Credit FAQ: Chinese Local Government Debt Is In The Spotlight Once Again

Local government debt concerns in China (AA-/Stable/A-1+; cnAAA/cnA-1+) have intensified yet again. This is not a new worry (see "Is Chinese Public Finance As Good As It Looks?", published Sept. 4, 2006, and "Credit FAQ: How Big A Worry Are Chinese Local Government Debts?", published March 14, 2010, on RatingsDirect on the Global Credit Portal). Many have expected nonperforming loans at banks to soar since 2009, when lending growth took off. In late 2009, local government-owned companies known as financing platforms or LGFPs became the center of attention as a major source of credit risk to banks. Chinese local governments at all levels had set up LGFPs to carry out public projects such as urban infrastructure and utilities.

In the past two weeks, LGFPs have been in the limelight again. This could be attributable to the National Audit Office's (NAO) recent audit of local government debt. This report is the most comprehensive official report to date on the direct and indirect debts of local governments, in our opinion. The LGFPs debt stated in this report is substantially smaller than figures that were reportedly produced by the China Banking Regulatory Commission (CBRC) and the People's Bank of China (PBoC). Another reason for the renewed attention to local government debt are local news reports of a few LGFPs, including those in Shanghai and Yunan provinces, facing financial difficulties.

Frequently Asked Questions

Why are LGFPs singled out as a major source of credit risk for banks?

On a stand-alone basis, the credit quality of LGFPs is generally weaker than that of the banking sector's overall credit portfolio prior to 2009. Some of these companies are little more than vehicles to raise debt for public projects. They rely heavily on government transfers, typically proceeds from public land sales, for debt servicing. But even some that have viable commercial operations (including companies in industries such as water utilities, urban transport, and power generation) have weak financial health. A number of such companies that Standard & Poor's Ratings Services examined in 2008-2009 were in the low speculative-grade rating categories on a stand-alone basis.

Owner-imposed non-commercial objectives often impair the profitability of LGFPs. For instance, local governments encouraged many of their financing platforms that own power companies to increase production to offset reduced generation at central government-owned power stations as coal prices soared this year. They had taken similar steps when coal prices increased in 2008. The local governments expect such steps to stabilize economic activity. But these measures have led to severe losses at LGFPs compared with smaller losses and even marginal profits at centrally owned power companies.

In addition, LGFPs' financial profiles are also often well below the average of companies in their respective industries. Some LGFPs have been able to increase leverage to a high level because banks expect local governments to support these entities. The liquidity position of several LGFPs is also below average, partly due to their high debt servicing needs.

Why have LGFPs become a concern only in the past few years?

While LGFPs have been in existence for several years now, they accounted for a small portion of commercial banks' loans until 2009. Since then, the credit risk that these companies pose to the commercial banking system has rapidly increased, albeit from a low base. This is because commercial bank lending to LGFPs surged in 2009 as the central government implemented its economic stimulus package.

These entities had traditionally relied mainly on policy bank credit (especially from the China Development Bank) to carry out public infrastructure projects. Until the recent economic slowdown, the central government's control over project approval, and from 2007, the credit quotas on commercial banks and restrictions on local government land sales constrained LGFPs' access to commercial credit. From late 2008, however, commercial banks rapidly increased lending to these entities as government controls eased. Since the end of 2009, commercial bank loans have overtaken the policy banks as the main source of credit for these companies.

The ranks of LGFPs also swelled in 2008 and 2009. At that time, the central government allowed local governments to use land and other assets to set up a large number of new companies to implement its economic stimulus package. In some cases, local governments transferred assets from existing LGFPs and other state-owned enterprises to piece together new LGFPs. These asset injections helped the companies to meet banks' requirements and allowed them to borrow heavily to fund projects started in the name of supporting the Chinese economy through a global recession.

We believe that the creditworthiness of LGFPs has deteriorated significantly since 2008 due to their increased borrowing. Assuming little or no government support for these companies, the risks of lending to them are now higher than before 2009 even as their importance to commercial banks has grown.

Do the recently reported problems at LGFPs herald the beginning of a large wave of defaults?

We expect nonperforming loans attributable to LGFPs to increase in the next few years. Most LGFPs loans are three to five year term loans. Some of them could have been structured as long-term project loans where principal repayments begin upon project completion. As more project loans come due in the next few years, some LGFPs could face problems repaying their debts without new financing or government support. In a stress scenario, the banking sector's cumulative nonperforming loans (across all borrowers, not just LGFPs) could reach 10% in the next three years if government support to LGFPs is not forthcoming (see "Sector Review: For China's Banks, A Little Pain Now May Prevent A Lot Of Pain Later," published May 24, 2011).

The central government's tightening of credit policy to counter inflation appears to have brought forward the day of reckoning for some LGFPs. On the CBRC's instructions, some banks have stopped financing projects that are in progress when loans are not backed with adequate collateral. As a result, the cash flows of a few highly leveraged firms have come under pressure. A highway company in Yunnan, for instance, has been reported by the local media to have threatened to default on its bank loan because of this. Nonetheless, as we had expected, the relevant local governments stepped in to support the companies.

Banks' credit losses are likely to mount despite local government support to LGFPs. We do not, however, expect the major national commercial banks to record full-year losses. Our expectation reflects Chinese banks' relatively wide interest spread (mandated by policy to help support financial stability) compared with that of other banking systems in the region and our baseline projections of strong and stable economic expansion. We expect China's real GDP growth to remain close to 8% over the next five years. In addition, the central government's top priority is still to maintain stability. It could, therefore, reverse some of its monetary tightening measures if it believes that LGFPs failures could weaken financial stability.

Even given the stable and strong economic growth in the next five years, aren't your expectations optimistic?

While LGFPs are an important source of credit risk, we believe that the major national banks are significantly less exposed to them than smaller banks. Local governments have little influence over the major national banks' lending decisions. In 2009, some of these banks reinforced their independence by requiring their branches to seek main branch approval for all loans to LGFPs. In contrast, smaller banks are subject to significant local government influence in the regions where they operate. One indication of this is that the five banks that showed the largest proportional growth in lending to LGFPs were regional commercial banks and a policy bank.

The big national banks are also in a position of being able to choose more creditworthy clients. Their dominance in the Chinese banking sector allows them to extend much larger loans at more flexible terms compared with their regional competitors, making them preferred banks for corporate borrowers. Consequently, their credit risks increase by less than regional banks' as loan growth accelerates.

Much of the bank credit to LGFPs is to companies that are more likely to be able to repay the loans. This likely reflects the results of large banks' risk management. In a report published in 2010, the Chinese Academy of Social Sciences found that financing platform debts are concentrated in the coastal region and in the economically more developed cities. The largest LGFPs debts were in Jiangsu, Shanghai, Zhejiang, and Guangdong--among the wealthiest provincial regions of China. Since governments in these regions also enjoy healthier financial positions than elsewhere in the country, these debts are distributed roughly in line with those of the companies that could afford them and where local governments could provide stronger support.

What are the bank and sovereign rating implications if China's economic performance is substantially weaker than your expectations?

The credit ratings on the sovereign and on the major commercial banks could come under downward pressure if Chinese economic growth in the next few years significantly underperforms our expectations. While we consider the likelihood of this scenario to be modest, it is not insignificant. The Chinese government continues to tackle the pressures of strong domestic liquidity and inflation with mainly administrative tools in an economy that includes many inefficient state-owned companies. The risks of a policy error resulting in economic volatility are not negligible, in our opinion.

In this scenario, a significantly larger proportion of loans disbursed to the financing platforms could turn nonperforming. At the same time, the performance of other loans could also suffer and add to banks' sub-standard loans. Local governments could see revenue growth slow sharply and land sale receipts could also fall significantly. They could, therefore, be in a weak position to lend financial assistance to LGFPs.

If the economic shock is sufficiently severe, banks' financial position could also be hit by a further surge in lending during a slowdown. While we expect that the government would be wary of imposing more credit risks on the financial sector, banks remain the fastest way of channeling funds into the economy. Consequently, it could initiate a new round of credit-funded stimulus measures to offset the economic weakness. Banks' balance sheets would deteriorate further in these circumstances and weaken their credit fundamentals. The ultimate cost that we expect the government to pay to restore the banking sector to reasonable health would also weaken China's sovereign creditworthiness.

What steps is the Chinese central government likely to take to address the problem of local government debts?

The publicity given to the issue within China and the three separate investigations into it suggest that the central government is finally gearing up to address this long-standing problem. However, any near-term solution is likely to be a partial one. The complex task of overhauling intergovernmental finances, central-local politics, governance standards (on the parts of both local governments and LGFPs), and government-corporate relations is unlikely to be initiated just before a major leadership change in 2012.

We expect that the government's near-term approach would balance the need to improve financial stability with concerns over moral hazard. The government is likely to emphasize enhancing banks' stability by minimizing the possible losses associated with LGFPs loans, while taking measures to get banks to provide for likely losses and augment their capital cushions. Despite its strong balance sheet, the central government is unlikely to inject resources into either the local governments or banks unless forced to (e.g. if the economy enters a renewed slowdown). Otherwise, local governments may continue to run up financial risks in the expectation that they would be granted assistance when needed.

Consequently, bank regulators are likely to ask local governments to provide more credit enhancements for their LGFPs, including capital injections and collateral. Local governments would be allowed to issue bonds in a controlled manner, as was the case in 2009 and 2010. If necessary, the central government could ask existing asset management companies to take impaired assets off smaller banks' balance sheets. It could also demand that local governments increase fiscal transparency.

Is China doomed to seeing a repeat of a credit-funded burst of public investment the next time another economic stimulus is needed?

Unappealing an idea as it may be under the current circumstances, a major economic slowdown in China in the next three to five years is likely to be met by another round of bank-funded investment projects. This reflects the still substantial part of China that continues to face infrastructure shortages. Consequently, such investments could still make sense as they add to economic efficiency. Moreover, until the social security system in the country matures and increases its coverage substantially, public investment spending will remain the most important way to support economic activity.

You mentioned that the recent NAO report finds LGFPs loans to be less than the results of earlier studies. How do these studies differ?

Before the NAO report, the CBRC and the PBoC had conducted related studies. However, the differences between the NAO report and the studies of the CBRC and the PBoC are:

• The objectives of the studies differ. The NAO audit intended to find out the amount of debts that Chinese local governments have responsibilities to repay. The PBoC and CBRC studies aimed to size up the potential size of the credit risk to the banking system from lending to these entities.

• The entities included in the various studies differ as a result. The CBRC and PBoC investigations focused on debts of companies that they consider to be LGFPs. The NAO included LGFPs as well as non-corporate entities related to local governments. As there is no common definition for LGFPs, the companies in each of the three studies may be different.

• The types of LGFPs debts included are also different. The NAO only counts the debts of LGFPs that it deemed local governments to have responsibility for. This likely included mainly debts of LGFPs engaged in non-commercial projects and debts of commercial LGFPs that are guaranteed (often without legal basis) by the local governments. The CBRC and PBoC studies include all bank debts of LGFPs that they identified.

What impact do these differences have on the amount of debts reported by each study?

Due to these differences, the debt estimates vary among the studies. While publishing no official number, the PBoC said in a recent report that no local region has seen LGFPs account for 30% or more of total bank credit. Making an extreme assumption that 30% of total bank credit at the end of 2010 was LGFPs loans, the figure would be less than Chinese renminbi (RMB) 14 trillion. The PBoC's actual figure, however, is likely to be much lower.

According to a local news report, the CBRC assessed LGFPs debts at about RMB9.1 trillion at the end of November 2010 (including RMB2.8 trillion that the CBRC considered as meeting general corporate loan requirements and, therefore, exhibits risk characteristics similar to other loans). We base our assessment of potential nonperforming loans in a stress scenario on the CBRC's estimates. We believe the scope and objectives of this study best suit our needs in assessing the potential credit costs facing China's banking system.

The NAO reported that local governments are responsible for about RMB8.5 trillion of bank debts. Of this, almost RMB5 trillion was borrowed by LGFPs. Another RMB2.2 trillion was owed to other lenders, including inter-government loans.