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LGFVs: China’s $1.7 trillion hangover

Elliot Wilson
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Outstanding bank lending to local government financing vehicles have reached an estimated $1.7 trillion – with up to 40% of the loans at high risk of default. So what’s a panicking Beijing to do? Force the market to pay for the state’s mistakes, of course…

In China’s wild, weird economy – superficially strong yet structurally brittle, propped up by cheap bank lending and protected by relative financial isolation – anything seems possible.

Often, it is. In a country so short on dependable data, where a secretive government’s decisions are rubber-stamped in private before being casually issued to the world via friendly media outlets, rumour and counter-rumour hold sway. Here, where concealment – of decisions, of opinion, even basic of information – is all, even the most speculative scuttlebutt can feel feasible.

Take the issue of local government financing vehicles ( LGFVs). These odd investment bodies are, or are set to become, China’s equivalent of mortgage-backed securities or collateralized debt obligations.

Beijing’s decision to pump-prime its stalling economy in late 2008 resulted in trillions of dollars being routed by state banks through regional governments into LGFVs, which channelled that cash into pet projects: golf courses, residential real estate, light rail networks, freeways, shopping malls.

Too late, Beijing realized it had merely repeated its errors of the 1980s and 1990s, when vast clods of cash were hurled at ropey regional projects by state-run lenders, leading to the huge bank bailouts of 1999 and 2004/05.

The 21st-century version of these earlier financial clangers might prove no less calamitous. Total outstanding bank lending to all LGFVs reached $1.4 trillion by end-September, up 25% year on year, according to the China Banking Regulatory Commission.

The banking regulator warns that around 35% of these loans are insecure, or at high risk of default. Most experts place the amount of LGFV loans liable to go sour at between 30% and 40% of the total.

Early last month, Yang Kaisheng, president of Industrial and Commercial Bank of China, the country’s biggest lender by assets, put the local debt figure at closer to Rmb10.75 trillion ($1.7 trillion), or just shy of 30% of Chinese GDP. That figure boosts total government debt at end-2011 to around $2.8 trillion, not far off the country’s total hoard of foreign exchange reserves, at $3.2 trillion.

Little wonder Beijing is concerned, or that the authorities are weighing up every possible solution to this growing crisis, however imaginative or eccentric. One of the odder options floated in recent months involves demanding that all local authorities and LGFVs provide proof of their lending and spending since China unveiled its $600 billion stimulus package in late 2008.

In other words – paper proof documenting every loan made, every parcel of funding received, to determine whether money was used wisely or poorly, and to discover how much cash slipped through the net, winding up in the pockets of officials working with, or connected to, LGFVs and favoured state firms.

Beijing started casting around quietly for opinions around early December, people close to the government say. "I sat in on a few meetings with [party] officials where this was discussed," says a long-standing foreign specialist who regularly advises the state council.

"There were compelling reasons both ways. On the positive side, doing this would create an effective financial census, giving the government a powerful insight into how money was used and misused within the system. On the downside, it was argued, this would prove very hard to do. Local authorities wouldn’t want their secrets exposed. The sheer volume of paperwork would swamp everything."

The argument went back and forth for months, but by March it had been decided it was best not to go ahead, the foreign specialist says, for two reasons. "First, it’s a transition year, with the leadership changing hands, and no one wants a big financial scandal unrolling now," says the specialist. "And besides – this is China. Everyone will have taken a slice of the action from the LGFV money, and you can’t afford to make everyone lose face."

With that unsavoury dish now off the menu, China appears to be mulling over a hackneyed alternative: forcing the market to pay for the state’s mistakes. Or, put another way, forcing the capital markets to – again – bail out the banking system.

This option, quietly gaining momentum since February, would involve Beijing issuing parcels of repackaged LGFV debt in the form of municipal-commercial bonds – which it would expect to get snapped up by state-run banks, insurance companies and mutual funds.

Around Rmb2 trillion in LGFV debt comes due this year alone. James Kynge, author of China shakes the world, believes that the bond markets could "easily handle" that total, even if it included as much as Rmb800 billion-worth of soured loans. It would also, Kynge adds, help the government find a credible solution to its "biggest red-button issue".

Others are not so sure. China would need to keep repackaging its local debt each year for at least the next five or six years, using the same old ruse every time. The past has shown that the state is most likely to flog its good debt first – tranches containing lower levels of likely non-performing loans – to keep institutional investors friendly.