Dubai: Local government debt in China has become a matter of ‘mianzi' or ‘face' for the authorities. When international banks and credit rating agencies sounded the alarm bells about the quality and magnitude of these debts and the fate of banks saddled with likely non-performing loans, the Chinese took offence, going so far as to call it a "conspiracy".

However, the total amount of local government debt in China has been a sensitive issue for a long time. And now figures speak for themselves. Statistics released by the National Audit Office last month indicate that loans taken by governments at the provincial, prefecture and county stood at 10.7 trillion yuan (Dh6.1 trillion) by the end of 2010, equivalent to 27 per cent of GDP and far exceeding the year's revenue of 8.3 trillion yuan.

To prevent these loans being transformed into a debt crisis or a banking crisis, as has happened in developed countries, Chinese planners have started to take steps, although there is still a strong sense of denial.

‘Financing platforms'

The Chinese Budget Law prohibits local governments from borrowing. To get around this restriction, local authorities set up companies, known as local government financing vehicles, to borrow money and carry out public projects in urban infrastructure and utilities. However, on a stand-alone basis, the credit quality of these ‘financing platforms' is generally weak, most of them relying heavily on government transfers and proceeds from public land sales, for debt servicing.

It is these companies which are now a major source of credit risk for commercial banks. While local government financing platforms have been in existence for several years now, they accounted for only a small portion of bank loans until 2008.

The floodgates opened when the central government introduced its 4 trillion yuan economic stimulus package introduced to cope with the effects of the global financial crisis. Of the package, the central government provided 1.2 trillion yuan, while the rest came from local governments.

To enable this, credit policies were loosened, creating an opportunity for local governments to get loans from commercial banks on an unprecedented scale. The number of local financing platforms shot up — from only 2,000 in 2008 to around 10,000 in 2010. Within two years, commercial bank lending to these ‘financing platforms' surged, even as the credit risk these companies posed to the banking system rapidly increased.

Bank risk

Foreign banks and rating agencies warn that non-performing loans of Chinese banks attributable to local government financing platforms will increase in the next few years. Most loans to these companies are three- to five-year term loans and as more project loans become due in the next few years, some companies could face problems repaying their debts and without new financing or government support.

Things may come to a head with the China Banking Regulatory Commission instructing banks to stop financing projects whose loans are not backed with adequate collateral. In this scenario, the likelihood of a significantly larger proportion of loans disbursed to the financing platforms could turn non-performing.

Safe zone

The regime, however, is nowhere close to painting a worse-case scenario. They insist that China's public debt is still in the ‘safe zone' considering the country's huge GDP of nearly 40 trillion yuan. Moreover, policy makers feel local government debt has not yet exceeded their ability to manage it.

On the plus side, money borrowed by local governments mostly goes to investments. So the local governments' assets increase along with their debt. However, lack of transparency, and a mismatch between the maturity of these debts and the long payback period of the projects that they have been invested in makes for a stressful package.


However, vigorous debates surrounding the debt issue indicates that government is gearing up to address the problem which has the potential of getting out of hand.

One way to restructure the debt is for local governments to issue bonds with a longer maturity period to replace short-term loans. This will boost transparency as bond, sold openly in the market, will have greater degree of disclosure to entice investors.

The Ministry of Finance plans to issue bonds of 46.6 billion yuan in August on behalf of local governments. This is the second issue this year, but the success of the bonds is uncertain as the previous round failed to generate any buzz.

Long-term reforms

A more abiding solution to eliminate debt risk is to reform the tax system to reduce reliance on land sales. Chinese economic experts are strongly pushing for the need for local governments to expand the scope and variety of taxes on resources and include part of these taxes in local revenues.

They also suggest reforming the environment tax and letting local governments get raise revenue from this sector. Most crucially, they wish to expand the range of real estate taxes and fully apply property tax, which is almost non-existent in China.