Beijing should prioritise the nation’s economic recovery over the “moral hazard” of reducing the debt burden on local governments by introducing a lower-interest debt-swap option, according to academics and analysts.
Meanwhile, they say, special-purpose bond sales – mainly used by local governments to fund infrastructure – are expected to skyrocket through next month after recent Politburo policy shifts.
As of Monday, there was still 31.2 per cent of the quota of 3.8 trillion yuan (US$527.5 billion) worth of special-purpose bonds that needed to be sold this year, Citic Securities said in a note on Wednesday.
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Special-purpose bonds have gained prominence over the years in China when it comes to their role in enabling local-level growth through fixed-asset investments. Some funds have also been used to replenish the balance sheets of the country’s financially strained small to medium-sized banks.
And now, after the Communist Party’s top decision-making body, the Politburo, vowed last month to speed up the issuance and use of local government special-purpose bonds, analysts say the logical expectation is that local governments will aggressively try to make use of the rest of their special-purpose quotas over the coming weeks and months.
As China’s local governments struggle to repay debts, should Beijing help out?
“The recovery still requires fiscal support, and the necessity of fiscal efforts to stabilise growth has increased. Therefore, it is reasonable to accelerate the supply of government bonds,” Kaiyuan Securities said in a note on July 31.
But as China’s recovery slows, there are mounting questions over the efficacy of local-level authorities using fixed-asset investments to drive economic growth, especially when assessed against the risk of accumulating excessive debt.
Local governments, which are mainly responsible for such investments, are already struggling to meet debt repayments. There are also calls for the central government to introduce a debt-swap programme with local government debts to stabilise confidence, by offering more favourable interest rates on their owed debt.
Moody’s Investors Service said in a report on Tuesday that local governments were facing an uphill battle to support the companies they control, as a result of declining revenue from reduced land sales; rising debt and state-firm liabilities; and weakened capital-market access for local government financing vehicles (LGFVs), raising the default risks of LGFV bonds.
The central government’s stance on not bailing out local governments has exacerbated fears of the first public-debt defaults in debt repayments by LGFVs, which could affect the state-owned financial system – a big, obvious and neglected risk that China’s policymakers call a “grey rhino”.
A Politburo meeting in July called for “implementing a comprehensive debt solution”, which signalled that the priority is no longer to deleverage local governments, according to a note by Macquarie Group last week. Instead, Beijing wants to prevent a crisis of confidence triggered by local government debt defaults, and to keep infrastructure investment growing at the current pace of around 10 per cent, Macquarie Group said.
Liu Qiao, the dean and professor of finance with Peking University’s Guanghua School of Management, said there is a sense of urgency for the central government to step in and support local governments.
“The debt problem of some local governments is relatively serious now. The primary issue to consider at this time is not the moral hazard, but rather stimulating economic growth, repairing the balance sheets of local governments, and gradually restoring the ability of local governments to repay debts,” Liu was quoted as saying by the Shanghai-based media outlet The Paper on Wednesday.
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The central government considers bailing out local governments a “moral hazard” because such practice may encourage reckless spending by local governments at the expense of taxpayers.
Beijing has vowed to support the private sector with an action plan that aims to shore up the ailing private sector that underpins economic growth, jobs and technological innovation, and to invigorate the national economy.
But according to a recent survey of more than 50,000 small to micro-sized firms by Peking University, expectations for the second half of the year remained pessimistic, according to Liu’s review of the unreleased findings.
The debt swap should be selective, with the goal to help enterprises that didn’t get paid by local governments for their work, Liu added.
Liu also expressed concerns about the direction of China’s economic policy and whether it has taken into account the “seriousness” of the problems in the nation’s post-Covid recovery, while not adjusting to requirements when it comes to developing new industries.
“I think the decision-making departments must change their policymaking mindset. Now that we have reached a critical point in the transformation of new growth drivers, we need to promote a series of long-delayed structural reforms as soon as possible. As for short-term macro policies, the key is to restore the economy to a normal cycle, and there are many policy tools that can produce good results,” Liu said.
UBS said in a note last month that China’s fiscal position remained rocky in the first half of 2023, partly due to the slower issuance of special local government bonds than in the first half of 2022. The Swiss bank added that the government may even bring forward some of the 2024 quotas in the last quarter of this year.
“Considering the size and complexity of China’s local government debt and potential moral hazard, we think a wholesale LGFV debt swap or bailout is unlikely in the near term,” UBS wrote. “Instead, the extension of local government and LGFV debt, and de facto restructuring, especially with banks, will likely be encouraged, while local governments may also be pushed to sell or mortgage some assets to gain more liquidity.”
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