From SCB China 28 July 2011

China – Solving the local government debt problem

• We outline our ideas on how to solve China’s CNY 10-14trn (USD 1.5-2.1trn) local government debt problem. Relying on tax revenues and land sales will probably not work, we argue: the funds available are simply not large enough. Neither are the banks in a position to digest more than a small part of the potential loan losses. We believe that the problem will need some kind of central-government resolution. However, properly handled, the local debt problem does not have to trigger a banking crisis or a macro-economic slowdown. The central government’s balance sheet and tax collection capabilities combined with strong nominal growth should mean this challenge can be met.
• In the short term, we think that there is a need for increased Ministry of Finance (MoF) budget spending on infrastructure. This would provide essential liquidity for troubled projects and stabilise the most exposed banks. We also like the idea of one of the national policy banks becoming involved – issuing bonds, buying non-revenue-generating loans from the banks (for a small haircut) and then managing projects through to completion. Then, a fraction of budgetary revenues and a portion of land-sale revenues could be used to finance an Infrastructure Sinking Fund (ISF), which would be used to buy back bonds over 2012-15.
• Significant reforms are also needed in the fiscal and financial sectors. More centralised responsibility for spending, published government budgets, and increased local-government autonomy in revenue-raising and debt issuance are required. Without these, this bailout, like the one in 1998-2005, will not be the last.
• We welcome feedback on our proposals. The ideas are not without weaknesses – and there are considerable unknowns still about the scale of the problem.