In the movie Sanctum, a team of divers tried to explore the largest underwater cave in the world, where no human beings had been before, and almost all of them, including the master diver, lost their lives. Only one young diver went through all the tunnels, inner lakes, and deadly terrain, found the exit to the sea, and survived.
The issue of China’s debt level is somewhat like the mysterious cave in that no one has a clear idea of its scale. The central government debt-to-GDP ratio, according to China Ministry of Finance and National Statistics Bureau, is 17.7% in 2010, and averaged 17.5% in the past 6 years. This seems to be low at first glance. However, just as the cave in Papua New Guinea that seemed welcoming, yet with dangerous underwater cave systems hidden behind, a lot of debt is hidden from the central government debt number and is de facto liability of Chinese central government.
The scale of the local government debt is even larger than the central government liability. The local government debt-to-GDP ratio is 26.7% in 2010, higher than the 17.7% central government debt ratio. The total amount of local government debt balance in 2010 is 10.7 trillion RMB ($1.67 trillion) according to National Audit Office, and forecasted at 11.8 trillion RMB ($1.84 trillion) according to J.P. Morgan.
Such a large amount of local government debt is accumulated in a very short time. Contrary to the relatively stable levels of central government debt, the local government debt level increase tenfold from 1998 to 2008, and almost doubled from 2008 to 2010. The growth rate of local government debt in 2009 was an astounding 61.9%. The rapid accumulation of debt in the past three years is mainly due to the 4 trillion stimulus plan which required local government to provide funds along with funds from central government to invest in infrastructure projects. Since local government didn’t have enough money at the time, they had to borrow money to invest, making the local government debt increase by 5.1 trillion RMB ($797 billion) in the past 3 years.
Could local government pay back the debt from their tax revenues? The answer is probably no. The local government has been facing fiscal deficits from 1999, if transfer payments and land sales were extracted. The local government deficit increased every year since 1999 and reached 3.30 trillion RMB ($516 billion) in 2010. The local government is in deficit now even after transfer payments. Local governments in China largely rely on land sales as a source of income and lack a stable and strong source of revenue such as property tax etc. So the around 1 trillion RMB annual debt payment is a burden too large for local governments.
Should local governments default, it would seriously hurt Chinese banks. According to National Audit Office, 79% of local government debt is financed by bank loans. Should the local governments become insolvent, the NPL in major banks would increase. The commercial banks have about 2 trillion RMB exposures to the local government debt, while the policy banks such as China Development Bank have assumed the rest 6 trillion RMB exposure. Any debt restructuring or defaults from the local government will hurt these banks first, and whether a central government bail-out is needed is still contingent on the extent to which the banks were hurt.
In conclusion, the local government debt lacks transparency, and has reached at least 26.7% of China’s GDP. The hidden local government liabilities cast doubt on the apparent low debt-to-GDP ratio of China. The contingent liabilities for central government are not known. If local governments defaulted regionally or even nationally, the fiscal budget will be restrained, banks would be hurt by surging NPL, and growth will slow down regionally or even nationally due to the potential austerity measures taken to repay the debt. A national bail-out might be necessary and at that time, China’s debt level will not look as healthy as currently it is.
Central Banking Seminar