China’s Debt Fix Could Be a Drag
Photo: China is trying to tame debt but faces major challenges in doing so. Photo: Bloomberg News
By Aaron Back
March 3, 2015 2:30 a.m. ET
A year ago China’s Premier Li Keqiang promised to “defuse” the country’s debt situation, implying it was a bomb ready to go off. This delicate operation looks ready to blow back on the economy.
Mr. Li’s annual agenda-setting address at Thursday’s National People’s Congress will likely provide an update on efforts he outlined a year ago in the same speech. What might be left unsaid is that imposing fiscal discipline is easier said than done.
China unveiled rules late last year to curtail off-balance-sheet financing by debt-laden local governments, a major source of China’s borrowing binge. Provinces are meant to sell bonds and partner with private companies to finance infrastructure spending, rather than setting up shadowy so-called local government financing vehicles, backed by implicit state guarantees, to borrow from banks and other lenders.
Such a system will take time to erect. Meanwhile, less local government spending represents a constraint on growth, which is already slowing.
A literal reading of the rules suggests there will be an outright ban on new borrowing by local government financing vehicles. This would cause a collapse in infrastructure spending, equivalent to around 4% to 5% of gross domestic product, according to Société Générale.
A watering down of the proposals to support ongoing projects seems likely. Just how much will be telling. Too much leniency risks undermining the effort to rein in local government debt, which came to around 30% of GDP at last count in mid-2013. A new audit currently under way by Beijing is expected to show a substantial increase from that figure.
Nonetheless, funding new projects will be a challenge. Beijing’s guidelines establish a two-tier system for new investments. In the first, provinces will be allowed to run deficits and issue municipal bonds to fund public welfare projects such as schools. These would be akin to general obligation bonds issued in the U.S. municipal bond market.
Provinces will have to show they have the revenue stream to make future interest payments. That will be tough. Many are in weak fiscal positions as a major source of revenue, land sales, has dried up.
There will also likely be limits to how much new issuance China’s nascent bond market can absorb. And lower-level governments such as counties aren’t yet allowed to issue bonds, so some planned spending could go unfunded, to the tune of 2.3% of GDP, UBS estimates.
In the second tier, projects with commercial returns, such as subways and water systems, are to be funded through public-private partnerships. Debt issued by these commercial projects won’t be guaranteed. Repayment will be conditional on revenue generated from the projects.
Such public-private partnerships face a long runway. In theory, they provide a means for local governments to tap the balance sheets of private and state-owned companies.
Yet it may be difficult to convince private companies to enter such arrangements. The state may be seen as too powerful and able to change the rules of the game at any time, notes Barclays analyst May Yan. Potential investors will also want to buy into projects at good prices, which could clash with the political sensitivity in China of selling state assets too cheaply.
The unholy budget mess made by local governments can’t be cleaned up overnight. A rocky transition to a new system is just one more reason to expect China’s economy to keep slowing.
Write to Aaron Back at aaron.back@wsj.com
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