IMF urges Beijing to take the tonic, but the rot now runs deep
(Originally published March 25 in “What in the World“) The head of the International Monetary Fund warned China that it is at a fork in the road and needs to reinvent its economy.
IMF Managing Director Kristalina Georgieva told the China Development Forum in Beijing that China could either “rely on the policies that have worked in the past, or reinvent itself for a new era of high-quality growth.”
Her prescribed medicine is the same one, though, China has been pledging to take for many years: reduce its reliance on investment (particularly in property) and instead boost the power of the consumer. “A key feature of high-quality growth will need to be higher reliance on domestic consumption,” Georgieva said. “Doing so depends on boosting the spending power of individuals and families.”
Foreign investors continue to vote with their feet. Foreign direct investment fell 20% in the first two months of this year, to 215.1 billion yuan, according to new figures from the Ministry of Commerce. FDI dropped 8% overall last year.
Georgieva also said Beijing needed to take decisive steps to reduce the overhang of unfinished property projects left by cash-strapped developers and eliminate the risk that heavily indebted local governments go bust.
To that end, Beijing has announced that it will sell 1 trillion yuan (US$139 billion) in ultra-long-term special government bonds this year. Premier Li Qiang announced the plan March 5 during the government’s annual legislative meetings.
Details are still scarce. The government hasn’t yet said how these bonds will be sold, how long ultra-long is, or how much of the proceeds will go to local governments. The only detail Beijing has provided is that these bonds would be considered off-budget, meaning it wouldn’t count them in its official tallies of government debt. That means it will pretend they aren’t pushing it further into deficit.
China has sold such ultra-long special bonds in the past. It did so after the Asian Financial Crisis in 1998 to recapitalize China’s four biggest state-owned banks and again in 2007 to help fund its newly created sovereign wealth fund. In early 2020, it used ultra-long special bonds to raise money to fight the pandemic. Those bonds had 15-, 20-, 30- and 50-year maturities and most of their buyers were the same as the buyers for most Chinese government bonds: Chinese state-owned banks, which hold about 70% of outstanding government bonds.
Selling bonds to bail out local governments is therefore just a way of spreading local provincial risks to the wider taxpaying public. And those risks are growing. As explained in this space last July:
Concerns that provincial and municipal governments may go bust under the load of massive debts continue to grow, meanwhile. Some governments have already begun trimming public services like bus routes so they can keep making debt repayments.
Much of their debt is owed through local government financing vehicles (LGFVs). Despite efforts in 2015 by Beijing to get provincial governments to roll LGFV bonds over into provincial government bonds, the International Monetary Fund estimates LGFVs may have now racked up as much as 66 trillion yuan ($9.28 trillion), more than double what they had in 2017. That’s higher than the 50 trillion yuan estimate recently cited in this space, and amounts to almost three-quarters of the 90 trillion yuan in total estimated local-government debt.
So far, no LGFV has defaulted on its bonds, but default among LGFVs traded in the exchanges, but there have reportedly been dozens of LGFV defaults on private loans this year, most in the cash-strapped provinces of Guizhou and Shandong. If they do start defaulting, it could quickly ripple through China’s banking system: by at least one estimate, LGFVs’ bonds may now account for up to 40% of assets at China’s banks.
Even as Beijing urges local governments to refinance those debts by selling new bonds, China’s banks appear to be taking preemptive measures. In Shandong province, where LGFV’s owe an estimated 4.3 trillion yuan in debt, state-owned China Development Bank, Agricultural Bank of China, and China Construction Bank have reportedly helped fund new companies to bail out several city governments’ LGFVs, including the coastal city of Qingdao.
Beijing can’t just let the provincial governments go bust. Local governments perform most of the crucial public services we tend to associate with the government—like healthcare. So, Beijing has been trying to get the local governments to clean up their own mess. Letting them go bust could also be devastating to their largest source of funding: China’s banks. As highlighted last September:
Rhodium has argued that Beijing is reluctant to do so because the same debt problems (and risk of insolvency) face China’s local governments and their local government financing vehicles, which were created to borrow money and fund their own property development and infrastructure projects. The International Monetary Fund estimates these LGFVs have at least 66 trillion yuan ($9 trillion) in debt, part of 90 trillion yuan in debt owed by local governments overall.
Beijing has for years been trying to encourage local governments to issue bonds to pay down the LGFV debts, thereby shifting the burden from the LGFVs onto their own balance sheets. That increases transparency around who ultimately owes the money, hopefully allowing for lower interest payments when the debt is refinanced. It also helps potentially shifts some of the burden away from bank lending to bond investors. Unfortunately, it’s been banks who’ve been buying most of the local government bonds. As a result, some of those local government bonds are now being used to inject funds into propping up local banks, according to Gavekal Dragonomics.
Besides, refinancing all that provincial and municipal debt doesn’t reduce it, it only keeps it rolling over until hopefully the projects it financed make enough money to pay it off. In China’s current economic climate, that day seems to be getting farther and farther off.
The local government and LGFV debts aren’t technically owed by Beijing, but they are what bankers call “contingent liabilities,” in that lenders basically assumed when making the loans that Beijing backed the borrowers. If Beijing does back the borrowers rather than let those local governments and their LGFVs go broke, its own debts would jump from just over 20% of GDP to well over 120% of GDP, according to Rhodium. Not only that, but Beijing would likely have to take over paying for vital public services now provided by local governments, including healthcare.
And Beijing is, to some extent, already on the hook for the local government debt. Not only because as the national government it can’t allow the citizenry to face a complete halt to government services, but because most lenders and investors have long operated under the assumption that Beijing implicitly backed them. As explained last December:
Moody’s, the credit rating agency, this week lowered its outlook for China’s creditworthiness to “negative,” from “stable,” citing the rising likelihood that Beijing would need to provide financial support to heavily indebted local and city governments. Wall Street was way ahead of it.
Global investors have sold more than $31 billion worth of China’s stocks and bonds so far this year, according to fund flows data from China’s State Administration of Foreign Exchange, as evidence mounts that the engines of its economic growth are dying, leaving it increasingly vulnerable to the mountain of debt it has amassed. The outflows are the largest since China joined the World Trade Organization in 2001.
Moody’s rating of China’s creditworthiness remains unchanged, at A1. Lowering its outlook suggests it may be considering a downgrade, however. Moody’s said heavy provincial and government debts posed a “broad downside risks to China’s fiscal, economic and institutional strength,” and “increased risks related to structurally and persistently lower medium-term economic growth and the ongoing downsizing of the property sector.” In other words, local governments pose a contingent liability on the national government, even though the national government offers no explicit guarantee that their creditors will be repaid.