The Institute Blog

China Economics Seminar: The Real Risk In China’s Local Government Debt

As I discussed in my previous post, when looking at the high level of debt compiled by China’s local governments, it’s easy to imagine that the country is on the verge of a United States-style municipal meltdown, with towns and counties going bust. But this is wrong, and more importantly it misses the real risk embedded in China’s soaring local-government debt levels.

State-owned assets, land reserves, central government guarantees, and domestic financing all offer China advantages over some other countries in dealing with local government debts. But they won’t solve the fundamental problem. As long as the debt-financed investments are not economically viable, there will be an unsustainable increase in debt and if this continues forever, a debt crisis will take place.

Historically, many countries that have experienced debt crises also had a lot of state assets, like South Korea and Russia. When everyone realizes that someone is struggling with debt and is eager to sell its assets, the assets usually are sold below fair value.

For China, this means that in a crisis the country would likely find itself with a much lower asset buffer than it thinks it has. Land is also very pro-cyclical and its value can depreciate sharply during a crisis. So while China is unlikely to have a Detroit-style local debt crisis, it could still accumulate systematic risk on the national level. In fact, China has not even had a default in the corporate bond market because the government bailed out troubled companies. But this sets a dangerous precedent because it may fail to prevent moral hazard in the future. It also could distort market competition and add to the burden for the government and taxpayers. As Rabinovitch perfectly pointed out in the FT:

With the steady stream of bailouts, what is nominally classified as corporate debt very quickly becomes government debt. This allows China to avoid the pain of defaults, but the debt remains in the system, just in a slightly different guise.

As long as all the debts keep accumulating in the system, China will eventually reach a tipping point. Some compare China’s debt-to-GDP ratio with that in the U.S., Italy, or Japan, and say that China’s ratio is below the “dangerous threshold.” It is true that many countries have debt-to-GDP ratios higher than China. But this does not mean that China is absolutely immune to a debt crisis – particularly since there are serious reasons to question the “threshold” theory. Debt-to-GDP ratio is one measurement, but a lot other things matter too. When Argentina suffered its debt crisis, its debt-to-GDP ratio was lower than China’s today. The trend in China is alarming enough, and we cannot pretend that there is no problem simply because China’s debt-to-GDP ratio is lower than that of Japan.

Government debt-to-GDP ratio in G20 countries (%)

G20 Countries’ Debt-to-Fiscal Revenue Ratio (%)

The only fortunate thing is that we are not there yet .There is still some time to make the necessary adjustments. Though the city of Guiyang is investing quite heavily, property sales and the debt level suggest that the situation is still under control. And even if Guiyang is doing a really bad job, it does not necessarily mean that China will have a crisis immediately. The GDP of Guizhou province is a mere 1.3% of China’s total GDP and the city of Guiyang might be too small to trigger a national panic.

People may say that in spite of high sales numbers, many apartments in Guiyang remain empty (shown by FT photos), so it is simply another “ghost city”. And since many “ghost cities” have been reported, the Chinese property market could collapse any minute.

This is a reasonable argument, but there are actually two different types of “ghost cities”. One type is that the apartments are not sold at all and the other is that apartments are sold but nobody actually lives in them. 

Sometimes people fail to distinguish these two “ghost cities” but they actually have very different implications. Both of them are worrying, of course, but the first type of ghost city is much worse than the second because when apartments cannot be sold developers can quickly fall into cash-flow troubles. This could trigger a crisis. The second type is worrying and would eventually lead to the same problems as the first, but it can take a very long period of time for a crisis to develop. And this is what appears to be happening China.

Why do people buy apartments that they won’t live in? The most obvious reason is that they expect property prices to go even higher and they did in the past. If households speculate too much in the property market, one might expect that their balance sheets would look worse as household debts would rise rapidly.

In the FT, Rabinovitch says:

Of the three kinds of debt – government, corporate and household – the latter is barely on the radar as a risk in China. Household debt is about Rmb15tn ($2.5tn), or a third of gross domestic product, according to RBS. That is roughly half of what the government owes and a quarter of corporate debt.

Yet this snapshot misses the dramatic changes afoot. The stock of household debt has tripled over the past five years. Average household debt jumped from 30 per cent of disposable income in 2008 to 50 per cent by the end of 2011, according to the Peterson Institute for International Economics.

According to the PBoC, loans to households totalled 18.5 trillion yuan ($3 trillion) as of July, even higher than RBS’s estimation of 15 trillion, and its 23% year-on-year growth was faster than overall loan growth of 15%. Household deposits, however, only rose by 13% to 44 trillion by July. The household loan-to-deposit ratio has risen from 24% in 2008 to 42% now, which also shows that households are leveraging up.

Still, this is probably not enough to conclude that China is at risk of an imminent property crisis. If we consider China’s extremely high level of home ownership, the balance sheets of Chinese households only look even healthier. Property investments have weakened their liquidity to some degree, but in general households in China still look pretty strong, especially if we compare them with those in the West.

This is not to say that there isn’t a property bubble. When a friend bought a built-in apartment outside Beijing’s fifth ring last year, which is 21 kilometers or 13 miles away from the city center, the price was 27,000 yuan (4,400 USD) per square meter. Last week someone wanted to buy his brand-new home for 44,000 yuan (7,100 USD) per square meter. The price is higher than what you would find in many European and American cities.

Clearly this is a bubble since Beijing’s GDP per capita is only $14,000. However, considering that prices can still go up 60% in a year when Beijing’s home vacancy ratio is as high as 29%, it is almost impossible to predict when the bubble will burst. Perhaps it will rise another 25% next year. Who knows?

No one can tell you exactly when the tipping-point will occur. But since last year more and more people in China are realizing that the economy is moving in a dangerous direction, and an increasing number of economists are calling for reform. We are running out of time and the adjustment is needed now more urgently than ever.

Sadly, history suggests that China only reforms after crises. Not before.