China's Local Bond Binge Sparks Debt Concerns

An analysis by Michael Lelyveld
china-qingdao-city-view-sept24-2019.jpg A general view of the modern urban area of Qingdao in eastern China's Shandong province, which in early 2019 implemented an comprehensive urban development plan, Sept. 24, 2019.
Associated Press

As China's government seeks to revive the economy, it has so far steered clear of excessive infrastructure spending, hoping to avoid the effects of building binges in the past.

Years of debt growth and environmental damage followed the government's massive 4-trillion yuan (U.S. $566-billion) spending plan in November 2008 aimed at overcoming the impact of the global financial crisis.

The debt-backed spending spree on housing, highways, and other projects succeeded in sustaining economic growth through the crisis period. But many investments were unneeded and unproductive, resulting in a decade of higher energy consumption, pollution, and waste.

This year, the government has responded to the economic challenge of the COVID-19 crisis with a different set of tools. The focus so far has been on fiscal stimulus with a planned increase in the budget deficit from 2.8 percent to
3.6 percent.

Tax cuts, targeted interest rate cuts, and increased bank lending have been supplemented by authorization for issuance of 3.75 trillion yuan (U.S. $530 billion) of local government bonds.

Last month, the Ministry of Finance (MOF) brought forward the quota for 1 trillion yuan in special purpose local government bonds for infrastructure due to the fast pace of borrowing. The government has also announced it will issue 1 trillion yuan of special treasury bonds this year.

Special bonds are used to raise cash for a specific policy or problem, Bloomberg News reported. They provide funding outside of the official budget and are not included in deficit calculations, it said.

Limited effect on liquidity

But the bond plans have come with their own set of complications.

On Wednesday, state media hastened to assure the market that the first tranches of offerings would have a limited effect on liquidity as investors chased higher yields and bond prices plunged.

Analysts expect the People's Bank of China (PBOC) to respond by injecting more cash into the financial system, Bloomberg said.

Public expenditures by central and local governments to contain the epidemic and stabilize the economy are expected to reach 24.79 trillion yuan (U.S. $3.5 trillion) this year, the MOF said, according to the official English-language China Daily.

This month, the World Bank's Global Economic Prospects report estimated that China's monetary and fiscal responses to the economic effects of COVID-19 so far have amounted to 2.8 percent of gross domestic product, while authorization for additional special central and local government bonds equaled 2.6 percent of GDP.

The country's total debt-to-GDP ratio rose by about 17 percentage points in the first quarter of the year, the report said.

China's central government is eager to draw distinctions between its financial strategies for overcoming the current crisis and the spending splurge of 2009 because regional and local governments are still struggling to pay their old

"We've been watching some regions traditionally considered weak in repayment ability being able to issue new bonds recently," said Ivan Chung, an analyst at Moody's Investors Service in Hong Kong, as cited by The Wall Street Journal.

Last month, the cabinet-level State Council said that government departments and large state-owned enterprises (SOEs) had cleared over 70 percent of their outstanding payments by the end of 2019, the South China Morning Post (SCMP) reported.

Regional governments had paid over half of their targeted overdue payments, the State Council said, without specifying the amount.

One distinction of the special purpose bonds is that the interest is expected to be paid from the income of a specific project rather than from fiscal revenues, the SCMP said.

A worker examines equipment at the Guangdong Ruigu Optical Network Communications Co. Ltd., an optical component and transceiver manufacturer in Dongguan, southeast China's Guangdong province, May 7, 2019.
A worker examines equipment at the Guangdong Ruigu Optical Network Communications Co. Ltd., an optical component and transceiver manufacturer in Dongguan, southeast China's Guangdong province, May 7, 2019.
Credit: AFP
‘New infrastructure’ projects

The central government is also promoting the use of local government bonds for "new infrastructure," such as 5G telecom networks, artificial intelligence (AI) applications and new energy vehicle (NEV) charging stations, rather than
traditional energy-intensive construction of roads and bridges.

It remains to be seen whether the local new infrastructure projects mark the start of a technological leap that will generate sufficient returns, or whether they are just a bunch of new-age buzzwords that local governments can use to sell bonds.

The major advantage of the local bonds is that they offer greater transparency than the alternative of "local government financing vehicles" (LGFVs), analysts say. Central government regulators have been trying to shut down "shadow banking" and the LGFV channel of off-book bank lending for years.

"You can see exactly how much new funding local governments are taking on," Jack Yuan, a Moody's assistant vice president told the SCMP.

But local governments have been quick to jump on the new infrastructure bandwagon with all the alacrity that followed the big-bang lending program of 2008-2009.

This month, the city of Guangzhou, the capital of coastal Guangdong province, announced plans for nearly 500 billion yuan (U.S. $70.7 billion) of projects for this year in fields including 5G, AI, and big data centers, the official Xinhua
news agency reported.

In May, agreements for 73 major projects valued at 180 billion yuan (U.S. $25.4 billion) were signed in Guangzhou, Xinhua said.

Shanghai plans to invest 270 billion yuan (U.S. $38.1 billion) in its first series of 48 new projects in the next three years, focusing on "new generation networks, innovative infrastructure, AI platforms and intelligent terminals," Xinhua reported.

Further plans call for 100,000 smart charging piles for NEVs, and unmanned factories, production lines and workshops.

Not to be outdone, Guangdong province announced 1,230 "major projects" for this year with investments totaling 5.9 trillion yuan (U.S. $835 billion) in 5G, inter-city transit and other fields.

The Guangdong spending plans alone exceed the central government's quota for local government bonds by over 57 percent. They are also equal to 70 percent of all the central and local government bonds expected to be issued this year,
based on MOF figures.

‘Probably fake’

As of early May, China's provinces had already made multi-year plans for investing over 40 trillion yuan (U.S. $5.6 trillion) in new and traditional infrastructure, said a commentary by the China Energy Program of the Oxford Institute for Energy Studies, citing a report by China's

Fortunately for China's finances, huge numbers like those in Guangdong's plans are unlikely to materialize.

"The most reassuring aspect of local spending plans is they are probably fake," said Derek Scissors, an Asia economist and resident scholar at the American Enterprise Institute in Washington.

"For obvious reasons, both central and local governments want to say more spending is on the way and will solve everything," Scissors said.

The central government's shift in focus to high-tech project funding may be a sign of bold thinking to redirect or redefine stimulus spending, but the result may be nothing more than old wine in new bottles.

"Technological rather than traditional infrastructure is a fun twist but the same problem remains. Worthwhile projects don't materialize out of thin air when you announce new spending plans," Scissors said.

The surge in local government spending plans contrasts with relative restraint in new yuan bank lending.

New bank loans of 1.48 trillion yuan (U.S. $208.9 billion) in May fell more than expected from a month earlier, down 13 percent from 1.70 trillion yuan in April, Reuters reported, although lending rose 25 percent from 1.18 trillion yuan a year before.

Scissors said the May jump in local bond sales is a concern, but the pace is likely to settle down as the year progresses.

"If spent, money would be wasted," he said.

"But local borrowing is likely to slow in the second half, before it starts to resemble the 2009 lending fiasco. Relatively calm bank lending this year is the tip-off for that," he said.

On Thursday, the PBOC responded to the calls for liquidity with a statement promising to keep it "at a reasonable and adequate level in the second half of the year," Xinhua reported.

New loans this year are expected to reach nearly 20 trillion yuan (U.S. $2.82 trillion), up 19 percent from 2019. Total social financing, a broad measure of credit and liquidity, is expected to exceed 30 trillion yuan (U.S. $4.23 trillion), rising 17.2 percent, PBOC Governor Yi Gang said.


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