Xu Zhong, head of the People’s Bank of China’s research bureau, is in an unusual position. In a nation known for government intervention in free market forces, he recognizes the slippery slope of the moral hazard of the government bailing out risky lending practices. Looking at how local Chinese governments have become over-leveraged, he says the world’s second-largest economy needs a bankruptcy process for local governments, using Detroit as an example. The central government needs to send a message that it will not give blanket bailouts for irresponsible practices, he says, amid mounting concern. The warning comes as the Bank of International Settlements and a wide variety of international finance organizations have been noting the fears.
China needs to change thousands of years of political history of central government backstopping market risk
The Chinese central government’s “core proposition for the political and economic history ”that has led to “thousands of years” of central government support for local government financing may be coming to a close.
In an editorial on the financial news website Yicai, Xu lamented to perverse incentives that have been created by a central government providing an unrequited risk backstop to local governments, who have issued bonds with little prospect of payback.
“There does not need to worry about local governments chaotically issuing debt,” he wrote, pointing to “the immense risk of the local bond market and its negative impact on macroeconomic volatility have become China's 'gray rhinos' that are of global concern.”
He pointed to 20 cities and counties that were “guilty of illegal debt guarantees” and a continued reliance on the central government backstopping bad bonds that, in a free market, never would have had much chance of success.
Xu is not the only one concerned.
When Chinese leaders all send the same message, it has added meaning
“Financial institutions must not provide financing to projects without a source of stable operating cash flow or that do not have compliant collateral,” China’s National Audit Office said in a report published Saturday. The report pointed to a controlled spending on new projects.
The report, which came days after Xu’s public statement, pointed to the need to break the “illusion” that the Beijing will bailout local regions that engage in irresponsible debt practices.
Chinese President Xi Jinping had earlier called for effective control of leverage in the world’s second-largest economy. In October, the nation’s central bank governor, Zhou Xiaochuan, called on reforms to crack down on local governments obfuscating their financial reports “to disguise debts,” a practice that made bond offerings riskier.
Local government financing vehicles (LGFVs), a primary method to market debt, have sold 1.7 trillion yuan ($259 billion) in onshore and offshore bonds markets in 2017: this represented a 23% drop from 2016’s level, according to data compiled by Bloomberg, as investor concerns about a lack of support for such bond offerings reverberated to investors.
Fitch Ratings said in September that bond defaults from Chinese LGFV investment vehicles were becoming more likely. Moody’s, for its part, has been warning about Chinese debt and their aging demographics for years.
The concern over Chinese debt is not new. Financial worries from Bank of America Merrill Lynch and legendary hedge fund manager George Soros have issued warnings that unsustainable debt underwriting practices and a blanket risk guarantee issued by central governments are a recipe for financial problems.
And it is here that Xu looks to Detroit, MI for answers.
“China must have an example like the bankruptcy in Detroit,” he wrote, pointing to the 2013 $18 billion municipal bankruptcy, the largest in US history. “Only if we allow local state-owned firms and governments to go bankrupt will investors believe the central government will break the implicit guarantee.” That said, Xu thinks the bankruptcies should not result in social services cuts, a delicate balancing act indeed.