China’s Debt Swap Gamble

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FT uncovering the conduits for China’s capital flight _ beyondbrics

More Confusion in Local Financing
There have been a spate of articles in recent weeks, including the Wall Street Journal Thursday, saying that local government companies in China are canceling bond issues because of a new policy from Beijing. The policy, called Directive 43, orders local governments to stop backing bonds issued by their off-balance sheet investment companies. The directive states that banks need to “Clearly draw the boundaries of government and enterprises, government debt…and can only borrow through government and its departments.” They specifically single out preventing “moral hazard.” This has scared off issuers and buyers. Without government support, these bonds could become worthless, and China’s fiscal structure could be thrown into chaos.

Local governments and affiliated companies, called Local Government Financing Vehicles (LGFV), have an estimated 20 trillion RMB of outstanding debt. The LGFVs account for about one-third of this amount, or an estimated 7 trillion RMB. Banks are technically prohibited from including government’s ability to pay when they lend to LGFVs as the LGFVs are supposed to be independent companies. However, unofficially, banks generally do assume the debt is municipal and there is recourse to government revenue in case of default. This is the “wink wink nod nod” aspect of local government financing.

The new Directive 43 is supposed to end this practice by forcing investors and lenders to acknowledge the stand-alone nature of LGFV debt — both bonds and loans. Concerned about this new policy, several LGFVs have retracted bond sales, putting in jeopardy the entire current and future structure of local government financing.

Potential for Massive Defaults
That could be a big problem for local governments. The LGFVs became financial forces after China’s 4 trillion yuan stimulus in 2009. Local governments, banned from bank borrowing, set up these off-balance sheet companies as a way to stimulate their local economies — and bypass lending rules. Beijing tacitly agreed. If governments are not behind these debt sales, the defaults could be massive.

Despite the teeth in Directive 43, it appears to show some loopholes. The directive allows exemptions of government backing for certain kinds of projects, but the definition of the nature of these projects is uncertain. There is a phrase that says that should continue to give priority to complete construction projects using bonds “if no other capital is available.” But it doesn’t ban LGFV participation in those bonds. Also, as pointed out by Chinese legal scholar Don Clarke of George Washington University, local governments technically are not allowed to issue bonds without approval from the State Council, which is rarely given.

Another way around this mess could be the Build-Operate-Transfer (BOT) scheme. It is generating a lot of interest because it allows local governments to postpone debt payments on infrastructure while the operator shoulders the burden of debt during construction. But it’s questionable how many operators want to partner with cash-strapped local governments given that most of these projects don’t generate income.

Banks Will Hold the Bag
The bond issuance has become Beijing’s way of trying to clarify the structure of local fiscal financing. It comes as Beijing slows the growth of Shadow Loans. However, most bonds are bought by banks, who will end up purchasing much of the new debt issued by local governments. Generally, the smaller local banks are under greater pressure to buy bonds, because they are under the thumb of local officials. This would implicitly place the debt on local government balance sheets. It’s an endless circle with no end. The metaphor that comes to mind is the shell game — how to find the coin under the shell? In China, often there is no coin.

At the end of the day, the PBOC will have to step in to either purchase or guarantee the bonds on the bank balance sheets, adding to central government debt. Beijing has been loathe to do this as it likes to keep its explicit debt to GDP ratio low — but it will have no choice.

How much capital is at stake? LGFV bonds are about 7 trillion RMB. But their total borrowing is probably closer to 10 trillion RMB, including other loans. Their entire capital structure could collapse very quickly if the bonds are deemed worthless. Some economists have argued that key infrastructure projects could be recognized on government balance sheets and bonds issued against them. But our examination of 20 LGFVs suggests the majority are property projects with little value as infrastructure. They are not “bridges to nowhere” but instead “apartments to nowhere.”

But Do They Have the Capital?
Even if half of the LGFV debt ends up eventually shifting on to bank balance sheets, that would be at least 5 trillion RMB. In 2013, the four state banks had 4.5 trillion RMB in equity, profits and provisions. Additional debt of this magnitude — if written down — would quickly reduce this number to zero. Chinese banks issued $59 billion in convertible bonds last year. Imagine their valuation if LGFV debt was considered to be bank debt….which is almost inevitable.

Rod Macfarquhar of Harvard spoke to a packed house at HKU in January 2015 following a week of teaching classes there. He thinks XJP and the Party are in trouble. The corruption crackdown is likely to be ineffective, and if it works, could lead to a Cultural Revolution style internal battle — even though he believes Xi is the strongest leader since Mao. He views the movement as a combination of factionalism and anti-corruption but there isn’t enough evidence either way at this point. As for his leadership, Deng had to contend with senior colleagues like Chen Yun (an influential Party leader), which Xi does not have.

Xi is also trying to instill a new ideology by reviving small aspects of Confucianism but Rod
doesn’t seem to think this will go anywhere and sees China as ideology-short. “He is taking a very
dangerous road…He’s fighting a very difficult battle to maintain ideological hegemony over his whole
country and nothing to put in place of western ideas.”

He used interesting numbers to demonstrate the problems with hitting the fleas. With 80M in the
party, if 10% are corrupt, that’s 8M. But add in spouses and relatives, and you reach something like
40M — too many for the Party to deal with. “If he gets all the fleas, what’s left of the Party?
There’s no Party. If he goes for the Tigers, is he going to be immune to plots against him? The
Tigers have accumulated massive influence.” The collapse of Russia also is very much on Xi’s mind.
But using the Party to attack the Party — which Gorbachev failed to do — may lead to the death of
the Party.

The Q&A had two noteworthy questions. One about rumors from “friends in Beijing” that Jiang is next.
He skirted that one. The second was about the future of HK. He said the PRC will have difficulty
replacing the various institutions in HK anytime in the near future.

I had two thoughts. One is that the Party may be more flexible than he believes…his research has
focused on the Cultural Revolution and he may be using that as a paradigm, a time of chaos. The rise
(and rather quick fall it seems to me) of the Guangdong model was nonetheless a hopeful sign. The
second is the impact of the economy on China — can Xi potentially tackle visible corruption (e.g.,
watches and banquets) and ignore bigger corruption (local companies stealing governments blind),
thus convincing the populace the Party is not corrupt but allowing cadres to steal; keeping the
system alive?