Debt restructuring with Chinese characteristics

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Critics may cry foul at the moral hazard but Beijing has bought itself time with its debt swap for local governments.

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The restructuring programme boosts Beijing’s efforts to keep the economy on an even keel


Those who think China’s economy is poised for a meltdown have squarely focused in recent years on ballooning local-government debt, which doubled to 36% of GDP between 2008 and 2013 and now stands at roughly Rmb11 trillion ($1.8 trillion). 

Local government financing vehicles (LGFV) – off-balance sheet vehicles to finance infrastructure projects – were unleashed as a means to sidestep Beijing’s ban on local governments’ on-balance-sheet capital-raising in the November 2008 stimulus plan.

But fears over the weakening credit quality of infrastructure projects and the debt-servicing capacity of municipalities have caused investor panic, given the opaque mix of corporate vehicles, such as bank- and trust-sector loans, used to finance borrowing. There has also been a lack of clarity over whether Beijing would bear fiscal responsibility of such "shadow bank" financing

Last month, however, Beijing assuaged concerns over a refinancing crisis facing local governments by issuing a Rmb1 trillion quota to convert their maturing high-yield debt into lower-cost longer-duration bonds, engineering a market rally in the process. By some estimates, it saves 1.5% of GDP in local government expenditures by allowing them to repay existing loans at lower rates. 

Fears over financing

The swap, which involves 53.8% of maturing 2015 obligations, is an unambiguous near-term boost to China’s challenge of stabilizing its growth rate while addressing its opaque debt burden. The restructuring officially reclassifies a large chunk, perhaps up to a third, of LGFV obligations as fiscal liabilities. The health of the latter is enviable by global standards with central government and LGFV combined obligations totalling a modest 53% of GDP. In fact, according to some estimates, the net equity of state-owned enterprises is larger than central and local liabilities combined, highlighting the public sector’s huge stock of assets at its disposal to service liabilities.

As a result, fears over the financing capacity of local governments have been remarkably over-blown in recent years. 

Further reading
 
China: special focus

While critics cry foul at the moral hazard involved in the programme, it offers a slew of other benefits. It reduces the crowding-out effect of public sector borrowing for private players seeking credit. It improves public-financial management at the state level since respective provincial and city governments will be in charge of the bond-issuance process. What’s more, it increases the quantum of capital in the banking system since local-government bonds attract a lower risk-weighting than LGFV loans, though it inevitably reduces lenders’ net-interest margins. 

It also buys Beijing time to bolster financial disclosure and bank-provisioning while transforming asset-management companies – which have bought SOE debt in return for equity – into commercial enterprises, without triggering a financing crunch at the local level.

Nevertheless, the debt swap does little to address the structural flaws in the credit cycle in recent years. Government officials have exerted political pressure on banks to provide credit while lenders have deferred provisioning and price discovery efforts for distressed project-finance loans.

Politically-sensitive reforms of state-owned enterprises and improvements to banks’ credit-underwriting standards are, therefore, badly needed. China’s shift to a market-orientated financial system requires a more efficient and transparent means of allocating capital.

But the latest restructuring programme boosts Beijing’s efforts to keep the economy on an even keel while addressing its debt burden. As a result, it should quash some of the absurdly bearish talk on the health of China’s economy.