Despite evidences pointing to a mountainous debt and non-performing loan, the Chinese Authorities have persistently refused to admit that actual debt is very much higher than they had initially insisted at 18% of GDP.
However, as doubts began building up with regard to the local financing vehicles’ ability to repay their debts in view of a slowing economy and falling property prices, the Central Government has decide to allow local governments to issue bonds to buy up these debts as a way to legally extend the repayment period of these debts by the financing vehicles and also to shore up the capital requirements of the Big Four banks that had been extending credits freely to these local governments’ financing vehicles to finance their pet projects and massive infrastructures building projects during the last global recession.
China’s Bank-Solvency Crisis of the 1990s
China’s banks current high debts problem is very much akin to that of the 1990s which ultimately led to China’s Bank-Solvency Crisis in the late 1990s.
The Big Four banks, with more than 100,000 branches across the country, are employers to more than a million employees.
When the local governments were banned from issuing their own bonds under the budget law of 1994, these local governments began setting up financing vehicles, usually state-owned enterprises, to obtain credit from state-owned banks to finance their pet projects and infrastructure projects. The cause of the crisis then was because the state-owned banks had extended too much credits and too easily to these unprofitable and inefficient state-owned enterprises that had ultimately resulted in high non-performing loans and soured debts among the Big Four banks in the late 1990s.
Due to the high non-performing loans and soured debts, the banks eventually became insolvent. In 1998, the Chinese government then injected $30 billion into the Big Four banks to bail out the banks. A further capital injection of $170 billion was carried out between 2000 and 2001. In 2004, the Chinese government entered its third bailout with another capital injection of more than $100 billion, with the subsequent public offering of the banks’ shares in Hong Kong.
The bad loans were hived into Asset Management Companies and sold to foreign investors. Meanwhile, authorities handed banks a golden opportunity to earn their way out of the hole by setting an ultra-low regulatory cap on interest rates on deposits.
Banks then profited from a guaranteed spread between their lowest allowed lending rate and their highest deposit rates. This technique, called “financial repression,” subsidized banks at the expense of taxpayers, who earn negative inflation-adjusted interest rates on their world-famous savings.
Partial Admission of Debts
In October 2011, the local governments in Shanghai, Shenzhen, Zhejiang and Guangdong have been allowed to issue their own bonds of about 30 billion yuan, to be evenly split into 3 and 5 years tranches, to buy up the debts which the local governments have incurred. These bonds will be issued within the annual quotas set by the Central Government and cannot be carried over into the following year.
By allowing these local governments to issue their own bonds for the first time since 1994 under a budget law, China is attempting to clean up 10.7 trillion yuan ($1.7 trillion) in local debt, according to a June estimate of only 6,500 financing vehicles by the National Audit Office, which she had previously refused to admit, and which is a hangover from a spending binge to cope with the global financial crisis. Much of these debts are due for repayment in 2011 and 2012. This move was undertaken mainly due to investors’ fears that a hard landing in China could trigger a wave of defaults by local governments and lead to a heap of bad bank loans, and also to recapitalize the banks.
With more than tens of thousands financing vehicles created by local governments across the country, China’s debt is certainly much higher than the 10.7 trillion which the Central Government has finally admitted.
From High Non-Performing Loans to High Non-Performing Asset
Although the move will just hide the debts and delay payments and prevents a sharp rise in non-performing loans, it, however, does not solve the issue since it would be just a shift of debt from one hand to the other hand as potential investors of these bonds will be determining the credit-worthiness of the respective local government. Moreover, it does not improve the cash flows of the financing vehicles whose debts will remain problematic.
In addition, due to the lack of transparency of the local government finances and information, it will not be an easy task for investors to make an accurate assessment of risk.
Meanwhile, the Chinese bond markets are ill-equipped to price risk. The yields are set by the Government rather than an assessment of borrowers’ credit-worthiness. And with the banks holding approximately 67% of bonds as the main players in the market with a buy-and-hold strategy, bonds are simply loans by another name.
While the creation of a local-government bond market could help reveal the amount of debts owed by the local governments, without any reformative steps taken, the debt is simply shuffled from banks’ loan books to their bond accounts which could help sweep under the carpet China’s local governments debt mountain, but it certainly will not reduce it.
One interesting observation is in spite of their high non-performing ratio, the Big Four banks are still reporting record profits, with announcement that the Chairman of Agricultural Bank of China, Xiang Junbo, has resigned today.
Andrew Michael Teo 