Frets Over Debts

China's massive loans raise repayment fears.
By Michael Lelyveld
Yuan-Dollar-305.jpg A Chinese bank worker arranges U.S. currency next to stacks of 100-yuan notes, March 20, 2010.

An audit of China's local government debt has sparked concerns that the country's construction-led growth may start to sag under the weight of bad loans.

On June 27, the head of the State Council's National Audit Office said local government debts reached 10.72 trillion yuan (U.S. $1.66 trillion) at the end of last year, the official Xinhua news agency reported.

Excerpts cited from the report to the National People's Congress (NPC) were apparently meant to provide reassurance.

The debts were "not as serious as some people thought," said Li Yang, vice president of the Chinese Academy of Social Science, according to Xinhua.

But other reports pointed to troubling details.

"The management of some local government financing platforms is irregular, and their profitability and ability to pay their debts is quite weak," said Auditor-General Liu Jiayi, as quoted by The New York Times.

While local authorities have used various investment vehicles to borrow from state banks, the governments are obliged to repay over 62 percent of the loans, MarketWatch said.

But how much can be repaid by the governments and financing entities may be anyone's guess.

Stimulus program

University of Pittsburgh economist Thomas Rawski said the problem may be traced to the central government's 4-trillion-yuan (U.S. $617-billion) stimulus program to stave off the global downturn in 2008.

As part of the plan, Beijing encouraged banks and local authorities to open their coffers, adding more liquidity to the stimulus, and more debt.

"The central government provided large sums of money to local governments for undertaking infrastructure projects, but the funds that the center provided were only a portion of the project requirements," Rawski said.

Because local bodies were not allowed to issue bonds, they created investment companies that borrowed, often with government guarantees.

The rush to invest worked in the short-term to pull China out of recession. But it also meant there was little checking on the financial strength of the borrowers, said Rawski.

"I think it's clear that the cost of this recovery is a lot of bad debt," he said. "We know the numbers are going to be large, and my guess is that this will come as no surprise to the Chinese policy makers."

Excessive debt levels

Xinhua hailed the report to the NPC's Standing Committee as a step forward for transparency, marking the first such disclosure of local debt size.

But the Times suggested that the problem could be even larger, citing a People's Bank of China report that local government debt may total 30 percent of GDP, or U.S. $2.2 trillion.

The question is whether the debt levels are excessive for a country that holds U.S. $3 trillion in hard currency reserves.

"It's excessive in the sense that the security underlying the lending is quite weak," said Gary Hufbauer, senior fellow at the Peterson Institute for International Economics in Washington.

"Much of it is based on the promise of paying back by developers and companies which don't have assets that could be seized if there's a downturn," he said, comparing China's risk to the U.S. subprime mortgage crisis.

If China maintains high economic growth rates and property values, the weakness of the loans may not be a problem, Hufbauer said. But he added that if a downturn comes, "a lot of these loans won't be paid."

Economic risk

Some official press reports have highlighted the risk to China's economy.

"Concerns are rising that the problem of local government debt could destabilize the financial system of the country if it is not managed properly," the official English-language China Daily said on June 28.

The local liabilities greatly exceed China's official national debt of 6.75 trillion yuan at the end of last year.

On June 1, Reuters reported that central banking authorities planned to write off 2-3 trillion yuan of the local government debt, but officials denied the report, according to the Communist Party-linked paper Global Times.

Derek Scissors, Asian studies research fellow at the Heritage Foundation in Washington, said the debt problem is serious but unlikely to be catastrophic for the Chinese economy.

"The government owns the financial system. It's not going to let it collapse. They have a number of options to prevent any sort of collapse," Scissors said.

But the options and the outlook are not good.

Unlike the bad loan crisis at China's national banks in the late 1990s, the problem may not be easily solved by recapitalizing with hard currency, since local banks lack foreign currency operations. Massive infusions of yuan would mean printing more money and spurring inflation, Scissors said.

Fighting inflation

China is already fighting the inflation problem with annual rates exceeding the government's 4-percent target month after month.

In a commentary for the Financial Times on June 23, Premier Wen Jiabao argued that China's anti-inflation measures "have worked."

"We are confident price rises will be firmly under control this year," Wen said.

But days later, Wen backed away from the government goal, telling Hong Kong television that inflation would be kept "under 5 percent" this year, Reuters said.

Inflation touched 5.5 percent in May and is expected to run higher in June following a Xinhua report that pork prices have jumped over 40 percent since last year.

The debt problem could squeeze the economy between bad loans and the battle to keep inflation in check.

"The outcome here is a drag on the Chinese economy. It slows them down. It reduces the return on their capital, which is a problem they have anyway," said Scissors.

Bad loans may also mean that many projects launched under the stimulus program may remain unfinished.

"There are all these great projects that average 25-percent returns, and then there all the projects we don't hear about that collapse because they were politically motivated," Scissors said.


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