Yellen arrives in Beijing to talk with a government facing slipping local government finances and a sliding currency

(Originally published July 6 in “What in the World“) U.S. Treasury Secretary Janet Yellen is due to arrive in Beijing today for a fence-mending trip. But if she manages to dig any fenceposts, she’s likely to find a lot buried not far below the surface.

Perhaps the first she’d notice lurking beneath China’s economic topsoil are provincial governments teetering on the brink of bankruptcy. Beijing’s answer? Borrow even more.

China’s Ministry of Finance is stepping up issuance of local government bonds to help them stay afloat. During the heady days of China’s property boom, local governments borrowed heavily against their land holdings to fund sometimes bizarre infrastructure projects. When land prices and land sales faltered, the government tried to reduce banks’ exposure to local governments’ rickety finances by banning new loans to them. That drove provincial governments to shift their financing needs to companies they controlled and whose debts they implicitly guaranteed, but whose borrowings wouldn’t show up on their own balance sheets.

These local government financial vehicles, of LGFVs, now are now sitting on estimated debts of as much as 50 trillion yuan ($6.9 trillion). Since 2015, Beijing has been forcing provincial governments to move those debts back onto their balance sheets, allowing them to issue special-purpose bonds.

But now, local governments have an estimated 90 trillion yuan ($12.4 trillion) in debt. Aside from the prospect that local governments might go broke, Beijing faces an even larger risk: most of those bonds are held by China’s banks, who stand to suffer enormous losses if they don’t get repaid. Beijing’s solution for now: let local governments borrow even more so none of that happens. In short, dig the hole even deeper.

The consequences of China slipping further into a Japan-style debt-coma stand to reverberate globally. China is one of the biggest sources of economic growth in the global economy. That comes from both Chinese investment, but also consumption. While China has been the factory of the world for the past 20 years, it’s consumption that accounts for more growth now than exports in China’s economy.

But China is still the world’s factory, which means “de-risking” or “friendshoring,” or whatever it’s called this week in Washington, won’t come without costs to businesses, innovation, and growth. And, as AXA economist Aidan Yao reminds us in an op-ed for (gulp) The China Daily, the U.S. could come to rely again on China’s surplus savings to finance its own government debts once the U.S. Federal Reserve has completely unwound quantitative easing and finished raising rates.

China already faces capital outflows, both by foreign companies and its own citizens. That’s adding to downward pressures on the yuan, financial markets, and economic sentiment. But perhaps the foremost pressure is the fact that the Fed has been pushing up rates on dollar holdings even as the People’s Bank of China cuts rates to stimulate the economy. The PBoC has mounted a campaign to discourage dollar-buying, including forcing banks to lower dollar deposit rates. But ultimately exchange rates are a battle that interest-rate differentials will determine.