LGFVs: China’s $1.7 trillion hangover
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.
That means if this second course is pursued, within a couple of years the percentage of NPLs held by LGFVs and their creditors will rise from 30% to 40%, 50% and beyond. One need only look at the failure of China’s four asset management companies (AMCs) – Huarong, Cinda, Great Wall and Orient – to rid their books of bad loans acquired during the bank bailout of 1999 to see how things could play out here. The books of China’s LGFVs could get very toxic, very quickly.
However, Beijing needs to do something. The LGFV problem is not going away. A pilot scheme involving the capital markets buying specified bundles of loans – packages that would be sliced-and-diced, mixing loans good and poor, again mirroring the west’s unsavoury experience with CDOs during the credit crunch – would give the authorities a breather, however temporary.
Beijing, in theory, can keep rolling over LGFV loans for the medium term – it might well do so for three or four years or more – but to do so indefinitely would smack of procrastination or impotence.
Many believe that, sooner or later, China will have to bite the bullet and write the whole thing off. This will likely involve another grand, sweeping gesture involving: the creation of a new AMC, mirroring the contortions of 1999; or a bailout replicating the events of 2004/05, when the People’s Bank of China (PBoC) pumped US dollars into the big four banks, boosting their balance sheets in preparation for stock listings.
|Jim Walker, the founder and managing director of independent Hong Kong financial consultants Asianomics|
Whatever China chooses to do, the results won’t be pretty. "None but the most Pollyanna-like commentators in China believe that the credit binge of the last few years will result in anything other than massive loan-loss write-offs against local government and some [state-owned enterprises’] debt," says Jim Walker, the founder and managing director of independent Hong Kong financial consultants Asianomics. Walker says estimates that only 30% of total LGFV debt will sour completely are soft. "The PBoC may eventually be asked to help fill [a hole] in bank balance sheets [that] ranges from around $300 billion to $470 billion," he says.
Local issues are also symptomatic of a much wider malaise. China’s once red-hot economy is cooling, leading to angst-filled meetings at the heart of government. One individual close to the government says there is a "very real and very clear" concern that the economy will slow markedly through 2012 and into 2013.
To Beijing’s reputation-conscious mandarins, obsessed with maintaining the appearance of control and keeping GDP above the sacred annualized rate of 8%, this matters. Beneath the braggadocio and gloating of recent years, while the west stumbled and China sailed serenely on, there has always been a lingering fear here that the financial crisis would inch its way east.
Some believe it now has. In January, the former CBRC chief Liu Mingkang was quoted by Caixin magazine restating his belief that the economic crisis would "spread from the US to Europe and finally land in Asia. Now we can see it has already begun influencing Asia." Liu’s comments in the article also make clear that by Asia he mostly means China.
Others say the crisis, like a dormant cold, never fully left Asia, or China. "I always thought that China would be the last major economy to emerge from the crisis," says Michael Pettis, professor of finance at Peking University’s Guanghua School of Management. "Why? Because the huge increase in investment it engineered to postpone the domestic impact of the global crisis exacerbated the imbalances within the economy and increased its already-excessive reliance on debt and investment to generate growth."
Throughout early 2012, predicting China’s slowdown became almost a blood sport. On March 14, Adrian Mowat, JPMorgan Chase’s chief Asia and emerging-market strategist, warned that the economy had hit the buffers. "China is in a hard landing," Mowat said at a conference in Singapore. "Car sales are down, cement production is down, steel production is down, construction stocks are down. It’s not a debate anymore, it’s a fact."
Few would seek to debate these views. The Shanghai Composite, China’s benchmark stock market, is down 17.4% in the year to March 18. On March 15, it tumbled 2.6%, its biggest single-day fall in nearly four months, after gloomy comments from premier Wen Jiabao on the property sector. Figures from the China Association of Automobile Manufacturers show deliveries of passenger cars and light-goods vans falling 3% year on year in the first two months of the year.
Most worrying, perhaps, are the data behind coal and power production – key drivers of China’s vast industrial economy. Energy production is tipped to slow to 7.5% this year, down from 10% in 2011 and 15% in 2010, due to slowing demand from thousands of mainland power stations, according to a March work report by the National Development and Reform Commission (NDRC). Raw coal output will slow as a result, the NDRC forecasts, rising just 3.7% this year, from 8.7% in 2011.
How worried should China be? That depends who you speak to. Carl Walter, a former banker who spent nearly two decades on the mainland – most recently at JPMorgan Chase – before retiring in 2011, believes that Beijing, having skirted the worst of the credit crunch, now faces a crisis of its own. "The next five years will be some of the most difficult since 1978," he says.
Fraser Howie, who co-authored Red China: The fragile financial foundation of China’s extraordinary rise with Walter, adds: "You look at almost any economic measure, and things are tougher now than they have been for a long time. For [small and medium-sized enterprises] and the private sector, there is no doubt that the hard landing started some time ago."
Things look just as bad on the long-range forecast. Dong Tao, chief Asia ex-Japan economist for Credit Suisse, tips the economy to grow at 8% in 2012 – the absolute minimum needed to maintain reasonably full employment – and keep the lid on rising social unrest.
The government feels even less optimistic. On March 17, Ma Jiantang, head of the National Bureau of Statistics, warned that an ageing population and a deteriorating natural environment would cut economic growth to a seven-year low of 7.5%.
And in February, the IMF gave the starkest warning yet: if eurozone concerns persist, and worsen, Chinese growth could sink to 4.5%. It is worth bearing in mind that Beijing deems 5% to be the line separating its own economy between economic growth and recession.
In truth, though, any attempt to build a genuinely coherent picture of China’s economy – using central government data cross-referenced against the quasi-state bodies, local authorities, banks and the capital markets – is doomed to failure. Trying to navigate the minefields of data here is a gruelling and unrewarding task.
Even the LGFV industry is full of smoke and mirrors. As no one regulates the industry, there is no way of assessing how many local financing vehicles exist. One Chinese expert says 6,000. A distressed debt specialist reckons up to 10,000. Even the NDRC, which is supposed to keep track of what local authorities are up to, professes not to know.
Most central data are unreliable, having been collected from townships and provinces run by officials seeking advancement by posting growth figures in line with government expectations. So if Beijing predicts 8% growth, local authorities post growth figures to match that total, irrespective of whether the real number is higher or lower. China has long had this problem, yet it is still a surprise to find that in 2012 reliable data in the world’s second largest economy remain so elusive.
"No one trusts any information here," says one distressed-debt specialist. "So foreigners have to infer, extrapolate, or assume stats. It’s a race for reality. A few years ago, official GDP was 10%, but everyone knew it was really around 14%. Is it 6% now? Who knows? It’s such a secretive country, we’ll probably never get a real, full picture of the situation."
Much now will depend on what economic course the new leadership of Xi Jinping and Li Keqiang, set to succeed president Hu Jintao and premier Wen Jiabao respectively at the National People’s Congress in March 2013, intend to chart.
|Nicholas Lardy, senior fellow at the Peterson Institute for International Economics in Washington|
"The future of the Chinese economy will be determined by whether the new leadership resumes the economic reform process that was abandoned by Hu and Wen," says Nicholas Lardy, senior fellow at the Peterson Institute for International Economics (PIIE) in Washington. "[The new leaders] should start with market-oriented interest rates. Without that, there will be no successful transition to consumption-driven growth." Most experts believe the Hu-Wen years will be seen as a missed opportunity, a decade when budget surpluses and soaring foreign reserves handed China a golden opportunity to steer its economy toward a consumption-driven model.
That chance was spurned, as was a second. Even hawks in Beijing agree that the 2008/10 stimulus spree was merely a short-term patch, plugging holes in a system overly dependent on exports and the funding of bloated, inefficient state firms.
"There is almost a consensus in Beijing now that the massive stimulus in 2009 has done more harm than good to the long-term sustainability of growth," notes Credit Suisse’s Dong.
So all eyes are on Xi and Li. Do they believe China must reshape its economy or die, or will they persist with the status quo, hoping that everything will just sort itself out? Many are quietly hopeful for this new generation, in a way they never were over the timid, intellectually brittle outgoing leadership. Xi is western in outlook with several children ensconced in US schools and colleges. Li is intelligent, an economist able to take the long view, yet lacking the worldliness of, say, a Zhu Rongji or a Deng Xiaoping.
This is where Wang Qishan comes in. A vice-premier and member of the 23-strong Politburo, Wang is on track for promotion to the nine-man standing committee this autumn, the highest authority in the land. Wang, a protégé of Zhu – China’s great industrial modernizer – is widely expected to have a role mentoring the callow Li.
"If he is given the chance to shadow Li, and to make decisions that Zhu would have made, tackling the financial crisis that might be looming on the horizon, then China has a reasonably good chance of transitioning to a fuller, broader, fairer economy," says the foreign-born government adviser. "If he can’t do [it], I suspect no one can."
In the latter scenario, the most likely outcome is a stuttering China struggling to pay its own debts, a still largely isolated financial system, and an economy still driven by inefficient state firms and banks.
World Bank president Bob Zoellick warned China’s leaders of the dangers of inaction in a strongly worded introduction to its China 2030 report, issued in March. Zoellick slammed Beijing for its lack of support for private enterprise, and warned that China needed to redress several issues, notably an ageing country hampered by rising inequality, a large and growing environmental deficit, and stubborn external imbalances.
Others are sharper when using their claws. The analyst Howie predicts that five years from now "Chinese growth is probably at 5%, and life is a lot tougher all round. A debt crisis could well be imminent."
Many analysts believe a few years of slower growth, and a concomitant chance to stress-test the system, would be in China’s best long-term interests. One recent post on micro-blogging site Twitter merely read: "China needs an economic disaster: discuss."
The comment was endlessly re-tweeted, garnering responses approving and reproachful, but it contained a refreshing honesty often missing from economic discourse. China has not had a real recession since the economy opened up in 1978. A genuine financial crunch would give Beijing the chance to hone its crisis management skills. A recession will, after all, hit the country sooner rather than later.
And for China, a daunting political year recently got harder, after the public purging in March of Bo Xilai, the former party secretary of Chongqing. Bo was a divisive figure, a powerful princeling seeking a place on the nine-man standing committee, and his dismissal merely rids China of a hardliner who pines for a return to revolution and red power.
Yet Bo’s humiliation also offers China an unusual path to financial redemption. The purging, believes one prominent Chinese distressed-asset specialist, will lead to all Chongqing-related LGFVs being "hammered on the market" – notably one listed subsidiary that will get "heavily audited as part of the anti-corruption investigation against Bo. Inevitably, they will find tons of dirt, and there will be a cash crunch for these companies, and default risks will also rise."
Two of the companies mentioned are Hong Kong-listed YT Realty and Shenzhen-listed Chongqing Yukaifa, two listed divisions of Chongqing’s central financing vehicle. Both companies’ shares were burned in the two days after Bo’s exit: YT’s stock falling 3.5% and Yukaifa’s tumbling 10%.
At the very least, the inevitable investigation will allow central authorities to understand the complex webs of LGFVs a lot better. At best, it will help Beijing plan a route through uncharted terrain, finding a solution to its local debt quandary.
And there remains much navigating to do. China’s financial landscape remains an overwhelmingly illogical place to many, one where new debts pile up – through LGFVs – while others, years and even decades old, remain on the books of state bodies, unresolved and gathering dust.
Take Cinda, for example, one of the AMC class of 1999. In March, it sold a 16.54% stake for $1.6 billion to investors including UBS, which bought 5% of Cinda, Citic Capital, 2%, and Standard Chartered, 1%. All investors are locked into a minimum three-year investment, paving the way for a Hong Kong initial public offering. Other new shareholders include China’s national pension fund, the National Council for Social Security Fund, which paid $790 million for an 8% stake.
Cinda board secretary Zhang Weidong believes Cinda will become a multi-limbed financial institution covering fund management, insurance, futures and trust services, thanks to its nationwide network of branches and Rmb60 billion in equity held in more than 170 companies. Bad debt management and equity holdings accounted for around 70% of Cinda’s Rmb8.2 billion in 2011 pre-tax profits.
Yet China experts remain dubious, despite evidence that some Chinese AMCs, notably Huarong and Cinda, have taken on a life of their own during the past 13 years. "I am sceptical that the AMCs have a bright future," says PIIE’s Lardy. "The plan to list Cinda strikes me as a stretch at best. They have had no profits for 10 years and had to roll over their bonds in 2009 when they came due and needed a second government capital injection in 2010."
As for the LGFV issue, it shows no sign of working its way through the system. Total local debts, at $1.7 trillion and rising according to official data, are no closer to being capped or tackled by a government fearful of making a fatal misstep during a tricky leadership transition.
Even when the scale of the problem is staring them in the face, officials appear determined to procrastinate, or look for reasons to be cheerful. Recent comments by Fan Jianping, chief economist at the State Information Centre – an influential, central think tank affiliated to the NDRC – show the self-denial at work. "Five or 10 years from now, local governments will borrow very, very little from banks," Fan said in early March. "Their debt structure will be almost entirely held in bonds."
That is a noble aim: to force LGFVs to borrow only in bonds rather than in the form of bank loans. That way, one can see if and when the debt is being paid off, and can rate the bond according to the financial reputation of the local financing vehicle. But allowing LGFVs to borrow via market-rated bonds will only happen if China eliminates loss-making investment activities, prevents debt being accumulated in an opaque fashion, and halts its addiction to maintaining a high growth rate by misallocating capital.
The only way to resolve local debt is either to default or to force someone else to make up the loss. Since the first option is politically unpalatable, the burden of payment will likely fall on the capital markets or the central bank. Or both.
As Peking University’s Pettis points out, there seems to be an "almost touching faith" in assuming that bonds are the answer to local debt woes. "If banks make foolish loans, stop calling them loans and start calling them bonds, the problem is immediately resolved – you have no more bad loans," he says. "True, we won’t, but [instead] we’ll have bad bonds, probably still on the balance sheets, and we’ll still be left with the problem of how to pay for them."
And so we return to Beijing’s latest, if not its greatest, fiscal nightmare. LGFVs constitute yet more proof that the state is not very good at allocating financial resources.
Not that the LGFVs are to blame: they were merely doing their job, lending and spending like drunken sailors when ordered to. They have done it before, in the 1980s and 1990s, when NPLs rose to toxic levels, and will likely do so again, unless the system holds itself to account, or forces itself to undergo genuine internal structural change.
And that, in a one-party system allergic to criticism, will not be an easy ask.