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Economic Outlook: China’s Local Debt Solution–Financial Liberalization or Debt Monetization?

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The total debt of local governments in China has soared to nearly $3 trillion as the country’s addiction to credit-fueled growth has deepened in recent years, according to the findings of a long-awaited report released on Monday by the central auditing agency.

The June figure also represented a sharp increase of 67 percent from the end of 2010, when an earlier report by the Audit Office estimated local government debt at 10.71 trillion renminbi.

In the five years since the onset of the global financial crisis, local governments at the provincial, municipal, county and township levels across China have gone on a spending spree, loading up on debt to finance a surge of investment in infrastructure, real estate and other projects.

The structure of much of this borrowing has also raised concerns. With a few exceptions for pilot programs, local governments in China are prohibited from directly taking on loans or issuing bonds. Instead, they have set up thousands of special-purpose financing vehicles that borrow on the government’s behalf to pay for a given project.

Such financing vehicles had confirmed probable and potential debt obligations totaling 6.96 trillion renminbi as of June, according to the Audit Office’s report, accounting for nearly 40 percent of all local government debt.

Analysts had for months been anticipating the results of the audit office’s survey. As part of an investigation that began in July, the agency said, it deployed 54,000 auditors across the country, who combed through the books of more than 62,000 government departments and institutions and examined 3.4 million debt instruments related to more than 700,000 projects.

Based on findings of the new report, Lu Ting, a China economist at Bank of America’s Merrill Lynch unit, estimated that China’s total public debt stood at 53 percent of gross domestic product. Adding corporate and household obligations lifts the total debt ratio to as much as 190 percent of G.D.P., he estimated.

China’s overall debt ratio “is neither exceptionally high nor low,” Mr. Lu wrote on Monday in a research note. Still, he said he was concerned that for the last two years China has been adding debt faster than its economy has been growing.

Financial Liberalization:

According to analysis by Reuter’s economists, China’s plan to reign in debt via municipal bond markets relies on “the one thing its officials are most afraid of: transparency”:

By letting local governments sell bonds for cash, China wants to rely on nimble markets rather than inflexible regulations to keep spendthrift units in check.

The stakes are high. A bond market is the centerpiece in China’s blueprint to mop up fiscal troubles and keep its economy growing at an even pace, giving it needed room to start other bold financial reforms.

But analysts say China’s dreams of a municipal bond market are so far just that, as building one has been impeded by a lack of disclosure from local governments on how much money and assets they have, and how much they owe.

“If you want to lend to a specific government, you need to have a clue as to what the financial conditions are like,” said Tan Kim Eng, a senior director of sovereign ratings at Standard & Poor’s in Singapore.

“There’s still a lot of work to be done on the fiscal transparency front.”

“Any improvement to fiscal transparency will be limited unless the central government regularly publishes similar audit reports,” Standard & Poor’s said separately in a note on Tuesday. “It’s also unclear whether China will disclose the debts of individual local and regional governments.”

To be sure, China is mulling other options for cleaning up its debt mess, including allowing private investors to pay for public works, and letting the central government absorb more spending responsibilities.

But no plan resonates better with reform-minded officials than that for a municipal bond market, partly because it fits perfectly with China’s goal of reducing central planning to let financial markets work their magic.

Facing savvy local officials quick to change financing strategies to evade rules, Chinese experts have championed creation of a municipal bond market. Such vehicles, they say, will decide which governments deserve funding, and spendthrift ones will be punished with higher borrowing costs.

Beijing appears to like the idea, and is testing the ground for such a bond market in six prosperous cities including Shanghai and Guangdong.

But short of full disclosure of just how much governments take in and borrow, analysts doubt China’s experiments with its local bond market will go far.

“Banks and rating agencies do not have easy access to local governments’ overall fiscal position, which includes not only budgeted revenue and expenditure but also extra-budgetary revenue and expenditure,” the International Monetary Fund said in October.

“This lack of transparency prevents banks and rating agencies from pricing credit risk properly and prevents local governments from managing related risks prudently,” it said.

Debt Monetization:

Another option to reign in local debt is “debt monetization”. In such a scenario, China’s central bank (The People’s Bank of China) would print money, and use that money to buy up outstanding debt (taking it out of the public’s hands). China’s central government could then cancel the debt it just purchased, on the condition certain policies it desires are enacted (financial transparency / fiscal responsibility / greater future role for the central government in local budgetary decisions for example).

The downside of “debt monetization” is that it increases the money supply, which can have inflationary consequences.

Which policy (or mix of policies) will China pursue to reign in local government debt? It depends if you believe in China’s economic blueprint rhetoric or not.

In recent months, China has revealed an ambitious plan that will allow markets to play a bigger role in the economy, beginning a shift from a primarily export based economy to one based more on personal consumption. In line with this plan would be a financial transparency / market based approach to the local debt problem. Increasing budgetary transparency would make local governments more accountable to financial markets and (secondarily) their electorates.

However, the debt monetization approach creates winners as well (who happen to be the usual winner in China–the political elite). It would provide a greater role for the Communist Party in local economic decisions. It would also reduce the value of China’s currency (monetary expansion), which while reducing disposable income (consumption spending) would likely make exports more attractive (which has been the traditional engine of Chinese growth). If you think the Chinese government is just blowing smoke with its economic “blueprint”, and cares more about aggregate growth rates than personal well-being, the debt-monetization approach makes more sense.

It remains to be seen what actions the Chinese government takes, and actions speak louder than words. “Pilot” market liberalization projects have begun in large “international” cities like Shanghai and Hong Kong, will they reach smaller municipalities as well? Can China’s blueprint for economic liberalization fit in with the  determination of the Communist Party to keep a strong grip on political power? Is the Chinese government trying to say the right thing, while further entrenching the role of the central government in everyday life?

The policy response to the local debt crises will provide some rare insight into the true intentions of the Chinese Communist Party.

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