Analysis-China can no longer 'extend and pretend' on municipal debt

 Analysis - China can no longer "extend and fake" municipal debt

BEIJING (Reuters) - China's promised "basket of measures" to ease local government debt risks is likely to include issuing special bonds, debt swaps, credit transfers and something Beijing really hates: dipping into the central budget.

Local governments are crucial to China's economy, with Beijing tasking provincial and city leaders with ambitious growth targets. But after years of overinvestment in infrastructure, plummeting revenue from land sales and soaring COVID costs, economists say indebted municipalities now pose a major risk to China's economy.China's leaders promised without detail last month to help ease their debt, signaling concerns about a potential chain of municipal debt defaults destabilizing the financial sector.

Economists saw the report as more constructive than in April, when Communist Party leaders called for "strict control" of local debt. The implication, they say, is that Beijing has realized it needs to throw money at the problem urgently.This could represent a major breakthrough in finding a way out of China's municipal debt crisis, where Beijing has for years demanded that local administrations fend for themselves.

"The issue of local debt is complex, so you can't simply say you don't want to take responsibility," Guo Tianyong, a professor at Beijing's Central University of Finance and Economics, explained the Politburo's instructions.

The extent of any central government involvement and any conditions attached are still up for debate, two political advisers told Reuters. It also remains unknown whether the package of measures will be short-term or multi-year.

These details will be for investors to assess how decisive and long-term Beijing's solution will be."The size of any restructuring and the scale of the problem that Beijing recognizes are important to the success of this effort," said Logan Wright, a partner at Rhodium Group.

THE BEIJING DILEMMA

Local government debt will reach 92 trillion yuan ($12.8 trillion), or 76% of economic output in 2022, up from 62.2% in 2019. Part of it is debt issued by local government financing instruments (LGFVs), which cities use to raise money infrastructure projects. The International Monetary Fund expects LGFV debt to reach $9 trillion this year.

The central government, which has repeatedly warned of the "risks of hidden debt", fears the figures are even higher when debt issued off municipal balance sheets is accounted for.It's an unsustainable situation that puts Beijing in a bind: provide no aid and the economic model crumbles with serious consequences for growth and social stability, or step in and risk encouraging more reckless spending.

"A principle should be established: not all debts will be taken over by the central government," a political adviser told Reuters on condition of anonymity.To avoid this risk, the adviser suggested that all stakeholders should bear part of the burden: financial institutions, local governments, Beijing and society as a whole.

Most economists expect Beijing to instruct state-owned banks to continue rolling over maturing debt with longer-term loans at lower interest rates, a strategy often referred to as "extend and fake."

However, banks must be selective based on the scale and urgency of any refinancing task. Debt restructuring hurts their own balance sheets and limits their ability to finance other parts of the economy.

For many local governments, "to maintain vital functions you need transfers from Beijing and to develop you need to issue bonds - the central leadership is aware of this," a state bank source told Reuters after a recent working trip to the two debt-ridden provinces.

Municipalities will be primarily responsible for cleanliness.

Local governments are likely to use remaining bond issuance quotas from last year to replace "hidden debt" with official bonds on their balance sheets, with up to 2.6 trillion yuan to be issued, according to analysts.

Such a move has a precedent. From 2015 to 2018, local governments issued approximately 12 trillion yuan worth of bonds, which were exchanged for off-balance sheet debt.Beijing may also ask certain locations to sell or use assets to raise funds.

"Local government and LGFV debt extensions and de facto restructuring, particularly at banks, are likely to be encouraged, while local governments may also be forced to sell or freeze some assets," said Tao Wang, chief China economist at UBS.Then comes moderate Beijing, which has the most room for maneuver with central government debt at just 21% of GDP.

Beijing issued 1 trillion yuan in special bonds in 2020 to cope with the pandemic, 1.55 trillion in 2007 to recapitalize its sovereign wealth fund, and 270 billion yuan in 1998 to recapitalize the "big four" state-owned banks.=

"The central government can issue cheap bonds to replace local debt," said a second political adviser.The yield on China's 10- to 30-year government bonds is 2.7 to 3.0%. Some cities and LGFVs pay 7-10% interest.Guo, the professor, said such swaps should exceed 1 trillion yuan this year to make a difference.

More generous direct fiscal transfers to fund vital public services could also be thrown in the bin, analysts say. The path is well-trodden: the Ministry of Finance expects a record 10 trillion yuan in such transfers this year, up 3.6% from 2022.In order to stop the problem of local debt from reappearing, politicians must introduce deep changes in the functioning of the economy.

BBVA analysts recommend diluting growth criteria when evaluating local government officials.But in the end, Beijing and Chinese society may have to accept lower growth after four decades of expanding at a staggering pace.

"Whether Beijing will be able to accept a significant slowdown in local government investment, and thus economic growth, will be one of the most important questions in any restructuring," said Rhodium's Wright.

In recent years, China's rapid economic growth has been accompanied by a sharp increase in municipal debt. Municipalities across the country have resorted to aggressive borrowing to finance ambitious infrastructure projects and sustain local economic development. 

While this debt-based strategy has fueled China's economic expansion, it has also raised concerns about the sustainability of the approach. As the global economic landscape evolves, China can no longer afford to "stretch and pretend" when it comes to municipal debt. In this article, we delve into the challenges posed by China's mounting municipal debt and explore viable solutions to ensure financial stability.

Impending debt crisis:

China's municipal debt is rising, posing a significant risk to the country's financial stability. Local governments have used shadow banking and off-balance sheet financing to accumulate debt, making it difficult to gauge the true extent of their indebtedness.

 The lack of transparency in reporting the exact numbers has fueled speculation about the size of China's debt problem, raising concerns among investors and international organizations.China's municipal debt crisis, shadow banking, off-balance sheet financing, financial stability.

The "extend and pretend" approach:

The "extend and fake" strategy refers to the practice of local governments continually rolling over existing debt and delaying the recognition of losses. They can thus maintain the illusion of financial stability while at the same time postponing the necessary structural reforms and adjustments. This approach has allowed the problem to worsen over time, leaving potentially catastrophic consequences for the Chinese economy and the global financial system.

 expand and pretend, structural reforms, financial stability, China's economy.

Debt Sustainability: The main problem with China's municipal debt is its sustainability. A rapidly growing debt burden can lead to repayment problems, raising the specter of default. This could have cascading effects on financial institutions and international investors.

 debt sustainability, repayment problems, default risk, financial institutions.

Economic slowdown: As China's economy matures and faces cyclical headwinds, the debt-led growth model may no longer be as effective at stimulating economic activity. A possible economic slowdown could deepen the debt burden and make it more difficult for local governments to manage their financial obligations.

 economic slowdown, debt-driven growth, financial obligations.

A. Better transparency: The first step in solving China's debt crisis is to improve transparency in reporting. Accurate and timely disclosure of debt data can help restore investor confidence and provide a clearer picture of the situation. transparency, accurate reporting, investor confidence.

 Fiscal reforms: Implementing fiscal reforms that focus on revenue generation and expenditure management can help local governments reduce their dependence on debt financing. Promoting more sustainable income streams and prudent spending practices will contribute to long-term financial stability. fiscal reforms, revenue generation, expenditure management, debt financing.

 Strengthened Oversight: Robust oversight mechanisms must be established to monitor and regulate the borrowing activities of local governments. This includes limiting off-balance sheet financing and limiting the use of shadow banking channels.

strengthened supervision, regulation, off-balance sheet financing, shadow banking.

China can no longer afford to "stretch and pretend" when it comes to its mounting municipal debt. The increasing debt burden poses significant risks to the country's financial stability and economic growth. To protect the economy and restore investor confidence, China must embrace transparency, implement fiscal reforms and strengthen oversight mechanisms. By taking proactive measures, China can chart a path to sustainable growth and mitigate the looming municipal debt crisis.