently, their credit risks increase by less than regional banks’ as loan growth accelerates.

Much of the bank credit to local government financing platforms is to companies that are more likely to be able to repay the loans. This likely reflects the results of large banks’ risk management. In a report published in 2010, the Chinese Academy of Social Sciences found that financing platform debts are concentrated in the coastal region and in the economically more developed cities. The largest local government financing platforms debts were in Jiangsu, Shanghai, Zhejiang, and Guangdong--among the wealthiest provincial regions of China. Since governments in these regions also enjoy healthier financial positions than elsewhere in the country, these debts are distributed roughly in line with those of the companies that could afford them and where local governments could provide stronger support.

What are the bank and sovereign rating implications if China’s economic performance is substantially weaker than your expectations?
The credit ratings on the sovereign and on the major commercial banks could come under downward pressure if Chinese economic growth in the next few years significantly underperforms our expectations. While we consider the likelihood of this scenario to be modest, it is not insignificant. The Chinese government continues to tackle the pressures of strong domestic liquidity and inflation with mainly administrative tools in an economy that includes many inefficient state-owned companies. The risks of a policy error resulting in economic volatility are not negligible, in our opinion.

In this scenario, a significantly larger proportion of loans disbursed to the financing platforms could turn nonperforming. At the same time, the performance of other loans could also suffer and add to banks’ sub-standard loans. Local governments could see revenue growth slow sharply and land sale receipts could also fall significantly. They could, therefore, be in a weak position to lend financial assistance to local government financing platforms.

If the economic shock is sufficiently severe, banks’ financial position could also be hit by a further surge in lending during a slowdown. While we expect that the government would be wary of imposing more credit risks on the financial sector, banks remain the fastest way of channelling funds into the economy. Consequently, it could initiate a new round of credit-funded stimulus measures to offset the economic weakness. Banks’ balance sheets would deteriorate further in these circumstances and weaken their credit fundamentals. The ultimate cost that we expect the government to pay to restore the banking sector to reasonable health would also weaken China’s sovereign creditworthiness.

What steps is the Chinese central government likely to take to address the problem of local government debt?
The publicity given to the issue within China and the three separate investigations into it suggest that the central government is finally gearing up to address this long-standing problem. However, any near-term solution is likely to be a partial one. The complex task of overhauling intergovernmental finances, central-local politics, governance standards (on the parts of both local governments and local-government SOEs), and government-corporate relations is unlikely to be initiated just before a major leadership change in 2012.

We expect that the government’s near-term approach would balance the need to improve financial stability with concerns over moral hazard. The government is likely to emphasise enhancing banks’ stability by minimising the possible losses associated with local government financing platforms loans, while taking measures to get banks to provide for likely losses and augment their capital cushions. Despite its strong balance sheet, the central government is unlikely to inject resources into either the local governments or banks unless forced to (e.g. if the economy enters a renewed slowdown). Otherwise, local governments may continue to run up financial risks in the expectation that they would be granted assistance when needed.

Consequently, bank regulators are likely to ask local governments to provide more credit enhancements for their local government financing platforms, including capital injections and collateral. Local governments would be allowed to issue bonds in a controlled manner, as was the case in 2009 and 2010. If necessary, the central government could ask existing asset management companies to take impaired assets off smaller banks’ balance sheets. It could also demand that local governments increase fiscal transparency.

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