Feature Stories | Jul 06 2011
– China has audited its previously unmeasured local government debt
– The result is a much higher level of public debt to GDP than reported
– Economists note reasons why China is different to Greece
By Greg Peel
International scholars Reinhart and Rogoff have proposed that a country's GDP growth begins to suffer once government debt exceeds 90% of GDP. Thereafter, the burden of interest cost and repayments overwhelms a government's ability to invest for future growth. A downward spiral begins.
At the end of 2010, Greece's government debt had reached 144% of GDP and has continued to climb since. With bankruptcy the only eventuality, Greece is being bailed out with EU-IMF funds in 2011 and another package is soon to be agreed upon for 2012. The usual solution when a country gets to this point is to default on sovereign debt and drastically devalue the currency, thus crimping local spending but making that country an attractive place for foreigners to set up factories or for tourists to visit, for example. Both provide valuable foreign currency receipts. This has not happened because Greece is a member of the eurozone and thus shares the common currency with sixteen other nations.
In 1998, Russia defaulted on its debt. It has not been a smooth recovery, but today Russia is included among the emerging market powerhouses.
The US Congress is currently locked in a heated debate about raising the country's statutory debt ceiling. US government debt is currently around 70% of GDP.
Throughout its dramatic GDP growth surge, China has been quietly reforming its financial systems and increasing the transparency of its disclosure. Given the massive foreign currency reserves built up over the past decade, China is not a country which leaps to mind when sovereign debt crises are contemplated. However despite relatively low ratios of reported Chinese government debt, outside observers have always declared concern over the level of local government debt within China and its lack of disclosure. China has not been providing the full picture, they have argued.
One simple reason for the lack of disclosure is that Beijing has always been unsure too. The enormous fiscal stimulus package implemented by Beijing in the wake of the GFC involved, to a great extent, local governments borrowing to fund ambitious infrastructure projects, often with a desire to outdo the local government next door. That is why foreign observers have become concerned over opaque reporting, and also why Beijing commissioned an audit of local government debt this year, the results of which were released last week.
The audit estimates that Chinese local government debt amounted to 27% of GDP in 2010. That figure matches an estimate made just before the release by GaveKal's Dragonomics team based in Hong Kong. Adding this number to the total of China's government debt brings us to a level of 82% of GDP. Throw in GaveKal's estimation of future bad debts from non-performing loans, and China's public debt is 89% of 2010 GDP.
Across the globe, the alarm bells are ringing.
For all its runaway growth, its global importance, and its slow but consistent monetary policy tightening, is China really heading down the path of Greece? With Europe in turmoil and the US running debts it could never hope to repay, a debt crisis in China would surely mean the end of the world as we know it. Three years after the GFC, perhaps the simple interim shifting of private debt into public hands will not prevent the Great Depression II after all.
Fear not, suggest economists. It's not as bad as it may seem. Let us explore GaveKal's conclusions:
China's current public debt burden is the result of two long term processes – one positive and one not quite so positive.
During the 1980s and 1990s Beijing forced state banks to make loans they may not otherwise have wanted to to finance the beginnings of China's push into capitalism and start the rocky road which led to the GDP boom exploding in earnest around 2003. Since then the central government has rightly assumed the burden of those non-performing loans. But given the “magic of rapid economic growth”, as GaveKal describes it, the central government's banking system liability has fallen to 10% of GDP in 2010 from 55% of GDP in 1998. This is the first long-term process.
The second process revolves around the unique nature of China's public debt structure. The Ministry of Finance claims central government debt to be currently only 17% of GDP, but realistically the total of central and local government debt and that of their agencies rose from 20% in 1998 to 70% in 2010. Little of this debt was actually issued by the MOF, rather large public sector entities like the China Development Bank and the Ministry of Railways and a vast number of local government investment corporations account for the loans. Such off-balance sheet public institutions are not unprecedented – Fannie Mae and Freddie Mac in the US are examples – but China does have rather a lot of them.
Official central government (MOF) debt is the most visible and stable of all China's public debt and includes fully disclosed domestic treasury bond issues and a very small amount of foreign borrowings. The ratio of this debt to GDP stood at 7% in 1998 but soon jumped, first to pay for stimulus following the Asian Currency Crisis and then to pay for stimulus following the GFC. As the recent package is phased out, GaveKal expects the ratio to decline once more.
China's old-style ministries such as the Ministry of Railways act as independent financial entities, albeit sovereign backing is implicit. The MOR builds and operates China's passenger and cargo rail network and issues its own bonds which are clearly disclosed. The MOR has been most active under recent stimulus given high-speed railways have been a centerpiece of the package. However while the MOR's debts have doubled as a result, they are only 4% of GDP.
Most of the infrastructure built in China in the last decade has been financed by China Development Bank loans to local governments. Because the bank lends on largely commercial terms, projects must satisfy commercial viability considerations. The CDB's debt in 2010 was 13% of GDP, which is not much less than that of the MOF. But the CDB and other, smaller state banks of similar nature earn commercial revenues and pay interest so they are not a direct draw on the public purse, albeit the ultimate liability lies with the government.
China's central bank, the People's Bank of China, is not independent of the government as is the case elsewhere. When China's trade surplus began to soar from 2003, the PBoC had to buy large amounts of foreign currency to keep the renminbi stable. This it did by printing renminbi and then heading off inflation by making China's banks buy ever more short-term bills. Runaway growth meant the level of this debt hit 15% of GDP by 2008. However the PBoC has now taken to increasing the bank reserve requirement ratio – a multiple of times recently – which has meant a decline by 2010 to 10% of GDP.
Add up all this debt and we reach a total of central government debt of 45% of GDP and that figure has been roughly steady for the last five years, albeit the figure is much higher than 1998's 21%.
Which brings us to where China's real debt binge of the post-GFC stimulus years has been centred – in the state-owned local government investment corporations charged with developing local economies and infrastructure. These entities are supported by the central government with capital or land but operate outside the formal budget.
GaveKal estimates such debt had doubled by 2010 during the stimulus period to 27% of GDP from 14% in 2005-08. This estimate has now been confirmed by the official audit. State and government debt in the US has often been touted as an issue of concern recently but the equivalent US ratio is only 16%. The magnitude of China's local debt is not unprecedented however – India's equivalent is 28% – although disclosure has to date been almost non-existent.
The good news is that 31% of these loans have been made on an essentially commercial basis and should be repayable, such that, again, they are not a draw on the public purse. The central government is nevertheless ultimately liable.
Adding together the two long-term processes of off-balance sheet debt structure and non-performing loan reduction through GDP growth, GaveKal estimates China's public debt to be 89% of GDP, as previously noted. As also previously noted, 90% is considered the threshold of an unsustainable debt spiral.
But GaveKal is not overly concerned. Much of the debt is not a direct draw on the public purse given the commercial nature of funded projects. Debts requiring interest payments directly from government revenues are a much more modest 24% of GDP. And most of the money has gone into infrastructure projects which should generate cash and improve productivity. Given the rush, there will no doubt be some duds – some ultimate white elephants – among the projects, but the amount of debt needing to be paid off by taxpayers is much lower than the total. The likelihood of every public liability coming due is low.
Even if that likelihood were high, China and Greece differ in one important aspect. Greece's debt is owned mostly by foreign investors and the value of that debt is subject to the forces of the open market. The path that has taken Greece close to default has much to do with the Lehman-style, self-fulfilling process of loss of confidence from investors leading to a liquidity spiral. China, by contrast, has foreign borrowings totalling less than 1% of GDP. State-owned banks own the majority of domestic bonds. Hence the only entities which could trigger a crisis of confidence in Chinese sovereign debt are entities owned by the government.
The risk of Chinese default is thus extremely low by comparison. This doesn't, however, mean China's debt levels pose no risk.
One risk, says GaveKal, is that Beijing is inclined to allow high levels of inflation to persist in order to devalue the debt over time, thus crimping GDP growth. Another risk is that China ceases its push towards open financial markets and keeps the financial system closed and highly regulated, leading to inefficient investment and economic stagnation as has arguably been the case in Japan over the past twenty years.
Both these risks would be on the cards if Beijing maintains negative real interest rates, meaning deposit rates below inflation rates, over time. GaveKal notes real rates turned negative in February 2010 and have been so ever since. Beijing is expected to raise rates again before the year is out, but glacial progress to date has economists a little concerned.
And there is still a bit of a rock-and-a-hard place problem here. As the Macquarie economists note, higher interest rates mean a greater cost to local governments of debt repayments, and a GDP growth reduction due to higher rates reduces the revenues from which to pay the debts.
The good news, however, is that inflation in China appears to be peaking and Macquarie expects inflationary pressures to ease in the second half of 2011. What is thus possible is a mix of higher interest rates met by lower inflation creating positive real rates without too much impact.
It was an arduous task undertaken by GaveKal to make its calculations and estimates given a lack of disclosure and the sheer time required for the economists to dig their way through official available data. Yet the economists did come up with a Chinese public debt to GDP ratio which matched that of the official audit, being 27% or 10.7 trillion renminbi (US$1.65trn).
Today, however, ratings agency Moody's has hit the headlines by suggesting that figure may be understated by 3.5 trillion renminbi (US$540bn). Having run their own slide rules over the Chinese audit figures, the Moody's analysts found discrepancies amongst numbers obtained from the various reporting entities. In accounting for these the analysts found more “potential” loans.
If the audit is understated then the level of non-performing loans on the books could be as high as 8-12%, Moody's claims. The analysts' base case level is 5-8% and their “stress” case level is 10-18%. The Chinese auditor omitted the RMB 3.5trn of loans as they were not considered to be real claims on local governments, Moody's notes. This has led Moody's to assume those loans are poorly documented and thus pose a threat.
Unless Beijing comes up with a master plan to reduce the level of Chinese local government debt, the outlook on China's credit will turn negative, Moody's warns.
Given the fact, as noted above, that most of China's sovereign debt is held by Chinese state-owned banks, it is unclear what a “negative watch” from a credit ratings agency might affect.
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