More On China to Clean Up Toxic Local Government Debt

This report by Reuters, suggesting that China was about to Do Something about its local government dud loans created a lot of chatter among investors:

China’s regulators plan to shift 2-3 trillion yuan ($308-463 billion) of debt off local governments, sources said, reducing the risk of a wave of defaults that would threaten the stability of the world’s second-biggest economy.
As part of Beijing’s overhaul of the finances of heavily-indebted local governments, the central government will pay off some of their loans and state banks including some of the “Big Four” will be forced to take some losses on the bad debt, said the sources, both of whom have direct knowledge of the plans.
Part of the debt will also be shifted to newly created companies, while private investors would be welcomed in projects previously off-limits to them, sources said.
Beijing will also lift a ban on provincial and municipal governments selling bonds, a step aimed at bolstering their finances with more transparent sources of funding.
Many analysts see China’s pile of local government bad debt as a major risk to the economy, especially as the economy slows, but few see widespread banking fallout as they believe cash-rich Beijing can step in to soak up losses.

Um, the Reuters writers need to be a tad more accurate: “shift 2-3 trillion yuan ($308-463 billion) of debt off local governments” does not amount to “reducing the risk of a wave of defaults.” It may prevent nasty knock-on effects, but only economic stimulus or borrower assistance can reduce default risks.

One expert compared the scale of the Chinese local government funding vehicle problem to US subprime mortgages. Since there was never an agreement on what “subprime” mean, market size estimates varied a lot, but they clustered around $1.1 to $1.3 trillion, or 8-9% of GDP. By contrast, this local government debt is 9 trillion RMB, or 30% of GDP, and the officialdom has now tagged 2-3 trillion as in need of restructuring. That is equivalent to the size of the total subprime market in 2007, and remember, even as bad as subprime has turned out to be, losses are expected to be 30% (40% eventual defaults with 75% losses). By contrast, on construction projects, loss severities of over 100% are not uncommon (the project turns out to be worthless, so the losses on the loans are 100%, and you have to spend money clearing the land for it to be resold). And remember, we are seeing this level of bad loans in a strong economy.

While some analysts gushed that this move would improve the perception of bank capital levels (an odd benefit given that the banks are all state creatures in one form or another), Michael Pettis was not terribly impressed:

How important is this announcement? It is good that the extent of the problem is being recognized and quantified, but this announcement doesn’t do much more than that. And I think there is a lot of confusion given what I read in the Reuters and other articles. First, this announcement, if it is true, doesn’t much change the risk profile of either the local governments or the banks because they were anyway implicitly or explicitly guaranteed. Second, the real issue here is not who gets to carry the liability, but rather who is going to foot the bill for the losses, and of course that hasn’t been addressed. As I see it there are only three sources of repayment.

1. The government can privatize land and assets and use the proceeds to pay for the losses. This might be very difficult politically right now, but ultimately I suspect that they are going to move in this direction.
2 The government can tax or confiscate wealth from SMEs and the wealthy: this is politically expedient since SMEs don’t seem to have much power as a bloc, but this could cripple long-term growth prospects if it causes SMEs to disinvest.
3. The long-suffering household sector can bear the losses once again, but of course this pretty much eliminates any hope of getting the consumption share of GDP to rise and become the driver of future GDP growth.

It is of course good that they are formalizing and recognizing the extent of the possible losses — everyone’s favorite solution of ignoring the problem is unlikely to have helped much. Perhaps these huge numbers, now that they are quantified and recognized, can push the debate forward, but in my opinion we still haven’t addressed the main issue: how will this debt be repaid and when will they slow down and reverse what has clearly become an unsustainable increase in debt?

In other words, this looks like a confidence building exercise, and it is oddly reminiscent of late 2007 and early 2008, when banks would announce big writedowns, the markets would rally on the belief that they had put their troubles behind them, when in reality, their troubles were only beginning. Here, the scale of the problem being ‘fessed up to (almost certain to be only a portion of the ultimate problem) and the lack of a real plan to deal with losses (mechanisms are not a plan) are far from encouraging.