China keeps an ace up its sleeve while upping ante on local debt

[HONG KONG] In addressing the dilemma over some US$4 trillion of debt racked up by spendthrift local authorities, China's leaders have so far kept one ace up the sleeve - an option that helps limit the potential for a financial crisis.

At a stroke, Premier Li Keqiang's government could bail out provinces and cities directly by issuing national bonds, rather than the current policy of encouraging banks to keep credit flowing to them.

With a debt-to-gross domestic product ratio less than half that of the US - and on a par with Switzerland's - the central government has scope to take on the borrowing. Global interest in buying yuan assets, given China's rising role in the world economy, means such a move could create a deep new market for risk-free securities and help internationalize the currency.

For now, policy makers are instead intent on an attempt to introduce risk-pricing into China's financial system, by reducing implicit guarantees and allowing at least some borrowers to default.

"That is probably the neatest solution," Fred Hu, chairman of Beijing-based Primavera Capital Group and former China chairman of Goldman Sachs Group Inc, said of nationalising local debt. "But on the other hand, if they just clean it up, it will create moral hazard."

Under the current plan, regulators want local authorities to swap high yielding short-term loans for lower-cost, longer- term municipal bonds. The idea is to force these governments to justify their borrowing.

For the plan to work, the government is prodding banks to buy the new bonds and stave off a credit crunch. Authorities are also barring lenders from cutting off credit for projects approved before the end of last year.

While the swap program can ease borrowing costs and push out repayment horizons, it does little to address the underlying debt build-up. That could pose a continuing challenge should fiscal revenues remain under pressure thanks to a slowing economy and less robust real-estate market.

"If the situation really deteriorates, I think it is possible that the central government will choose to absorb a majority of this debt - but right now we are not in such a stressed environment," said Charlene Chu, a partner at Autonomous Research Asia Ltd in Hong Kong who previously worked at Fitch Ratings Ltd. "The central government needs to instill a new mentality toward governance among local officials, and bailing out bad behavior goes against this, and against the thrust of the anti-corruption campaign."

It was the national leaders who first encouraged what became a record credit expansion in China, during the depths of the 2008 financial crisis. Then-Premier Wen Jiabao's cabinet on Nov. 9 announced a 4 trillion yuan stimulus program - US$586 billion at the time. Five days later, national authorities specified that they'd only be providing just over a quarter of that sum, with the rest to come from elsewhere.

Cities and provinces, limited from selling municipal bonds by law, rushed to set up off-balance sheet vehicles to raise funds from banks and tap other sources of funds, in the shadow banking system.

In the end, they took on far more debt than first envisioned. Local government obligations may have reached 25 trillion yuan (US$4 trillion), according to estimates from Mizuho Securities Asia Ltd. That compares with a 17.9 trillion yuan estimate for June 2013 from the National Audit Office.

For now, officials in Beijing are hoping they can steer a path that improves transparency around local authority borrowing without running the risk of a credit crunch, said Peng Wensheng, global chief economist at Citic Securities Co.

"The central government is trying to strike a balance between a full backstop and a chaotic and disorderly adjustment," Mr Peng said in Hong Kong. "This is trial and error."

On a separate track, China's regulators are opening up access to its capital markets, and seeking reserve-currency status for the yuan. But the size of China's bond market is smaller than many advanced and emerging economies due to the central government's relatively low borrowing.

Central government debt is around 43 percent of gross domestic product, according to the International Monetary Fund.

"The limited size of China's bond market has constrained the international use," of the yuan, analysts at China International Capital Corp wrote in a note. "Financial deepening is a necessary step to provide enough instruments for domestic and foreign investors."

By some estimates, almost US$1 trillion of global reserves could shuffle into Chinese assets in coming years if the IMF green lights the yuan as an official reserve currency this year.

"Right now, a lot of people are interested in holding RMB, but in what?," said Wang Tao, chief China economist at UBS Group AG in Hong Kong, referring to the renminbi, another term for China's currency. "A lot of people are scratching their heads." The size of the market for China's central government bonds pales in comparison with that for US Treasuries. Around US$6.8 trillion of U.S. debt is due to mature through 2020, compared with the equivalent of US$793 billion in China, according to data compiled by Bloomberg.

"That's a direction that China will move, but it will take some time to reach that," Justin Lin Yifu, a former chief economist at the World Bank, says of creating a deeper central government bond market.

BLOOMBERG