By Minxin Pei
The second question to be asked here is whether local governments can service the debts and repay the loans. If they have made sound infrastructure investments that generate income streams, debt accumulation isn’t a problem. Unfortunately, that doesn’t appear to be the case for most infrastructure projects built by local governments. Typically, such projects are highly leveraged, with local governments putting in little equity capital and borrowing nearly all the costs. This makes debt-servicing a huge burden.
There are only two sources of income to service such debts. One is to sell land controlled by local governments (land is used as collateral for securing bank loans). The other is to use the cash flow generated by these projects (power plants, ports, and toll roads). With the frothy real estate teetering, local governments shouldn’t count on land sales to come to their rescue. The economic viability of their newly invested infrastructure projects is even more abysmal. One banking regulator revealed that only one third of these projects can produce enough cash flow to service their loans. This implies that local governments won’t be able to recoup the bulk of their infrastructure investments – or repay the banks.
So what about the economic consequences of this ticking debt bomb?
Because about half of the bank loans borrowed by local governments will come due in the next two years, we can expect a short-term repayment crisis. Chinese state-owned banks will have to roll over these loans, pretending that they are still performing. They may even have to lend local governments new money to pay the interests on these loans. The net effects of such accounting gimmicks would be reduced profitability for Chinese banks, admittedly not a cause for real concern. But accounting tricks can only temporarily delay the inevitable.
The longer term effects of massive non-performing loans owed to state banks by local governments are likely to manifest not in the form of a banking crisis, but in other more insidious – yet equally – harmful ways. Because the Chinese state owns trillions of RMB in assets (land, natural resources, state-owned monopolies, and $3 trillion in foreign exchange), Beijing should have enough resources to bail out local governments when these loans have to be repaid. But there’s no free lunch. Bailing out local governments with valuable financial resources in the coming decade – a decade in which China will experience the end of the demographic dividend, rising costs of healthcare and pensions, and slower economic growth – will mean China will have less capital to invest. For an investment-led economy, this implies even more sluggish growth.
It’s tempting to blame irresponsible and corrupt local government officials for wasting the country’s precious capital. That would be unfair. While there are no doubt unscrupulous local officials who see Beijing’s bank-funded stimulus plan as a golden opportunity to line their pockets, the behaviour of local governments is perfectly rational: they would be fools if they hadn’t jumped on the gravy train of freely available bank loans in the last two years. From their perspective, China’s system of public finance is grossly unfair to local governments. Beijing collects the bulk of taxes (60 percent of all taxes), but spends little on social services, which local governments must fund. Unlike their Western counterparts, local governments can’t issue bonds to borrow money. So if they want to develop local infrastructure (which Beijing doesn’t fund, either), the only source of financing is bank loans.
For all practical purposes, bank loans borrowed by government entities are actually free money – they don’t have to be repaid even when they go sour. Beijing has always come to the rescue, something local government officials are fully aware of. But we all know what happens when people get to spend free money.
Reddit
Digg
StumbleUpon
Delicious
Technorati
Yahoo
Google
Plurk
Frankie Fook-lun Leung
China’s economy and her financial system is not fully integrated with the rest of the world. Hence she can shelter the adverse effects of a melt-down or crisis in a way different from Italy or Ireland. However, one would not expect China to withstand those pressures by standing along and away from the rest of the world. Chinese leaders are worried since their domestic situations of unemployment, social unrests, disparity of wealth, corruption and inefficiency will sooner or later surface, however hard the government try to hide or suppress them.
CorkerG
After reading many of these posts, I understand that my knowledge of government spending and borrowing and how it affects economies is very limited, so please forgive any unusual thoughts I may have concerning this matter.
Private businesses show all assets (revenue, property, land, equipment, vehicles, etc.) to prove solvency, and if I’m not mistaken, governments only show revenue and expenses.
If this is the case, can governments set up their financial program like private companies? Because if they do, then most every large country, especially the United States, Europe, Japan and China must be able to show assets that range into the hundreds of trillions of dollars.
And since many of these governments have assets in this range, then our governments must be completely solvent, especially since the largest debt, that I know of, is only a mere 14/15 trillion dollars (US).
Like I said, I am not aware why governments set up their financials without using all their assets, but would it make more sence for all to show their true solvency?
Muhammad
So you suggest when govt’s don’t have money to repay debt, start giving out land to say other countries to whom the debt is owed to ?
Solvency in this case is availability of cash – or cash equivalent. Of course govt’s should count their cashable assets like Gold reserves in the picture if that is the point.