By CRAIG STEPHEN at Marketwatch
HONG KONG (MarketWatch) — China’s latest plan to tackle its local-government-debt problem appears to be pretending there isn’t one. This might actually stave off a wave of unpleasant corporate busts and bankruptcies, but investors need to be alert for other signs of distress in China’s repressed financial system.
In recent weeks, plans floated to address local government debt — estimated to be some 22 trillion yuan ($3.54 trillion) — have included swapping loans for bonds and even potential quantitative easing by the central bank. But as these initiatives appeared to lose steam, it emerged Friday that Beijing had reverted to a more traditional plan: Tell banks to keep lending to insolvent state projects and roll over such loans.
The directive was jointly issued by the Ministry of Finance, the banking regulator and the central bank, saying that financial institutions should keep extending credit to local-government projects, even if borrowers are unable to make payments on existing loans.
The positive take is that this latest maneuver postpones a painful debt reckoning and will help protect the property market and broader economy from another leg down after more weak economic data for April.
Caution is understandable, as local-government debt presents numerous contagion risks. Société Générale describes it as the “critical domino” in the chain of China’s credit risk.
This is not just because of the size of the problem, but also due to the labyrinth of funding which straddles special-purpose-funding vehicles and the shadow-banking market. Further, local governments are inextricably linked to the property market, as they rely on land sales for their revenue. So if the implicit guarantee on state debt were to be removed at the local-government level, the potential for a messy unraveling looks high.
It’s also easy to see how this represents a larger systematic risk, as Fitch estimates banks’ total exposure to property could exceed 60% of credit if non-loan financing is also taken into account.
Yet any relief that funding taps will not be switched off will also be balanced by concerns over the dangers of building up an even larger debt burden.
Fitch warns that the more authorities permit loans by weak entities to be rolled over, the greater the build-up and cost of servicing that debt, and the greater the strain on banks and the overall economy. They calculate that the interest-cost burden of servicing debt has risen to 15% of gross domestic product.
Banks are being put in a tight spot. While being conscripted into national service by taking on toxic state loans, they are at the same time subject to new competitive pressures as China moves forward with interest-rate deregulation.
This presents another vulnerability: Nomura has flagged deposit deregulation as potentially the first trigger point for a credit down-cycle, because as competition drives funding costs higher, banks will no longer be able to keep lending to low-margin customers.
You might ask what the problem is if banks carry a few extra bank loans, even if we don’t know about them. But if this happens, the concern is China may be setting itself up to repeat Japan’s “lost decade(s)” experience.
Nomura notes that after Japan’s bubble burst, no major financial institutions went under, and loans were often not marked to market. This ended up creating “zombie banks” which were not in any state to lend, and the wider economy suffered.
It remains to be seen whether there will be push-back from banks over this new directive. The latest batch of municipal-bond sales are slated for later Monday and will be closely watched. And there is also the possibility that Beijing will still come back with a more comprehensive plan for local-government debt.
Yet it seems inevitable that the implicit guarantee on state debt will have to be removed at some stage, leading to a shakeout. Already we have seen a trickle of offshore-bond defaults, although the consensus is that such defaults will be managed.
Ultimately Beijing needs to be extremely skilled as it tries to steer a path through its debt problem. If too much burden is placed on the banks, it risks handicapping their ability to lend to support a recovery needed to maintain social cohesion. Go to a further extreme, and depositor confidence could be damaged, leading to a run on the banks. At least China’s banks have introduced deposit insurance this year.
Meanwhile if authorities move forward with non-conventional measures such as quantitative easing to mop up debt, this is likely to increase money outflows and put pressure on the yuan USDCNY, -0.0177% to weaken.
For now there appears to be no painless options. The only thing that seem certain is that Beijing’s debt problem will not just “roll over” and go away.