by Amanda Lee in SCMP, Aug 24, 2023
China is considering stronger measures to address risks from its local-government debt crisis, but opportunity costs are rising when it comes to curbing systemic risks in the state-dominated financial system, according to analysts.

The financial system has already been put under pressure from property woes over the past few years, and analysts have warned that the costs could be huge if Beijing does not move fast enough to resolve the real estate market crisis, which has ramifications for local governments.

“All in all, while the structural consequences of a disinflating real estate bubble cannot be avoided, Chinese policymakers should focus on limiting potential spillovers into the financial sector and thereby systemic risk,” Alicia Garcia-Herrero, chief economist for Asia-Pacific at Natixis, said this week.

“The longer they wait to do so, the bigger the cost will be.”

Beijing has recognised the urgency of the local government debt crisis and stipulated last month that it was necessary to resolve it with “a comprehensive solution”.

Wang Tao, chief China economist at UBS, said there are risks in policy support not being delivered on time or effectively to the wider economy.

In particular, how to handle inefficient spending by local governments when they already account for 90 per cent of China’s fiscal resources, Wang said.

“In addition, the [central] government also faces structural challenges, including an ageing population and restrictions on access to advanced technology [from] abroad, and is supposed to steer the economy away from property- and local government-led growth model towards a more sustainable and high-quality one,” Wang added this week.

“The internal deliberation may take time and result in delays in delivering effective policy responses.”

Caixin magazine reported on Saturday that China’s central bank may set up an emergency liquidity tool with banks to provide low-cost funds with longer maturities to local government financial vehicles (LGFVs).

LGFVs are hybrid entities that are both public and corporate and were created to skirt restrictions on local government borrowing and have proliferated since the global financial crisis in 2008.

Concerns have been growing over the ability of local governments to repay LGFV debt, as their revenues from land sales have been squeezed by the slumping property market, though many have continued to borrow to fund costly infrastructure projects in a bid to boost growth.

Logan Wright, partner and director of China Markets Research at Rhodium Group, said the plan described by Caixin was a “very early and a small step”.

But such a proposal has the potential to create additional market risks for provinces or areas that receive low or no quotas for refinancing bonds, he added.

The US-based Rhodium Group estimated that, as of July, LGFV loans made up 20 to 25 per cent of total bank loans in China, while LGFV bonds accounted for 51 per cent of all corporate bonds and LGFV credit covered around 13 per cent of system-wide financial assets.

Most of China’s local-government debt is held by domestic investors, and the banking sector’s exposure to LGFVs is seen as significant.

Any form of debt resolution will incur loss-sharing throughout the system, and a large proportion of the losses would be taken on by China’s banking and nonbank institutions, added Rhodium Group.

“This is the dilemma for Beijing. Local-government investment is still a considerable proportion of overall investment and likely reflects around 14 to 15 per cent of gross domestic product right now,” Wright said. “So, letting local-government investment slow too much would clearly have an impact on growth.

“They need to manage both the stock of existing debt and [establish] a more sustainable mechanism to finance local investment in the future.”

From 2015-18, local governments issued around 12 trillion yuan worth of bonds to swap for off-balance-sheet debt, following approval by Beijing.

But LGFV debt soon piled up again, and in a report published in February, the International Monetary Fund estimated that China’s total LGFV debt had swollen to a record 66 trillion yuan (US$9 trillion) this year, more than double the 30.7 trillion yuan reported in 2017.

A number of policy advisers to Beijing, including Liu Shangxi, the head of the Chinese Academy of Fiscal Sciences, have urged the central government to reform its role as well as the role of the local governments to support sustainable development.

“The basic framework of our current central-local government relationship is a legacy from the past, and it is not suitable for the current dynamic society,” Liu told the state-backed Economic Observer in July.

Liu described the reforms as “urgent” and said the central government should take over some of the responsibilities for economic development from the local governments.

“The lower the level of the local government, the lower the ability [to coordinate with cross-region economic policy],” Liu said. “With the improvement of China’s economic and social development, powers and expenditure responsibilities also need to be moved up; otherwise, governance costs will rise exponentially.”
https://www.scmp.com/economy/economic-indicators/article/3232066/china-debt-beijing-warned-opportunity-costs-are-rising-it-seeks-comprehensive-solution-local