Fiscal Credit Puts Reform on Slippery Slope

飞雪寒冰

While other major world economies struggle in the throes of a credit crunch, the brevity of China's credit shortfall has taken many by surprise.

Between March and October 2008, China recorded a credit growth rate of less than 15 percent. And if inflation is taken into account, real credit growth for that period was in the single digits.

After the People's Bank of China, China's central bank, relinquished direct control over lending last November, the country saw an explosive expansion in commercial bank credit. The growth rate reached 30 percent year-on-year in April. Tight credit seemingly vanished into thin air.

But China's credit relief was not driven by growing market confidence. It was the result of expanded government credit. So unless market confidence rises, China's hopes for future economic recovery will be stymied by a government debt bottleneck.

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Unprecedented Financing

There is little reliable statistical information for how many fund-raising platforms are available to local governments in China. These fund-raising strategies are backed by governments in cities of all sizes, nationwide. Some may have as many as eight platforms.

A reasonable estimate is that about 2,600 of these platforms are currently in place. That figure assumes one platform has been established in each of the roughly 300 major cities and two-thirds of the 2,895 district- and county-level cities nationwide.

Likewise, there are no statistics to indicate the scope of this debt. But there have been clues. According to Ministry of Finance estimates, 2007 nationwide local government debt was approximately 4.1 trillion yuan. Of this amount, cities at prefecture, district and county levels held approximately 61 percent, or about 2.4 trillion yuan, in outstanding debt.

According to central bank statistics, major commercial and policy banks issued nearly 900 billion yuan in medium- and long-term loans for infrastructure projects in the first quarter 2009. That accounted for half of all new medium- and long-term loans nationwide during the period. Most loans went toward local government fund-raising platforms.

If debt for each fund-raising platform averaged 1 billion yuan – a conservative estimate – the debt total could amount to an enormous 3 trillion yuan.

Another data clue can be found in the growth rate for medium- and long-term loans. These made up less than a quarter of all loans in China in 1999. But by 2007, the proportion had climbed to more than 50 percent.

The increase in medium- and long-term loans paralleled and matched almost precisely the vigorous growth in city investment companies. This does not appear to have been a coincidence. Medium and long-term loans, which continue to make up about half of all lending, topped 17 trillion yuan in March.

Thus, trillions of yuan in credit has apparently provided support for recent government infrastructure projects across the country. Infrastructure investment plans from each province show transportation projects alone should reach 1.08 trillion yuan in 2009. This would not include Shanghai, which did not release specific figures.

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The central government's pledge of 200 billion yuan on behalf of local governments would account for less than 20 percent of this amount. Estimating based on current trends, if this year sees 9 trillion yuan in new loans (i.e. new growth of 500 billion yuan per month), infrastructure projects would require 4.5 trillion yuan in medium- and long-term loans and 2.25 trillion in credit from funds.

And this does not take into account the local investment platforms' short-term loans, long-term investment funds or funds raised through bond issues.
　　
These simple estimates indicate that the total amount of local fund-raising platform debt is somewhere between 3 trillion and 8 trillion yuan. And it's growing rapidly.

The Ministry of Finance estimated 2007 local government debt reached more than 4 trillion yuan – equal to about 16.5 percent of the nation's GDP that year. Infrastructure investment this year is only 1 trillion yuan, but that's still equal to 41 percent of local government revenues.

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Bank-State Cooperation

Since the beginning of bank reform, a separation of government and commercial banking has widened and then narrowed again. Reform's original intent was to separate enterprises from the state and break local government control over lending decisions. But banks discovered that government interference can be a two-edged sword. As banks shook off interference, they also lost implicit government guarantees.

Policy banks felt a deeper impact. Their large loans over long terms make their risks difficult to estimate. Within existing risk management capabilities, they needed a model for collateral while continuing to supply the market with huge sums of money. Without this effort, business expansion would be exceedingly difficult.

Against this backdrop, bank-state cooperation has been revived. In essence, banks decided to seek government credit with explicit or implicit guarantees for their loans.

Ironically, a major measure of success or failure for bank reform was whether banks saw profitability as the ultimate goal. To increase profits, firms should naturally integrate the most efficient market segments. Everyone knows the private sector is more efficient than the public sector. So why would banks choose to shun cooperation with the private sector and cozy up to the state?

First, the government monopolizes the most important resource in the economy: guaranteed government credit. From a revenue perspective, future cash flow of local governments would be insufficient to repay loans. But if we look at market prices for resources under their control – land, monopoly licenses, etc. – local governments are still the largest net asset holders. Not only can they provide implicit guarantees for bank loans, but they can provide explicit ones as well.

Second, after suffering through a loss of control over the non-performing bank loans, regulators adopted a zero tolerance attitude toward loan risk. They also introduced regulations that placed too much emphasis on loan securitization and collateral requirements. Commercial banks even introduced a lifelong lending responsibility system, which shifted focus to the gains and losses of individual loans at the expense of emphasizing overall credit returns.

Third, attempts to limit moral hazard among commercial banks pushed bank lending to the other extreme. It became impossible to effectively prevent borrowers and lenders from conspiring to cheat the system. Lenders naturally became the most obvious suspects in these cases, and private sector borrowing became known as the most likely place for such conspiracies. Working with government departments or state-owned enterprises (SOEs) made it possible to avoid risk. In the end, lenders were only willing to lend to the state and SOEs.

Fourth, the public nature of infrastructure and the stated goal of increasing domestic demand to ensure growth have added legitimacy to bank-state cooperation efforts. Before reforms, propping up troubled SOEs was the main reason for government interference in the loan business. Today, the goal is infrastructure build-out. And that's offered legitimacy to rampant fund-raising among local governments. Proponents of the credit binge note that in economic down times, when market credit is inadequate and deflationary pressure looms, it is the government's duty to provide necessary credit to drive domestic demand.

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The final point is most often overlooked. The current interest rate regime in China's banking sector encourages cooperation between commercial banks and the government. International research on the liberalization of interest rates has shown that, following rate liberalization, interest rate spreads narrow for commercial banks and fall for market loans.

Interest rate liberalization also helps reduce bank collateral requirements. Furthermore, allowing the market to decide interest rates reduces traditional "relationship loans" (i.e. reliance on long-time customers), and bank willingness to accept risk rises. Likewise, these changes would stimulate enterprise demand for loans and increase bank lending to enterprises and the private sector.

By contrast, banks can thoroughly enjoy the advantages of low-cost funds and high interest rate spreads in a controlled interest rate regime. But banks in this situation are risk-averse, embrace government cooperation, and turn a blind eye toward the higher profits offered by higher risk.

Taking on large-scale debt to pump investment into infrastructure is a classic response to a faltering economy and deflation. The main variations occur in fund-raising approaches and the strength of investments.

Pre-reform steps toward bank-state integration created a defective system. In contrast, the latest round of bank-state cooperation is based on voluntary decisions by the banks. If banks let down their guard on the safety of local government loans, or if local governments conceal debt, there is a danger that this fiscal credit system will spin out of control.

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Credit Squeeze

In the near term, the government credit expansion, facilitated by local government financing platforms, has offset the negative impact of a tighter market credit, with a noticeably positive effect on investment.

This unique institutional arrangement allows the government to leverage relatively limited financial resources into huge levels of credit, reducing fiscal pressure. Of particular importance is the system's ability to, with government credit as a base, ensure the low-cost, rapid, barrier-free flow of capital to projects supported by the government, with the result of state-sector investment far outpacing others. In a year when other major economies are in recession, China's economy will grow as much as 8 percent.

However, the benefits of the rapid expansion for local government credit are short term. Over time, costs will accrue.

Under a bank-state cooperation system, local governments directly compete in a low-cost capital market, pushing out private investment. For now, interest rates for bonds issued through local fund-raising platforms are running between 7 and 8 percent, while the benchmark interest rate for loans of five years or longer is 5.94 percent.

This large amount of local government fund-raising through banks is intensifying market competition for low-cost capital. While monetary policy is loose, the extraordinary growth of local government loans is tightening the financing space for small- to medium-sized enterprises (SMEs).

Because local government investments in infrastructure projects are long term, reducing short-term loans becomes more difficult when monetary policy tightens. Loan recovery pressure is likely to mount for SMEs. In addition, SMEs are being squeezed by government's increasing involvement in the credit sphere, which is reducing the private sector's power in favor of state-owned companies

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Rapid expansion of fund-raising by local governments could hamstring the central bank's currency policies and make controlling inflation difficult. Stimulating the economy relies on fast loan growth to support local government investments, but the result will only make it more difficult to adjust currency policy. With local governments controlling capital flow, future growth must come from continued loan growth. If lending policy tightens, local government loans will be difficult to roll over, greatly increasing possibilities of a liquidity crisis. Whether out of fear of a local government repayment crisis, or due to pressure from local governments, the timing of the currency policy adjustment bears consideration.

Rapid expansion of local government debt also may create a bubble for infrastructure construction, which would result in a new round of nonperforming loans.

China's economic stimulus policy appears to be "fiscally conservative, and credit radical." But in the end, credit stimulus has to be resolved through fiscal policy. One way or another, fiscal sources will end up footing the bill for the high debt load of local governments, or the next round of significant, non-performing loans held by commercial banks.

If China's economy is unable to recover in a relatively short period of time, or experiences a soft recovery, this year's extraordinary credit growth will be difficult to sustain. And next year's credit stimulus will carry significantly less punch, with fiscal stimulus bearing the responsibility.

During the changes of the past 30 years, as government and enterprises separated, and prices were reformed, equal importance has been placed on fulfilling responsibilities toward large SOEs, privatizing smaller SOEs, and market liberalization. The ultimate goal has been to restrain government and let the market play its basic role by allocating resources. The latest trend toward bank-state cooperation reverses this trend.

While direct interference by local governments in bank affairs is not significant, the current regulatory environment is such that banks are being forced to work closely with local governments. Moreover, to maintain cooperative relationships with banks, local governments may become defenders of current policies, even pushing future policy development in the direction of bank-state cooperation. That could include ensuring government control over important resources and industry monopolies.

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The division followed by a reuniting of banks and government demonstrates that separating the state and enterprises involves more than systemic change. It also requires reforming policy and market environments.

In terms of policy reforms, bank reliance on local governments can be lightened through interest rate liberalization, corporate bond market development, and transparency in local government debt. As mentioned, interest rate liberalization is beneficial for the market operations of commercial banks.

Development of the corporate bond market can alleviate enterprise fund-raising problems and resolve the problems of concentrated risks associated with over-reliance on bank loans. Diversification of enterprise fund-raising channels would likewise make banks more willing to provide corporate loans. Additional transparency in local government debt would let banks better evaluate the risks of extending loans to local governments, while also providing fundamental data for developing a future local government bond market.

It has been a long decade since exchange rate liberalization and a multi-level capital market were first put forward. It's time to move beyond slogans and advance the reform process.