Hanging China by a thread - Local Government Financial Vehicles: the Adversities and the Answer King Kai Wing Christina

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1 Hanging China by a thread - Local Government Financial Vehicles: the Adversities and the Answer King Kai Wing Christina In the 21 st century, China becomes a synonym of an economic miracle. While its rapid economic growth has taken the globe by surprise, some begin to question its sustainability. A deeper investigation will soon uncover that despite the betterment of financial overview as denoted by declining non- performing loan ratios, a series of complications are hidden beneath the sugarcoat. Local Government Financial Vehicles (LGFVs) is one of them. In 1994, amid a series of reforms of market organization and political centralization, the PRC Budget Law forbids local governments to directly borrow from the financial market. Against the backdrop, local government financial vehicles emerged to fill the fiscal gaps that bother many local authorities. What is a LGFV? LGFVs are municipal state- owned enterprises under China s company law. They serve as the financing agent of various layers of local governments. Based on the capital injected in forms of budget revenue, public land use rights and other rights e.g. receiving T- bonds on behalf of the local government, these companies raise additional funds from banks as well as the equity and/or bond market. It usually begins with securing long- term loans from the China Development Bank with land as collateral. With this initial funding, it then borrows short term loans from state- owned commercial banks or sell bonds on the inter- bank bond market. These companies then directly invest in construction and public welfare projects. Ideally they will be able to settle their debts with the profits from their public projects, or alternatively through property sale. In many cases, they rely on further injections from local governments, which comprises tax revenue, central government transfer and government managed funds. All these additional funds are ultimately linked with land sale revenue. In this model, local governments circumvent the Budget Law financial restriction and deliver public services through these purportedly independent entities. These entities are blessed with

2 the best of both worlds. On one hand, they enjoy huge flexibility in debt financing. At the same time, these entities have significant fund- raising capabilities with the guarantees of local government and public assets as collaterals. LGFVs growing importance LGFVs play an increasingly crucial role in public financing in the past 2 decades. A major reason is tax centralization. Since 1994, central government monopolizes the most lucrative sources of fiscal revenue the value- added tax, resource tax, personal tax and enterprise income tax. In 2002, local governments are obliged to further contribute 50% of personal and enterprise income tax to Beijing. Scholars estimated that local governments are now shouldering 80% of total fiscal expenditure with only 50% of total tax revenue. Graph 1 illustrates that after the reform in 1994, local governments are generally suffering from serious fiscal deficit. The wide fiscal gap persists till today. Graph 1: local government revenue and expenditure (% of general government revenue and expenditure) Such local fiscal deficit deteriorates when local governments are obliged to enforce costly national policy without proportionate financial support from Beijing. An instance would be the 4 trillion fiscal stimulus package in In that scenario, Chinese government injected 4

3 trillion yuan in total to shield Chinese economy from the global financial shock. They are invested to infrastructure, large- scale engineering projects and social welfare housing construction. However, over 60% of the funds came from local governments. The financial burden of local administrative branches is thus aggravated. Therefore, LGFVs appears as the panacea to many local governments who have been struggling to make ends meet. Unfortunately, one coin has two sides. And the LGFV model is no exception. The Adversities LGFVs clouds Chinese public finance and ultimately the Chinese economy with their recklessness, doubted creditworthiness and vicious cycles they brought to the Chinese financial market. Reckless lending and investment LGFVs are notorious for their risky and loss- making activities, which are attributable to three reasons. First, an unsually high moral hazard risk is imprinted in the nature of LGFVs. While local governments often pledge to serve as deep pockets once LGFVs default, the local governments also expect bailouts from the central government under the unitary governing structure. This contrasts the case of America where federal government bears no responsibility to bail local government out in bad times. Loans are thus available to LGFVs even if both the LGFVs and its supporting administrative branch appear creditworthless. Second, objective assessment of risk is often impossible. The lack of transparency of LGFVs and local governments makes it very difficult for lenders to objectively assess the creditworthiness of their borrowers, especially when extra- budgetary revenue and expenditure are left in the dark. At the same time, banks are often under pressure to support these local initiatives so as to maintain a friendly relationship with local and even central government. This brings about many uninformed and imprudent lending decisions.

4 Third, the ambitious local government officials tend to be injudicious. Since they are evaluated with the economic growth of their district, they favour short term GDP boosters despite their underlying unsustainable debt financing. Their short term of office further motivates them to meet aggressive economic goals or national policies without considering its fiscal implications in the long run. Uncertain debt repaying capabilities Another issue lies in uncertainty in debt repaying capabilities. As explained above, these LGFVs often engage in unprofitable projects. The debts owed to lenders are eventually paid off through land sale revenue (either directly generated by LGFVs or first generated by local government then injected to LGFVs). This model is in fact logical LGFV may first use a piece of undeveloped land as a collateral to borrow. With more funds it may construct infrastructure on top of the land. Since the construction project is presumably value- adding, the value of land rises and the sale is profitable. The LGFV may hence repay the loan and the interest with the profit and pocket the rest of the revenue. The success of this theory however presumes eternal appreciation of land price. One should not forget that this is not necessarily the case, since LGFVs not only invest in infrastructure delivery of public services is often less profitable and does not top up the value of that piece of land. This leaves the financial viability of LGFVs prone to turbulence of the real estate market. Once the property price drops, the profitability of these public projects will be questioned. More importantly, given the lengthy payback period of these public projects, many LGFVs heavily rely on short- term loans to remain liquid. A plunge in property value means depreciation of LGFVs assets as collaterals, and thus a sharp decrease in their capacity to borrow. This is likely to trigger a break of capital chain, where default follows.

5 Vicious circles in financial market The over- expansion of LGFVs may further induce two unhealthy circles in the Chinese financial market, which can snowball into sovereign risk. To begin with, many poorly performing LGFVs have a high risk of default. Once they are insolvent, the capital market will respond by repricing the credit risk in LGFVs, which occasions higher interest rate and consequentially a even higher risk of default of other existing LGFVs since they cannot afford the higher interest rate. More LGFVs will default and the vicious circle of default LGFVs then continues. Even if the government manage to interfere, the cycle of credit expansion, followed by credit loss and later government bailout will only encourage further unsustainable credit expansion, since LGFVs now assume governments as their unconditional guarantors. This may prompt escalation of government debt, which reduces government s creditworthiness and in the long run lead to loss of confidence in the whole Chinese financial market given the implicit yet pivotal involvement of the Chinese government behind the banking and financial industries. The Answer In light of the alarming level of off- balance sheet local debts and the non performing loans LGFVs create, the government should implement a multi- pronged solution. In fact, Chinese government has begun some reform in the same direction, but as analysed below the policies are to be enforced to a fuller extent. Diversification of local government financing municipal bond In 2016, the Budget Law is revised with a view to regulating LGFV activities and enabling alternative financial means. Under the amended law, local governments are no longer able to provide guarantee for firms, private institutions or persons without legal authorizations. On top of that, municipal bonds are introduced. Certain provincial governments are now allowed to issue government bonds to finance their investment projects with the approval of the National People s Congress. This is a right move in line with the macro transition from

6 planned economy to market economy. The introduction of market force into the public finance will encourage efficiency the market will selectively fund prospective public projects, and loss- making investment is discouraged. Nevertheless, at this moment the bond issuance mechanism is still under stringent control of the central government. Scrutiny from Beijing is present in every step, from permission to issue, size of issuing to determination of coupon rate. In fact, given the strict repayment requirement through the Ministry of Finance, these local bonds are sometimes described as quasi- treasury bonds that works far from decentralization of fiscal power. With the scrutiny by central government rather than the market, the scope of the issuance scheme remains extremely limited. The red tapes involved also undermines the efficiency of such financing channel, which is further impaired given central- local politics. This renders the current reform a drop in the bucket. On top of that, the existing tax- sharing system best proves that central government is extremely inefficient in catering local need. To enhance efficiency in budgeting, an ideal bond issuance system eventually requires withdrawal of the central government and genuine entry of the market force. PPP and transparency The central government also encourages public projects to be sponsored by public- private partnership (PPP). Compared to the LGFV model, in a PPP the private sector assumes a more active role by participating in project planning and execution. This also enhances efficiency of public finance. Be it issuance of local bonds or PPP, marketization of public finance requires transparency. Ultimately the price of bond and the market attractiveness of public- private project should be determined by the market. To allow accurate market assessment of credit risk, the Chinese government should promote the culture of financial reporting, where different layers of government regularly disclose in public their fiscal positions, including their contingent liabilities and extra- budgetary revenue and loss. This also serves as a prerequisite of a credit rating system, which can be introduced in the future to assist private investment decisions.

7 Matching of power, Healthier economic growth and Appraisal based on debt ratio Currently, local governments are in lack of fiscal power to support their policies. The mismatch of fiscal and administrative power of local government widens the local fiscal gaps, which induces the emergence of LGFVs. Reflections should be made as to centralize policy- making authority or decentralize fiscal power. An important remark however is that local government ought to be duly supported in financial terms when they are to enforce national policy, such as national fiscal stimulus or China s Western Campaign. Moreover, China should opt for a healthier economic model e.g. consumer- led economy. The GDP growth of China in recent years is supported by the very unsustainable investment in infrastructure which does not generate quick return, incurring fiscal debts to no one s benefit. Last but not least, the central government may provide individual incentive to local officials. Local officials should also be appraised with reference to debt ratio, rather than purely short term economic development or welfare improvement. This will discourage reckless investment decisions. Conclusion LGFVs are one of the many anomalies in the Chinese financial market where its capitalist development contradicts with its socialist roots. It stems from the fiscal gap and the grey area of the then Budget Law to offer local governments an alternative source of capital. While some successful LGFVs launched popular welfare programs that benefit many, others present significant financial risk given the reckless nature of investment, uncertainties in repaying capabilities and vicious circles it introduces to the financial market. The Chinese Government is aware of the alarming phenomenon and initiated some reform that encourages a more efficient introduction of private capital into public projects. While the overall direction is correct, the government is expected to do more. Further relaxation of local financing rules, promotion of transparency, healthier economic growth and improved personnel appraisal system are steps to be taken.

8 References Fan, L. (2015) Quenching Thirst with Poison? Local Government Financing Vehicles Past, Present, and Future. In Regulating the Visible Hand?: The Institution Implications of Chinese State Capitalism. Oxford: Oxford Scholarship Online. Lu, Y. & Sun T. (2013) IMF Working Paper: Local Government Financing Platform in China: A Fortune or Misfortune? Retrievable at Wu, X. (2015). An Introduction to Chinese Local Government Debt. Retrievable at content/uploads/2013/08/policy- Report- of- Chinese- Local- Government- Debt- final.pdf Zhong, H. & Lu, M. (2015). Europeanization of Chinese Economy. (translation) Retrievable at