Having spent too much filling in holes in their roads, China’s local governments are now going to get some much-needed help filling holes in their budgets. The FT reports that banks have been instructed to roll over much of the RMB10.7trn (US$1.7trn) in loans they have made to provincial and municipal borrowers, extending the point when some must be repaid by as much as four years.
Such a move has long looked inevitable if local governments are to avoid a wave of defaults as a direct consequence of China’s stimulus efforts during the 2008-2009 global financial crisis and the unusual form they took. Rather than embarking on a central government-led package, the approach followed by most economies, Beijing encouraged local governments to boost their spending on infrastructure and other investment.
Since local governments were generally not allowed to borrow directly, they formed special purpose vehicles to invest in specific investment projects. These apparently commercial entities – known as local government financing vehicles (LGFVs) - then borrowed from state-owned banks, which had in turn been instructed to ramp up lending.
As you’d expect, this debt-fueled surge in spending was accompanied by generous amounts of incompetence, corruption and malinvestment. But the off-balance sheet structure of the LGFVs meant that the scale of the problem remained hidden for many months after the crisis and even today the situation remains relatively unclear.
Estimates many loans will eventually go bad are best treated with caution given the debate quality of information, but around RMB3trn is the current consensus. Since nobody wants to contend with a problem of this size immediately, rolling the loans over is clearly the preferred short-term solution.
The hope is that, once completed, many of the projects will be able to earn some kind of return and service their borrowings over time. In theory, the rollover scheme is a mechanism designed to separate the wheat from the chaff, according to the FT.
Day of fiscal reckoning
However, given the way this affair has played out so far, it seems plausible that many bad loans will be among those evergreen-ed and problems remain concealed for years yet.
In any case, whether they are recognized now or in the future, somebody will have to foot the bill for those projects that turn out to be largely worthless. That somebody is likely to be the banks in the first instance: The fact that Central Huijin – the government holding company that controls the state’s stakes in the biggcest banks – has recently instructed them to trim dividends to shore up capital may suggest some rising concern about having to absorb loesses on bad loans here and in the property sector.
But while dealing with these bad loans may require some careful juggling and could constrain bank profit growth over the next few years, the crucial step is not the decision to clean up the current mess but to prevent it from happening again.
The central government is attempting to fix the flaws in its fiscal system that allowed the problem to develop. A small number of local governments have been given permission to raise money by issuing bonds and this scheme is likely to be rolled out more widely. In theory, scrutiny by a transparent bond market should impose more restraint on local government borrowing and spending than the opaque system of bank loans and LGFVs, preventing this kind of problem arising again.
Further reading:
CHINA: Degrees of freedom - Emerging Markets