China is trying to impose debt limits on local governments as they struggle to meet major repayment deadlines by the end of the year.
In what may be a critical step toward financial order, the State Council, or cabinet, issued new debt rules for local authorities on Oct. 2, seeking to end backdoor lending schemes that threaten to spiral out of control.
Last year, the National Audit Office found that the total of direct local government debts, guarantees and contingent liabilities had reached 17.9 trillion yuan (U.S. $2.9 trillion) by June 30, 2013.
There has been no official estimate since then, but many local entities are believed to have borrowed heavily to finance construction and budget spending as economic expansion has slowed.
Nearly 40 percent of the debt and guarantees will mature by the end of this year, putting repayment pressure on local authorities, The Wall Street Journal said, citing the audit report.
Many have skirted a previous government ban on local bond issuance by establishing arm's-length corporations known as local government financing vehicles (LGFVs) to raise funds, often from the shadow-banking sector.
The number of unregulated LGFVs has snowballed with estimates ranging from 7,000 to over 10,000. As of mid-2013, the audit found local governments had borrowed 4 trillion yuan (U.S. $651 billion) through their LGFVs, the official Xinhua news agency said.
The State Council's statement characterized the risks from government debts as "generally controllable," stopping short of a full-throated assurance.
Independent assessments of the debt situation have ranged from "troubling" to "alarming."
With the explosion of local debt, central government regulators seem to have concluded that the local bond ban has done more harm than good.
Earlier this year, the Ministry of Finance allowed 10 provincial and local governments to sell bonds directly as a pilot program and prelude to repealing the ban under budget law amendments approved on Aug. 31.
'Tough love' approach
The State Council's new rules are a further step in the process, but they signal a "tough love" approach in an attempt to get local debt under control.
In its statement, Beijing barred future LGFV borrowing and warned there would be no central government bailouts, although it suggested that the old form of financing might be allowed for a time to complete current projects.
"The time when everybody bought LGFV bonds for high returns without considering credit risks are over. For any sales in the future, investors will apply a different set of criteria," said Chen Jianheng, a China International Capital Corp. analyst in Beijing, cited by Bloomberg News.
Under the new rules, the State Council said it would set quotas for borrowing by 32 provincial-level governments, requiring approval by the parliamentary National People's Congress (NPC).
"Prefecture-level and county-level governments can commission the provincial governments to borrow, if necessary," Xinhua reported.
Last week, Bloomberg reported separately that the National Development and Reform Commission (NDRC), the government planning agency, would not approve bond issuance by "units in regions whose outstanding LGFV debt exceeds 8 percent of annual economic output."
Ryan Rutkowski, a research analyst on China at the Peterson Institute for International Economics in Washington, said the arrangement suggests that provinces will be authorized to sell bonds on behalf of municipal and other governments to cover their financing needs.
The alternative would be to allow thousands of independent bond issuing authorities, which would be difficult to manage or rate for risks.
But the State Council statement leaves many questions unanswered, suggesting the clean-up of the local debt mess could be complex.
So far, the central government has not said when the new system will go into effect or how large the debt quotas will be.
Beijing's no-bailout pledge could also throw the debt market into disarray because many shadow-banking loans were made on the assumption that the government would ultimately step in to avert an LGFV default.
It is unclear whether responsibility for bailouts will simply be passed on to the provinces or whether they, too, will be prohibited from preventing defaults.
Local governments have been advised to cut projects, reduce spending and sell assets if they face repayment pressure, Bloomberg said.
The new system appears to rely on the ability of each province to assess the financing needs and capital project plans of hundreds of subordinate governments, so it can negotiate debt quotas.
The capabilities to manage such a process may not yet exist.
"That's a potential problem with this system," said Rutkowski.
In an analysis on Oct. 11, Xinhua stressed that debt management would become "a major factor" in evaluating local government performance, or in other words, the promotion prospects of local officials.
"Local governments will be required to monitor new debt, debt ratios, liability ratios and overdue debt," it said.
In the past, local governments were able to dodge Beijing's financing restrictions by using LGFVs. Under the new rules, they may face new restrictions but some of their financing needs may be unchanged.
"They probably would still have the incentive to turn to alternate channels," Rutkowski said.
An excerpt from the State Council's statement may point to a more difficult problem for reforming local government debt finance.
"Money raised through municipal bonds may only be used to fund public services and pay existing debt, but not government operations. Debts arising from bond issuance must be included in the local government budget," Xinhua quoted the document as saying.
The terms suggest that central government authorities are trying to establish the practice of using long-term bond financing to fund only long-term capital projects like highways and bridges, rather than short-term operating expenses.
At the local level in China, governments are likely to be borrowing for all purposes, finding financing wherever they can to cover budget obligations such as pension and healthcare liabilities.
The scope of such problems is yet to be defined, but municipal governments borrowed heavily to finance projects supported by China's 4-trillion yuan (U.S. $651-billion) stimulus program in 2009 and now face a revenue squeeze because the housing sector and land sales have slumped.
"Their revenue and expenditure items aren't really aligning, and a lot of local governments have been borrowing a lot for infrastructure, but a lot of that was also going to things that should have been budgetary funded," Rutkowski said.
One major change cited by Xinhua is push by the central government to get localities out of the development business, reducing their liabilities.
"Local governments will no longer be involved in commercial projects—most notably commercial real estate—and existing projects will be sold off with the debt converted into corporate debt," Xinhua said.
It remains to be seen how quickly or completely local governments will untangle themselves from various ventures.
The task of reforming China's local debt financing may be formidable, but it is not taking place in isolation, since the central government is slowly introducing property taxes as a new source of revenue.
At the same time, Beijing has pledged to steer clear of another massive stimulus program and has signaled that it will tolerate slower economic growth.