Chi on China China s Debt Conundrum (II) The Local Government Debt Problem

Transcription

1 For professional investors 26 October Chi on China China s Debt Conundrum (II) The Local Government Debt Problem SUMMARY China s local government debt (LGD) risk is rising, but it is not fatal. The problems do not lie in the size of the debt but in its opaque nature, its balance-sheet mismatch structure and the high concentration of bank exposure to it. The central and western regional governments appear to have the highest risk profile. Toll road debt is also under pressure. Even when only 20% of all LGD is recoverable, the systemic shock on Chinese banks is still manageable. Overall, favourable debt dynamics and ample financial resources at the government s disposal for any necessary bailouts will help prevent the local government debt bomb from exploding in the medium-term. If Beijing were to bailout all the LGD quickly, it would be very positive for the banking sector. The special audit by the National Audit Office (NAO) in June this year shows that China s local government debt grew by about 13.0% in total between 2010 and 2012 to an estimated RMB 12.1 trn from RMB10.7 trn in This indicates a local government-debt-to-gdp ratio of 23% in 2012, down from 27% in Bank loans remained the key funding source, accounting for 78% of total credit to the local governments in 2012, compared to 79% in But bond financing, through local government financing vehicles (LGFVs), surged to 12.1% of total LGDs in 2012 from about 7.0% in The LGD problems The NAO s RMB12.1 trn LGD estimate is not far from Fitch s estimate of RMB12.85 trn (or 25% of GDP). This is well within manageable limits. Hence, the problems with the LGD are not related to its size. They are about their opaque nature, which took the form of LGFVs (off-balance items with a hidden ownership structure) and the balance-sheet mismatch structure of the debt.

2 China s debt conundrum (II) 26 October Official data shows that over half the LGFV debt (including that in the form of bank credit) matures in less than three years. However, such debt is invested in long-term, mainly infrastructure and social, projects that do not generate enough cash flows to service it. This debt structure is seen in the NAO s special audit results, which showed that illiquid assets accounted for 37.6% of all LGFV assets. Crucially, 68% of the LGFVs did not have enough income to make interest and principal payments and they needed to either rollover their debts or receive public fund injections in Such a balance-sheet mismatch debt structure is systemically unstable due to interest rate fluctuations. The debts of the central and western regional governments appear to have the highest risk profile. They account for 23% and 27%, respectively, of total LGD, but only 18.9% and 18.6%, respectively, of all local fiscal revenues. This suggests that the interior regional governments have borrowed beyond their ability to repay (Chart 1) and, thus, are more susceptible to credit or interest rate shocks than the eastern regional governments. Toll-road debt is also under pressure. Provincial debts incurred to fund motorway projects have surged by 37% since However, the economic slowdown has meant less road freight, and there has also been an increase in toll-free travel. All this has reduced the revenues of the new toll roads and made it difficult for the local government to service their debts. The NAO special audit showed that eight local governments out of the 18 audited had to rollover their debts with new loans and three had fallen into arrears in Systemic risk still manageable Chinese banks are central to this issue as almost 80% of LGD is from bank loans. So how safe or dangerous is the Chinese banking system? The NAO special audit found that 37.6% of LGFV assets were illiquid, which suggests that local governments would be unable to recover the full value of these assets. To be conservative,

3 China s debt conundrum (II) 26 October let us assume all this illiquid debt to be non-performing loans (NPLs). Let us further assume a 20% NPL recovery rate 1. From official data, the total capital in the Chinese banking system in 2012 was RMB8.19 trn, including RMB6.43 trn in Tier 1 capital; the total risk-weighted (RW) assets was RMB60.6 trn. All this implies a core-capital-to RW assets ratio of 10.6% and a total capital ratio of 13.5%. Moreover, the banks had RMB0.49 trn of NPLs, but they held RMB1.46 trn of total loan loss provisions (implying a loss coverage ratio of almost 300%). We assume that the banks would use the excess provisions of RMB0.9 7 trn (i.e. RMB1.46 less RMB0.49 trn) to offset their LGD losses. Table 1 works out the systemic risk. Table 1: Systemic risk of LGD on banks (2012) Total LGD RMB trn 78% funded by banks RMB 9.44 trn Assume 37.6% NPL RMB 3.55 trn a Loss to banks (assuming 20% recovery rate) RMB 2.84 trn b NPL provisions RMB 0.97 trn c Net loss to banks (= a - b) RMB 1.87 trn From the official data: d Tier 1 capital RMB 6.43 trn e Total capital RMB 8.19 trn f Risk-weighted (RW) assets RMB trn All this implies Tier 1 capital to RW assets ratio (= d/f) 10.6% Total capital to RW assets (= e/f) 13.5% Estimated hit on the banking system Loss as % of Tier 1 capital (= c/d) 29.1% Loss as % of total capital (= c/e) 22.8% Loss as % of RW assets (= c/f) 3.1% New Tier 1 capital to RW assets ratio (= [d-c]/f) 7.5% New total capital to RW assets ratio (= [e-c]/f) 10.4% => Tier 1 capital to RW assets ratio drops by 3.1 ppts => Total capital to RW assets ratio drops by 3.1 ppts sources: NAO data, BNPP IP (Asia) estimates 1 This 20% recovery rate is consistent with the experience of China s commercial banks asset management companies. See Fung, Ben and Guonan Ma (2002), China s Asset Management Corporations, BIS Working Paper 115, August.

4 China s debt conundrum (II) 26 October Based on this information, we estimated that when a systemic shock hits and with only a 20% NPL recovery rate, the net loss to the banking system would be RMB1.87 trn after the application of loan loss provisions. This would reduce banks core and total capital by 29% and 23%, respectively. In turn, this would reduce the banks capital-to-rw assets ratio by 3 percentage points, taking the Tier 1 capital to 7.5% of RW assets from 10.6% before the systemic shock. However, this remains 0.5 percentage points above the minimum Basel III Tier 1 capital requirement of 7.0%. The point is that while the systemic risk from LGD is still manageable, the margin of error is small. If the size of the LGD is larger than the NAO s estimate, the system s core capital ratio would easily fall below Basel III s required 7% minimum. For example, if former Chinese Finance Minister Xiang Huaicheng s LGD estimate of RMB20 trn was correct 2, Tier 1 capital in the banking system would have fallen to only 4.5% of RW assets. Further, this macro analysis masks problems at individual banks. Those banks owned, or controlled, by the local governments are especially worrying due to their significant and direct exposure to the local authorities. Favourable debt dynamics and financial resources Favourable debt dynamics are also on China s side. Its nominal GDP growth rate averages about 13% a year, though this is expected to slow towards 7%-8% in the medium-term. The average funding cost of the public debt is about 6%. As long as the nominal interest rate is lower than the nominal GDP growth rate, China can easily sustain a debt-load far higher than it is today. Direct central government debt is only 15% of GDP. If we include the debts of government agencies, such as the policy banks, the Ministry of Railway and the four asset management companies, total central government debt is about 30% of GDP. Add the LGD (23% of GDP), and China s total government debt is still below the 60% danger mark. It is also below many other countries total debt-to-gdp ratios, though it is the highest among the BRIC countries (Chart 2). In short, the Chinese government has the capacity to take on the LGD if it has to. 2 See Massive debt plagues local gov t, China Daily (USA),

5 China s debt conundrum (II) 26 October Indeed, the government has enormous financial resources. It owns the country s land and has controlling stakes in many listed companies. These assets can be privatised, if necessary, to raise funds to fend off any local government debt crisis. In the worst case scenario, even if China had to monetise its local government debt, its current account surplus, which is expected to remain in the medium-term, would ensure that no externally-driven crisis would crush the domestic system. Not a fatal problem Bailouts will be inevitable to resolve the local government debt problem. But unlike in the developed world, where governments hands are tied by their dire financial positions and huge debt burden, China has many options, including funding from fiscal revenues, asset sales and refinancing. Local governments may also be allowed to issue bonds soon to finance their social projects and replace their bank borrowing. If the central government were to take the entire LGD burden off the local governments balance sheets quickly, it would be positive for the Chinese banking sector, as it would remove a significant debt-overhang on banks potential losses over time. But if such action were to be taken without structural and regulatory reforms, it would only increase moral hazard and, hence, the systemic risk further down the road. Going forward, Beijing is likely to increase regulatory control on local government borrowing from shadow banks and on the operations of the shadow banking market. This is a step towards improving credit risk management, but it will also slow investment growth as it will tighten local governments funding sources. It is unlikely that Beijing will come down too hard on the local government debt problem, as such a move may trigger systemic risk. In Beijing s policy framework, a stable macro growth environment is needed to help sustain structural reforms. This means that the leadership will not risk a sharp deleveraging of the local government sector that could set off a potential financial crisis. Capital reallocation rather than quick and significant deleveraging will be the policy priority in the medium-term. Chi Lo Senior Strategist, BNPP IP

6 China s debt conundrum (II) 26 October DISCLAIMER This material has been prepared by BNP Paribas Asset Management S.A.S. ( BNPP AM )*, a member of BNP Paribas Investment Partners (BNPP IP)** and is made available in Australia by BNP Paribas Investment Partners (Australia) Limited ABN , AFSL , ( BNPP IP ). It is produced for general information only and does not constitute financial product advice. You should consider obtaining independent advice before making any investment decision in relation to any financial product referred to. The value of investments can go up and down. Past performance is not necessarily indicative of future performance. Any opinions included in this document constitute the judgment of the document s author at the time specified and are subject to change without notice. Given economic, market and other risks, there is no guarantee that any investment strategy referred to in this document will achieve its objectives. The contents of this document are based upon sources of information believed to be reliable, but no warranty or declaration, either explicit or implicit, is given as to their accuracy or completeness. BNPP IP to the extent permitted by law, disclaims all responsibility and liability for any omission, error, or inaccuracy in the information or any action taken in reliance on the information and also for any inaccuracy in the information contained in the document which has been provided by or sourced from third parties. *BNPP AM is an investment manager registered with the Autorité des marchés financiers in France under number 96-02, a simplified joint stock company with a capital of 64,931,168 euros with its registered office at 1, boulevard Haussmann Paris, France, RCS Paris ** BNP Paribas Investment Partners is the global brand name of the BNP Paribas group s asset management services.