Op-Ed Contributors

Flexible measures needed

By Xiao Gang (China Daily)
Updated: 2010-10-15 08:12

There has been much chatter about bank loans to local governments' financing vehicles, widely regarded as one of the main risks facing the Chinese economy. Set up by local governments to borrow money for infrastructure investments, these vehicles are rather like Western companies' special purpose vehicles. They have played an important role in stimulating the Chinese economy and helping it to recover from the global financial crisis. But they face a problem, too:The bank loans they have received have increased extraordinarily.

Local governments at all levels have set up their investment companies, some of which are directly controlled by the leaders responsible for fundraising for their pet projects. These companies take a variety of forms depending on the industries and sectors they belong to.

There are thousands of such companies across the country, which sometimes are even irregular. Some of them, particularly those operating at the county-level, will not be able to service their debts.

It is thus reasonable to be alarmed. But it is still too early to say that the level of non-performing bank loans will increase drastically even if we cannot estimate the precise number and amount of loans given to local governments until the formal assessment is completed at the end of this year.

To generalize the special vehicles' business model we have to go back in history.

Local governments' financing vehicles started in the 1980s and became popular in the 1990s. After the Chinese government began reforming the fixed asset investment and taxation systems, local governments took the responsibility of constructing some infrastructure.

Local governments have accumulated outsized economic resources - land, equities in State-owned enterprises and local banks, licenses for exploring natural resources, and influence in the allocation of economic resources among other things. Most of these "assets", operating or non-operating, cannot be translated into cash immediately. And the current Budget Law prohibits local governments from issuing bonds, cutting off the channel for direct fundraising.

This business model is unique. The local governments' vehicles borrow money from banks and invest it in infrastructure and public utilities, and finally repay the debt from the revenue generated by the transfer of land-rights use.

Bank loans are used as a substitute for fiscal spending, enabling the local governments to access tomorrow's money today. This model has been operating quite smoothly over the past few years. The ratio of non-performing loans to the total loans to the vehicles has usually been less than 1 percent on the banks' balance sheets, which means there is little possibility of defaults on the loans.

The banks have been enthusiastic about acquiring such good assets by marketing to and establishing strategic partnerships with the local governments. The competition among banks is intense, because by entering this business they can capitalize on an even wider range of opportunities and tap into other profitable projects, fee-based businesses and fiscal deposits, all of which bring about a lot of comprehensive benefits to the banks.

In a way, this model looks like giving large "mortgage" loans, but only to local governments, not individuals. In China, mortgage loans extended to individuals are very good assets. Banks not only hold the homes as collateral, but also have recourse to the future income of the borrowers even after default.

The financing vehicle of a province or a city is usually a big company with the governor or mayor as its CEO. Unlike average CEOs, such leaders are almost always powerful enough to cope with difficulties, and the government as a whole assumes de facto unlimited responsibilities for their debt.

Obviously, the repayment of these loans is not mainly based on the cash flow of the infrastructure projects in question, but on the rapid growth of transfer of land-use rights and fiscal revenue.

Last year, the local governments raised 1.59 trillion yuan ($239.92 billion) through transfer of land-use rights, accounting for 4.7 percent of GDP, the majority of which was not included in fiscal budgets. Apart from receiving 2.46 trillion yuan in tax revenue, the local governments also got 2.9 trillion yuan through transfer of funds from the central government.

The central government has a healthy and strong fiscal capability. It is true that its debt-to-GDP ratio could be much higher than the official figures, if a lot of hidden liabilities, such as the loans to the local government-backed vehicles, were included. But the debt-to-GDP ratio is well below the international warning level.

Many people complain about the local government's opacity in liabilities. In practice, surprisingly, they own significant amounts of valuable assets, both tangible and intangible, which they obtained pretty cheaply, and they have always had much room to work on different solutions to financial difficulties.

Some measures taken by the local governments to virtually guarantee loans from the banking sector seem to be really effective. Several local governments leave a sum of fiscal revenue as an unallocated item, or set up a debt service reserve account, sometimes approved by the local people congress, to make preparations for repay their debt.

There is a heated debate on whether the local governments should be allowed to issue bonds. If local governments are allowed to issue bonds, it may be an option to replace some of new bank loans or swap some old loans with bonds, a move which may mitigate the fear of defaults further.

As some readers have no doubt guessed, real estate property prices are the key issue. It has been reported that the money some local governments earned record sums from the transfer of land-use rights in the fist eight months of this year. The measures launched by the central government recently might cool the real estate property market, but there is little possibility of it curbing the transfer of land-use rights.

The governments should take a series of steps to improve its debt management. The local governments have begun to re-clarify and re-evaluate their liabilities and assets in order to create real consolidated balance sheets. Other active measures would be welcome. Some local governments have reined in debt according to the conservative fiscal revenue expectations, rather than over-relying on revenue from future land-sales. Some have also improved their debt transparency.

The local governments' financing vehicles need a soft landing. Any harsh measures or "one-size-fits-all" policies will harm rapid urbanization, economic growth and the banking sector.

Such complex situations cannot be solved overnight. The problem could be solved gradually, but for that we need a flexible and considerate plan.

Time is precious, and sometimes time is the best way out of problems. So we can be confident of overcoming the problem.

The author is chairman of the Board of Directors of Bank of China.

(China Daily 10/15/2010 page9)