Possible Consequence of the Development of Local Governments’ Debts
The local debt crisis in China has increasingly become a hot topic, mainly resulting from the “monetary tightening game” between central bank and local governments.
Distinguished from most central banks around the world, the People’s Bank of China (also known as central bank) prefers quantitative instruments when implementing monetary policies instead of price-based instruments. Why? One of the major hidden constraints, which can also be called an important driver, is to control local debt costs, as using price-based instruments can increase local debt costs. In other words, controlling local debt cost is a significant weight of central bank’s overall policy weighing.
When the central bank needs to implement quantitative deflation policy, the advantage of high priority of local government debt is shown (the bank system will ensure creditable local governments have priority to take loans at the cost of increased loan costs of small and medium-sized enterprises). Usually this priority provides local governments with enough protection. But when inflation is severe, the degree of central bank’s quantitative tightening has to enlarge. When the credit market is about lack of liquidity, the cost of local debt will suddenly skyrocket and the local government debts crisis will become extremely severe overnight as if falling off a cliff. Medias call this phenomenon as debt black holes. From a penetrating perspective, these black holes mainly consist of so-called contingent liabilities—local governments often openly or secretly guarantee or pay bills for some enterprises and projects. When the degree of tightening is limited, these possible debts are underwater and not observable; when the degree of tightening is strengthened, relevant enterprises and projects have difficulty in financing in succession and therefore these government-relevant contingent liabilities become dangerous submerged reefs or even bare rocks.
It’s alarming that while external economy including America and Europe has entered the cycle of deleveraging and repairing balance sheet, correspondently there is high possibility that China will enter a stage of high inflation with restricted conditions that exchange policy has no space to operate in, which means that the central bank will have to implement high tightening quantitative monetary policy that will make a large amount of local governments’ contingent liabilities emerge from the water. That is to say, the debt problem of local governments will be consistent.
Another factor that may cause local debt crisis is land policy in China. If the current policy of strictly monitoring lands is sustained, local governments’ ability to repair balance sheet will be seriously restricted and meanwhile this influence the asset quality of main commercial banks. In some extreme situations, the achievements that have been acquired through the ten-year reform of commercial banks will be endangered or even be devastated in a day. From this perspective, loosening land policy and real estate policy will be carried out sooner or later. In some developed areas, local financial revenue can be increased by tax property. But it should be clearly realized that simply depending on land is just expedient and not sustainable, because the impetus that real estate can generate has come to its final stage and can reverse, becoming the future killer of balance sheet. Reutilizing the land lever is just to win time and space for the fundamental resolution. It’s worrying that decision makers and performers haven’t reached a consensus on this point.
Let’s look at the big picture.
The economy of China is facing another shunt. The features of this shunt are manifested in the following aspects: increase power transforms from external demands to domestic demands; distribution transforms from in favor of capital department to resident department; the deposit and loan interest rate is in a increasing cycle; inflation rate enters the rising channel and severe inflation crisis may erupt.
What do these four features implicate? They implicate government assets devaluation and increase in debt burden; they implicate that invisible subsidies which are contained secretly in local debts and are from resident department disappear; they implicate that the normal debt maturity mismatch risk will enlarge rapidly; they implicate the weakness or even deprivation of local governments’ traditional financing ability; they implicate that local governments need to open up new financial resources and turn to new financial instruments.
Although at present local governments’ debts are comparatively heavy and the solvency seems to be a problem, those debts still cannot be called bad debts, because the current debt dilemma of local governments is only maturity mismatch instead of insolvency or Ponzi scheme.
In fact local governments’ assets greatly outnumber debts. In order to repair balance sheet, they will probably sell lands, licenses and access rights. As long as the market of land hasn’t faded, local governments won’t be a problem. But from the perspective of ten-year and twenty-year cycles, mortgaged lands will be in the devaluation in the future. If banks are full of these mortgages, we will be on Japan’s route, getting involved in balance sheet fading.
By issuing bonds, local governments can find a new finance channel breaking away from banks. In this process, local governments’ financing channels will be divided: high quality assets entering financing market while low quality assets entering into balance sheets of banks.
This means that a great move needs to be implemented in the Chinese financial market. The great move, that is, the government largely increases the proportion of directly financing as a part of the entire liabilities and also largely decreases that of bank loans will be a great event influencing the Chinese financial market for many years. Therefore, the severe restrictions of local government bonds and city investment bonds need to be loosened. Potentially such bonds will even possibly become the main part in the bond market.
Two more significant meanings are embodied in this great move. One is that the basic completion of the move will liberate the central bank, effectively pushing the central bank to transform from the quantitative control to the price-based control. The second is that the realization of this move will expose governments’ behavior to the assessment by public market investors instead of only by banks in the case of indirect financing, which as a constraint will largely improve local governments’ governance level and fundamentally shackle their borrowing impulses in a legal way. In a sense, issuing local government bonds is the approach of realizing rule by law in China.
Originally published on PHONEIX WEEKLY | 2012-12-30
