China s Rising Local Government Debts Spark Concerns

Transcription

1 China s Rising Local Government Debts Spark Concerns Sarah Y TONG and YAO Jielu* China s local government borrowing via Urban Development Investment Vehicles (UDIVs) has soared since the late 2008, posing both credit risks for the banks and fiscal risks for the governments. Nonetheless, systemic risks in the near term are limited, considering Beijing s tightening measures, China s relatively strong fiscal position and the banks recent recapitalisation. In the longer term, however, there could be another surge in nonperforming loans associated with UDIVs, especially if the overall economic growth slows down markedly. THE ENORMOUS BANK lending, which played a central role in financing the government s stimulus package, has helped China weather the economic downturn. According to the People s Bank of China (PBoC), new loans in 2009 amounted to RMB 9.6 trillion, almost doubling that of the previous year. In the first half of 2010, the Chinese banks further extended credit totalling RMB 4.6 trillion, around 61% of the annual target set by the regulators. * Sarah Y TONG is Research Fellow at the East Asian Institute, National University of Singapore. YAO Jielu is Research Assistant at the same institute. 38 east asian policy

2 Unlike the rescue programme for the Asian financial crisis in 1998, which was under the strict control of the central government, China s recent stimulus package has been accompanied by substantial local investment projects. To finance these projects, local governments have raised funds from commercial banks and bond investors via various Urban Development Investment Vehicles (UDIVs). Such off balance sheet liabilities of local governments have soared since late Liu Mingkang, chairman of the China Banking Regulatory Commission (CBRC), suggested that the new loans going to UDIVs in 2009 were around RMB 3.05 trillion, or 35% of the total new loans, bringing the outstanding UDIV loans to RMB 7.38 trillion. Economists at Citigroup also expect loans borrowed via those vehicles to reach RMB 12 trillion by the end of Yet the practice of borrowing through UDIVs is rarely new. According to the World Bank, its creation can be traced back to the early 1990s when the central government adopted a national strategy to marketise the infrastructure development function of local governments.since then, UDIVs have been treated as municipal corporations under the Company Law of the People s Republic of China, and function as municipal-level state-owned enterprises. Within two decades, the UDIV model has gained widespread popularity and become a major force in China s urban development. Often, UDIVs at various government levels were established to provide an essential channel to raise capital for local infrastructure projects. CBRC reported...udivs at various government levels were established to provide an essential channel to raise capital for local infrastructure projects. CBRC reported that there were 8,221 UDIVs in China by the end of May 2009, of which 4,907 were established by prefecture and county-level governments. that there were 8,221 UDIVs in China by the end of May 2009, of which 4,907 were established by prefecture and county-level governments. The borrowing via UDIV has been growing fast for three reasons. First, local governments have few sources of funding for their infrastructure projects, since by law they are prohibited from borrowing directly or issuing bonds. Second, infrastructure development is one of the most conspicuous indicators of the success of local leadership as it not only promotes growth but also creates jobs. Last, while local governments are keen in pursuing rapid economic growth in their localities, they need not worry about economic overheating or inflation at the national level. Concerns are rising over local governments large and growing borrowing, especially as a substantial portion of fresh lending by Chinese banks flow to local infrastructure east asian policy 39

3 projects via UDIVs. The worry is that such loans may be subject to higher credit risks. Although the rate of nonperforming loans (NPLs) for major commercial banks in China stood at merely 1.4% by the end of the first quarter of 2010, in large part, it may only reflect a dilution of bad loans by a flood of new lending. Given the intrinsic risks associated with UDIVs, such as relatively low level of information transparency and the lack of effective government supervision, some of these loans are likely to turn sour eventually. In addition, local governments usually provide collateral assets, typically land, for the loans by UDIVs. That adds additional risks to the Chinese banks. As pointed out by central bank governor Zhou Xiaochuan, land could be overvalued during the heyday of property market; if land prices plummet in the future, some UDIVs may default due to the difference in the assessment of the loans. On the other hand, large amount of UDIV loans could also pose fiscal risks for some local governments. As these local governments in many cases extend implicit guarantees on the loans borrowed by their UDIVs, infrastructure projects without sufficient cash flow may have to rely on the governments fiscal revenue to cover interest payment and repay loans. Although China s overall fiscal position is relatively strong, local governments capabilities in repaying the loans vary drastically. The risk of county or township governments defaulting on UDIV loans is much higher than that for provinciallevel governments. With an overheated property market, even provincial-level governments might find themselves deep in debts. Indeed, land sales revenue weighs heavily on local governments total fiscal revenue. If the property market tumbles, the proceeds from land sales to repay government debts could fall short in many localities. The Chinese authorities are fully aware of the brewing risks. In a recent speech to the National People s Congress, Premier Wen Jiabao warned of latent risks in Chinese banks and pledged to stave off an asset bubble. CBRC s Liu Mingkang also reiterated his strong concerns for UDIV loans, pointing out that borrowing by the so-called local government financing vehicles may threaten the banking industry, urging all the banks to heighten their vigilance against any possible embedded credit risks. CBRC also plans to dispatch inspectors to the banks in the third quarter of 2010 to examine UDIV loans and banks capital sufficiency. Indeed, various policies have been employed to slow down the massive borrowings by local governments. First, to tackle the problems associated with existing loans, the Ministry of Finance (MoF) and CBRC ordered banks to re-examine their existing UDIV projects thoroughly. Meanwhile, to prevent problems in new loans, the central government has become more prudent in approving new local investment projects. CBRC also requires that banks rely solely on those projects cash flow sources and collaterals to make lending decisions. With central government s recently heightened vigilance over UDIV borrowing, together with China s relatively strong fiscal position and the recent recapitalisation of major Chinese commercial banks, there seems no large systemic risks to China s bank industry or fiscal health in the near term. However, in the longer term, there could be another surge in NPLs associated with UDIVs, especially if overall economic growth slows down considerably. If that happens, the central government might have to step in 40 east asian policy

4 and take over the loans eventually, which would weaken China s banking sector and perhaps prove costly to the Chinese government if it has to further overhaul and restructure the banking industry. The Myth of Urban Development Investment Vehicles There is neither any official definition to Urban Development Investment Vehicles (UDIVs) nor any specific legal restrictions on the UDIVs investment scope. Known also as local government investment platform, UDIVs are set up by local governments to raise funds for local projects, including constructing and operating of infrastructure, and managing infrastructure-related commercial projects. In practice, they are treated as municipal state-owned enterprises (SOEs), subject to the special rules on fully state-owned companies of the Company Law. Despite many operational structures, most UDIVs are under the direct control of local governments, with the rest reporting to different branches of local governments, such as the Department of Construction, State Asset Management Department, and the Department of Development and Reform. Figure 1 demonstrates how local governments borrow through UDIVs to finance local infrastructure projects. The solid lines show that local governments usually provide collaterals to support UDIV borrowing, as well as the initial capital to get infrastructure projects started. Upon the projects completion, the UDIVs will repay loans through cash flows generated from the projects, or rely on the local governments to settle the issue. FIGURE 1 LOCAL GOVERNMENT S BORROWING VIA UDIVS east asian policy 41

5 FIGURE 2 CHINA S URBANISATION, Sources: China Statistical Abstract 2009; China Statistical Yearbook, 2009 To better understand the nature of UDIVs, it is useful to examine their historical background and relationship with local governments. Since the 1978 economic reform, China s rapid growth has brought about significant urbanisation (Figure 2). By 2008, China had 655 cities and an urban population of 607 million, compared to 193 cities and 172 million urban residents in More specifically, China s urbanisation and urban development are primarily government driven. With this accelerated pace of urbanisation since the 1990s, the demand for capital investment to finance the construction and operation of urban infrastructure has been enormous, which poses serious challenges to governments at various levels. Local governments, however, have few sources of funding. According to the Budget Act and the Guarantee Law, local governments are not allowed to issue municipal bonds or to borrow directly from banks. The 1994 tax reform also weakened local governments fiscal position by significantly increasing the central government s share of tax revenue. Consequently, local governments often face severe fiscal pressure and find themselves having limited financial resources to invest in infrastructure projects. At the same time, local governments have strong incentives to improve local infrastructure and provide public goods as they are widely considered as one of the most conspicuous indicators of a successful local leadership. As a result, UDIVs of various forms have been established since the early 1990s to serve as ideal marketborrowing vehicles for local governments. The development of UDIVs can be divided into three major periods. The initial stage was between 1992 and The Shanghai municipal government is the first to 42 east asian policy

6 set up an UDIV to raise fund for local infrastructure projects. In 1992, it founded the Shanghai Chengtou Corporation to invest, construct and operate the city s infrastructure facilities. Since then, as the role of local governments in infrastructure development underwent transformation, UDIVs have become a way for local governments to marketise infrastructure projects. During this period, the number of UDIVs was few and mostly established by provincial level governments to take up limited functions. UDIVs took off between 1998 and The year 1998 was a critical year for the development of UDIVs. For the first time, an UDIV set up by a local government, Wuhu of Anhui Province, signed a borrowing contract with China Development Bank (CDB) for a package of local infrastructure projects. In 2002, Chongqing municipal government established eight state-owned UDIVs which have sector-specific responsibilities and respective financial teams. This Chongqing UDIV model was so influential that the World Bank started a research project on it in Overall, UDIVs played an increasingly important role in China s urbanisation between 1998 and UDIVs rapid development started in The outbreak of the financial crisis in late 2008 dramatically precipitated the borrowing of local governments via UDIVs. While the central government implemented a moderately loose stance to rekindle the economy, local governments took it as a great opportunity to carry out their infrastructure projects. Take Beijing Infrastructure Investment as an example. By the end of September in 2009, its short-term and long-term loans rose by 41% from the end of 2008, totalling RMB 43 billion, with a credit line of RMB 181 billion from various banks. While the UDIVs have played a significant role in China s infrastructure development, they have several inherent defects. First, UDIVs are subject to a lower degree of transparency requirement. These investment platforms are designed mainly to raise funds for public infrastructure projects. Although they are commercial corporations by definition, UDIVs are not required to disclose project details. In other words, the public do not have access to key information such as corporate governance, project management and financial statements. It intrinsically violates the principle of open and transparent operation of public projects. Moreover, UDIVs also suffer from a lack of effective supervision. Relying on bank loans, UDIVs and their projects are rarely supervised as public spending under governments budget. For example, following the stimulus package introduced by the central government in late 2008, there seems to have been a rapid surge in UDIV borrowing to finance various ostentatious projects. It is quite likely that many of these projects would aggravate the problems of excessive expansion, overlapping investment and low efficiency, while accurate figures to confirm these are hard to come by. Third, many UDIV loans depend on unreliable guarantees by local governments. In cases where assets, typically land, are used as collaterals for the UDIV loans, there may be a huge difference in the assessment of loans when land prices plummet. In other cases where the local governments use implicit guarantees such as guarantee letter of local People s Congress, supporting documents from local government or commitment letter of local department of finance to back the loans, the lending banks could face default risks by local governments. east asian policy 43

7 FIGURE 3 NEW LOANS AND LOAN GROWTH (SEP 2008 TO APR 2010) Source: People s Bank of China New Loans in 2009 When assessing risks associated with bank loans, the ratio of NPLs should be read with caution. Just as its deep decline from 29.6% at the end of 2002 to 6.2% by the end of 2007 was mainly achieved by the establishment of Asset Management Corporations and the recapitalisation of the state banks, the recent improvement in ratio from 5.5% in late 2008 to 1.6% by the end of 2009 was due largely to a substantial amount of new lending which diluted bad loans. A useful alternative is to analyse the allocation of new loans since the start of the financial crisis. New loans, as defined by the PBoC, are the difference between outstanding loans at different points in time. In other words, it is the net increase in outstanding loans. The actual lending, therefore, would be bigger than the new loans reported since some loans would have matured in that period. Though not an accurate account of real new loans, it is the best available indicator to understand China s credit conditions. Figure 3 shows that China had a record year of bank lending in 2009, especially during the first three months, with total new loans amounting to RMB 9.6 trillion and an annual growth in loan balance of 32%. The high number of new loans in 2009 made a significant impact on China s economic structure and the bank industry, throwing light on the relative importance of UDIV borrowing. The composition of new loans could best be understood from two aspects, one by using central bank s report and the other by compiling information from individual commercial banks. Table 1 shows that of RMB 9.6 trillion new loans in 2009, retail 44 east asian policy

8 TABLE 1 NEW BANK LOANS AND LOAN BALANCE, 2009 (RMB BILLION AND %) RMB Billion New Loans % in total Balance Annual Growth Mortgage % % Consumption Loans 224 2% % Farmer Loans and Retail Loans for 661 7% % Commercial Use Sub-total of Retail Loans % % Infrastructure % % Property Development 576 6% % Other Medium and Long-term Loans % % Discounted Bills 457 5% % Work Capital Loans % % Other Corporate 301 3% % Sub-total of Corporate Loans % % Total Loans % % Source: Estimated by authors using data from PBoC loans accounted for around one quarter, or RMB 2.5 trillion. Of corporate loans, RMB 2.5 trillion, or 26% of total new loans went to infrastructure, while RMB 2.2 trillion went to unspecified other medium and long-term loans and other corporate loans. Loans in these three categories are considered as UDIV-related by the market. Therefore, by summing up these loans and subtracting central government-led projects, economists at Citigroup estimated that total new loans via UDIVs were around RMB 4 trillion in Similar conclusion may be reached by examining loan data from individual banks. Table 2 shows the contributions of loans in different categories to annual loan growth in seven major Chinese banks. The banks selected are all listed companies, including three state-owned commercial banks and four joint-stock commercial banks: Industrial and Commercial Bank of China (ICBC), China Construction Bank (CCB), Bank of China (BOC), Bank of Communication (BoCom), China Merchants Bank (CMB), China Citic Bank (CNCB), and Minsheng Bank (MSB). The total amount of new loans lent by these banks in 2009 accounted for 57% of total loans. On average, infrastructure-related loans contributed 30% to loan growth in 2009 while other commercial loans accounted for 22%. Considering that loans under these two categories are likely UDIV-related, the total amount of loans via UDIVs could amount up to 52% of the total, consistent with the estimated 49% based on PBoC statistics. east asian policy 45

9 TABLE 2 CONTRIBUTION TO 2009 YEAR-ON-YEAR LOAN GROWTH % ICBC CCB BOC BoCom CMB CNCB MSB Total Mortgages Other consumer Sub-total of retail loans Manufacturing Infrastructure related Property development Construction Other commercial Sub-total of corporate loans Discounted bills n.a n.a. 4.6 Overseas n.a. n.a. 5.0 n.a. n.a. 0.9 Total Loans Source: Compiled by authors based on financial statements of the banks. Table 2 also shows that different banks have very different exposure to the risks associated with UDIV. For example, infrastructure and other commercial loans accounted for 28% of CMB s new lending in 2009, compared with 53% for ICBC and 55% for BOC. This is largely due to the difference in the banks business focus. Given that CMB concentrates predominantly on the business of small and medium enterprises and retail loans, it stands out with the least exposure to UDIV risks after the financial crisis. Overall, all major commercial banks in China have been active in extending credit to UDIVs, for three reasons. First, the loans are mostly guaranteed, explicitly or implicitly, by local governments. Second, there is excessive liquidity in the financial market. And third, the banks lack capacity in conducting credit appraisal. In the longer term, the banks exposure to risks associated with UDIV borrowing may have a profound impact on the overall quality of their loans and future earning capacity. Policies for Mitigating the Risks The Chinese authorities have made efforts to reduce the risks related to UDIVs by both ring-fencing the stock problems and limiting the flow problems. For the existing exposure, the banks are required to assess all UDIV borrowing and to categorise them into three groups based on their ability to repay the loans: 1) loans for infrastructure projects with cash flow or collateral sufficient to cover the debts; 2) loans for social purpose but reliant on fiscal revenue for repayments; and 3) loans without either sufficient cash flow or credible guarantee from the local government. Specific measures are taken to monitor existing loans in each category. First, the 46 east asian policy

10 UDIVs with loans in the first category may continue to receive credit from banks, although they are required to improve the capital adequacy, introduce private investors and transform into shareholding companies. But implicit guarantees issued by local governments are no longer valid. Second, for loans that rely on fiscal revenue or government subsidies, the Chinese banks are required to investigate the liability of local governments, especially those of county-level governments, to reduce fiscal risk. Moreover, the authorities suggest closing UDIVs relying on fiscal revenue to repay the loans after the loans have been paid if they were designed merely to raise funds. For UDIVs that not only raise funds but also construct and operate the projects, they are required to cease the financing activity after completing the construction and paying back the loans. Third, responsibility for the loans without sufficient cash flow or collaterals must ultimately lie with the local government and banks should take all measures available to mitigate losses and to recoup loans as soon as possible. Regarding the flow problem, or problems associated with new loans, CBRC raised lending standards for UDIVs in early With rising concerns over overcapacity, inefficient spending and local governments fiscal conditions, the central government is especially prudent with the approval of new local investment projects. Besides, the MoF is also mulling the idea of introducing an indicator system to normalise the borrowing of local governments. The system will not only set explicit targets for indicators such as debt ratio, current ratio and debt service coverage ratio for UDIVs, but lay down rules to prevent local governments from defaulting on bank loans. A potentially important policy is that qualified local governments might be allowed to issue bonds in the near future to either build new public projects or repay current loans. It is widely believed that the move would increase the transparency of local infrastructure projects and improve market supervision. Because of the interwoven nature of property market and UDIV loans, the Chinese authorities have also taken various measures to curb speculation in the property market. On the supply side, the Ministry of Land ensures that no less than 70% of new land supply would be used for affordable or small apartments, and it strictly forbids land supply for villas. On the demand side, the State Council requires second home buyers to place a down payment worth half of the property s value and at a mortgage rate of no less than 1.1 times the benchmark rates. Moreover, for the first-house purchase, a minimum 30% down payment must be paid if the unit is bigger than 90 square meters. Chinese banks have already stopped accepting applications for the third house loan. Appraising Risks Associated with UDIVs The substantial debt burden caused by UDIV loans could place a serious strain on local governments, but local governments do have assets. More importantly, it is not likely that the central government would allow local governments to default on bank loans. In fact, local governments borrowing via UDIVs should not amount to a systemic NPL crisis for several reasons. east asian policy 47

11 FIGURE 4 GOVERNMENT S FISCAL REVENUE AND EXPENDITURE 2009 Source: Ministry of Finance First, as discussed earlier, both Chinese banks and regulators have acted promptly to limit problems and reduce risks. Some policies have proved effective. For instance, the monthly lending has declined steadily after the PBoC monitors the credit growth. Second, China s fiscal revenue position is quite strong relative to the size of the potential problem. Since some UDIVs rely heavily on local governments fiscal revenue to repay the loans, it is critical for these governments to have sufficient revenue sources. As shown in Figure 4, in 2009, total fiscal revenue of local governments was more than RMB 6 trillion. Compared with the estimated RMB 4 trillion new loans related to UDIVs, the risk is still at a manageable level. Moreover, the State Council agreed to issue government bonds for local government fiscal deficit which amounted to RMB 200 billion. According to an estimate by UBS, a global financial service company, land related revenue, a source of local governments fiscal revenue which is drawing more and more attention from the public, accounted for only 22% of the total in Therefore, a moderate drop in land-related revenue should not significantly weaken local governments fiscal position. China s ability to grow out of a possible new NPL problem lies in the strength of its economy, which has maintained an average annual rate of over 10% since early This has provided a favourable environment to resolve the potential NPL problems in 48 east asian policy

12 FIGURE 5 CHINA S ECONOMY AND FISCAL POSITION, 1978 TO 2009 Source: National Bureau of Statistics of China the future. Meanwhile, fiscal revenue has grown at an even faster pace, resulting in a rising share in total GDP, from around 12% in the mid-1990s to around 20% in recent years (Figure 5). This has enabled the Chinese government to not only deal with risks associated with UDIV borrowing but also further reform the banking sector. Third, recent recapitalisations by some banks shall help the Chinese banks cover the capital holes created by the credit surge. For example, the Bank of Communications completed its rights issue of RMB-denominated A shares in June 2010, raising RMB billion. To maintain capital adequacy ratio (CAR), China Construction Bank and Industrial and Commercial Bank of China also announced their rights offering plans up to RMB 75 billion and RMB 45 billion respectively in July Although sceptics are wondering whether these moves are efforts to get ready for a looming bad loan surge, the capital boost is a positive sign since it both maintains banks prudent buffers and gives more room for further lending. To conclude, thanks to the huge stimulus package and the supportive lending binge, China s economy recovered swiftly from a significant slowdown in early Although there are serious concerns over the risks associated with the bank loans, especially those via UDIVs, the risks are not an immediate threat to China s banking industry and fiscal health in the near future. Indeed, the Chinese government has been taking this opportunity to make structural adjustments to the economy, regulate the property market and reform the financial sector. east asian policy 49