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

Original Article:

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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Economic Outlook: As U.S. Debt-Ceiling Battle Continues, China Seizes Opportunity

Original article:

China accelerated plans to internationalize its currency on Thursday by agreeing to swap euros and yuan with the European Central Bank in a deal that is set to be China’s second-largest to date.

The bilateral currency swap agreement between the European Central Bank (ECB) and the People’s Bank of China (PBOC) is valid for three years and has a maximum size of 350 billionyuan, or 45 billion euros ($60.8 billion).

The deal is the latest of a string of currency swaps that China has created with other nations to promote usage of the yuan in global commercial and financial transactions, with the ultimate goal of rivaling the dollar as a reserve currency.

“The emphasis is on renminbi internationalization,” said Louis Kuijs, an RBS economist in Hong Kong.

The yuan is now the world’s eighth most-traded currency, financial services provider SWIFT said this week, with a market share of 1.5 percent and overtaking the Swedish krona, the South Korean won and the Russian rouble.

To be sure, the Chinese renminbi is still a long way from rivaling the USD as the worlds primary reserve currency. While the renminbi has become the 8th most traded currency in the world at a 1.5% market share, the USD is still the undisputed king, accounting for 61.9% of foreign reserves according to the IMF. One of the main factors holding back the renminbi’s attractiveness as a reserve currency is the fact that it’s value is not determined on the open market but rather set by the People’s Bank of China. A free-floating renminbi is unlikely any time soon, as it’s low value is a crucial element of China’s export driven economy.

However, recent events point to increased attractiveness of the renminbi, and troubling signs for the USD as a reserve currency. The Federal government does not have to default on it’s debt obligations in order to hurt the standing of U.S. debt as the ultimate “safe-asset”; just the threat of a default led to the first ever downgrade of U.S. credit rating in the summer of 2011.

Furthermore, there are signs that markets are beginning to shy away from U.S. debt, leading to higher borrowing costs:

In good times and bad, the world’s financial system has long been able to rely on one thing: that the United States government would pay back its debt on time.

This assumption has made short-term government debt the most basic building block of the financial system, as reliable as a dollar bill.

In recent days, however, the fiscal impasse in Congress has been testing investors’ confidence. As a result, investors have been shifting their money out of the $1.7 trillion market for the short-term government debt known as Treasury bills, worried, for the moment at least, that they may not be the risk-free asset they have known.

The clearest sign of the changing perceptions has come in the prices for the bills that the Treasury Department is supposed to repay in the days right after the debt ceiling is set to be reached.

Normally, as the day of repayment for a Treasury bill gets closer, the chances of getting repaid go up and the bill becomes worth more to investors. Now, however, the opposite is happening, and the bills are becoming worth less than they were previously, making them available for a discount on their face value.

The discount on bills to be paid on Oct. 24 has grown by 400 percent since the beginning of the month; on Wednesday, it jumped 24 percent. That has brought the price that the government has to pay to borrow money for a month to three times what the average AA-rated American company has to pay, according to Federal Reserve data. Typically, the United States government can borrow money for less than big corporations.

Confidence in investments widely considered to have little or no risk has been periodically shattered in the recent past. Until 2008, most investors thought they could not lose money on mortgage-backed bonds that carried a rating of AAA. Last year, investors were forced to rethink their belief that countries in the European Union would always repay their debt.

In the longer term, the fear is that a default would dent the willingness of foreign investors to use Treasury bonds as a place to park their money. Their desire to do so today has made the dollar the world’s most widely used currency.

In remarks prepared for a hearing on Thursday, the head of the industry group for mutual funds, Paul Schott Stevens, said that if a payment was delayed for as little as a few days, “investors will learn a lesson that cannot and will not be unlearned.”

“That lesson is simple: Treasury securities are no longer as good as cash,” Mr. Schott Stevens said.

Let me be clear, the sky is not falling–yet; it seems that politicians on both sides of the political spectrum understand the importance of not defaulting on U.S. debt obligations. However, one has to question the long term effects of even the threat of a debt default. The G.O.P has proposed a temporary debt ceiling increase in exchange for negotiations over budgetary issues. This is not a good compromise, kicking the can down the road will just lead to another debt-ceiling showdown a few weeks from now; one has to wonder at what point global markets will begin to question the USD as it’s main reserve currency. Surely, every-time we have this debate, we risk a credit rating downgrade and further damage the sterling reputation of U.S. Federal debt. As a nation, we literally cannot afford to lurch from one debt showdown to another.

Perhaps investors, fed-up with American political gridlock and uncertainty, will begin to see China, with its insulated and unified leadership, as a safer place to park its money–surely China’s rulers would not even entertain the idea of a default on their debts. 

The debt limit is not a political bargaining chip; it must be raised in the very short-term, while entitlement and tax reform are longer term issues (which have been unsuccessfully negotiated for the better part of the past two decades, is it realistic to believe we will be able to reach a grand bargain in a few weeks?!). As the NYT editorial board put it, “First End the Crisis, Then Talk“.