China’s massive stimulus spending has raised widespread concerns about local government finances. Local governments have ramped up infrastructure spending since late 2008, while they are also under pressure to spend more on health, education, and social security, for which they are in large part responsible. With monetary conditions likely to become tighter this year and land revenues possibly slowing down or even declining, local government finances may become strained.
At the heart of the concerns are local government investment platforms. These are state-owned-enterprise (SOE)-type entities set up to finance infrastructure construction and urban development—sometimes also called Urban Development and Construction Companies. Set up in part to circumvent rules prohibiting local governments from borrowing, their investment activities are mainly financed by land sale revenue and bank financing, often using as collateral land requisitioned from local residents.
The amount of new lending to such platforms in 2009 has been very large, but this is not a new phenomenon. The China Banking Regulatory Commission (CBRC) recently estimated that their bank debt increased by RMB 1.3 trillion in 2009 to RMB 5-6 trillion at end 2009, with estimated additional committed lines of RMB 3 trillion. The possible total of RMB 9 trillion is equal to 27 percent of GDP, while some other estimates of the total liability are even higher. But a large portion of this debt was accumulated before 2009 and so far no systemic problems have occurred as a result of it.
Problems would emerge if the infrastructure projects do not generate enough growth and revenues to pay the operating and interest costs and repay the loans. While the obligations are technically a liability of the platforms, they can become a liability of the local government in the case of an explicit or implicit guarantee from the local government or via subsidies to cover operating costs of projects that are otherwise not financially sustainable. To date, some local governments have at times gotten into financial problems. But infrastructure construction in China has by and large created additional economic growth and the loans were repaid using higher future tax and land transaction revenues.
Looking ahead, if things go well, this could continue to be the case. But, after the large increase in investment and debt in 2009, it is important to reduce the flow of new activity. In the medium term, the major risks lie in low(er) growth and volatile land sale revenues. New challenges are higher relocation fees for resettled people and the possibility that some of the second generation of infrastructure that is now being emphasized—sewage systems, environmental projects, public housing—may not boost economic growth and revenues as much as roads and ports have done in the past.
Such financial problems would affect future local government investment spending and could lead to a rise in non-performing loans (NPLs). Local government fiscal activity is broadly divided in 2 parts. Local government general budget spending is largely current spending, financed by local current revenues and central government transfers and refunds. The spending on infrastructure and urban development is extra-budgetary, financed by land sale revenue and other non-current revenue, notably bank loans. Since 2007, land sales and related expenditures are reported in local governments’ funds budgets, but they are not consolidated with the general budget of local governments. Thus, lower extra-budgetary revenues—because of policy tightening or a correction in the property sector—would mostly affect infrastructure construction and urban development.
Localities that have relied heavily on land revenues and that have accumulated a lot of debt may face liquidity problems and could default on their debts, leading to NPLs for the banks. While this is a problem for all banks, it is probably particularly a problem for smaller, local level banks and credit cooperatives. These are likely to have weaker risk management, may be more susceptible to political pressure, and tend to have fewer low risk loans in their portfolios. For the large, nation-wide banks, NPLs are likely to be less of a problem, as their portfolios tend to be better balanced and their lending to infrastructure has tended to go to larger projects with support from the central authorities.
The authorities in Beijing are aware of the problems and have taken some measures to contain new local government lending and mitigate the risks. The People’s Bank of China (PBC) and the CBRC have both warned of potential problems and called on banks to strengthen risk assessment of lending to local government projects. PBC governor Zhou warned in January that "if [this] is handled poorly it could result in local government financing platforms being unable to repay their debts, creating bad assets for banks and other problems. " Liu Mingkang, China's chief bank regulator, asked banks to “fully assess and effectively guard against risks from local government financing platforms." Some individual banks subsequently announced increased vigilance towards this type of lending. News reports also indicate that the central government is preparing new rules on local government guarantees, with suggestions that letters of guarantee or comfort will not be valid anymore.
Given China’s healthy growth prospects, with an appropriate policy response these problems are unlikely to be large enough to cause systemic fiscal or banking sector stress. The scale of the debt of the local government investment platforms and the possible problems created by it in the coming years will depend on economic growth and on the effectiveness of the government’s measures to contain new local borrowing. If large portions of the debt end up being taken over by the government, that will add significantly to the official government debt. China’s fiscal position appears to be sound enough, though, to take that on, especially when compared to the fiscal position of most other major economies. Also, as a surplus country China has more room in deciding how to deal with such problems, since the government debt is largely held domestically.
Nonetheless, reforms may be indispensable to mitigate such risks in the future. Overall, China ‘s model for infrastructure financing has served the country well. But, reform of the intergovernmental fiscal system is needed to increase and diversify the revenue base of local governments, making it rely less on land sale revenues. And, local fiscal activity needs to become more transparent. It would be good to include land sale revenues and the infrastructure and urban development activity in local government budgets.