China Has a Fresh $7.2 Trillion Problem That Could Spook Markets

Everything is under control, if China’s repeated assurances about its debt mountain are to be believed.

Over the past two years, the country’s leadership under President Xi Jinping has made debt reduction an economic priority, especially loans amassed by local governments and state-owned enterprises (SOEs).

Beijing has also shifted attention away from growth targets, taking some of the pressure off lower-level authorities to use borrowing to finance rapid expansion.

But international institutions are again hearing rumblings from the debt mountain that are too loud to ignore, and have urged Beijing to tackle causes before it is too late.

Ratings agency Moody’s and the International Monetary Fund have both issued fresh warnings about China’s debt in the past week.

On Tuesday, for the third year in a row, Moody’s said the outlook for China’s local governments for the next year was “negative” because of the growing liabilities of state firms and implicit guarantees from local administrations.

Two days later, the IMF urged China to prioritise financial stability above development goals. In its annual Financial Sector Assessment Programme report, the organisation said pursuit of regional growth targets and attempts to avoid heavy SOE job losses had led to a surge in debt, particularly at the local government level.

“Some of the underlying causes of risks are yet to be fully addressed, reflecting policy tensions,” the report said. Risks include “the overriding projective, especially at the local government level, to achieve high growth rates that encourages credit expansion”.

There is strong evidence to support that view.

In the first nine months of the year, the total liabilities of local SOEs, including local government financing vehicles (LGFVs), rose by nearly 21 percent to 47.6 trillion yuan (US$7.19 trillion), according to data from the Ministry of Finance. That total was nearly triple the 15.9 trillion yuan in direct debt held by local governments at the end of June.

At the same time, Xi wants SOEs to bigger and stronger, raising the prospect of more bank loans to fuel their expansion.

Moody’s analysts led by Amanda Du said the liabilities of local SOEs were already high compared to the revenues of many local governments. In Tianjin, for example, the outstanding)debt of local SOEs at the end of September was seven times the municipal government’s revenue.

Part of the problem is that local governments have massive infrastructure needs but Beijing has limited their capacity for direct borrowing.

“The gap will need to be filled by higher borrowing by local SOEs, especially LGFVs,” the analysts said.

Andrew Collier, managing director of Orient Capital Research in Shanghai and author of Shadow Banking and the Rise of Capitalism in China, said local governments needed capital to keep growth afloat and to pay for essential services.

“So the system – including banks and shadow banks – finds ways around the rules to move credit down to the trenches, although China is pushing financial institutions to reduce risks to avoid a financial crisis, ” Collier said.

While Xi and other top leaders have stressed the need to reduce risk in the financial system, they also have had to ensure sufficient lending was available to keep the economy on course to meet their economic growth target of at least 6.5 percent for the year.

According to Bloomberg Intelligence, China’s total outstanding credit climbed to about 260 percent of gross domestic product at the end of last year, up from 160 percent in 2008.

The increase in credit has helped to fuel a mortgage boom and a hefty rise in household debt, which is now equivalent to 44.4 percent of GDP, triple the level in 2008, according to the Bank for International Settlements.

In 2008, on the eve of the global financial crisis, China’s total leverage – as measured by a ratio of credit to GDP – was 132 percent. It rose to 160 percent in 2012 after an unprecedented 4 trillion yuan was pumped into the economy. Today, however, it stands at 258 percent and is on track to reach 288 percent by 2021, the IMF said. The global total for emerging economies if 189 percent.

Qingdao University economics professor Yi Xianrong said China was essentially asking households to foot the bill for local governments through the state-controlled land and property market.

“By encouraging residents to buy property, governments are de facto shifting their debt to property buyers. As a result, household debt has risen sharply,” he said.

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