Analysis: China local debt cleanup could spur more rebalancing

SHANGHAI Wed Jun 1, 2011 7:58pm EDT

A pedestrian walks past the headquarters of the People's Bank of China, the central bank, in Beijing November 8, 2010. REUTERS/Grace Liang

A pedestrian walks past the headquarters of the People's Bank of China, the central bank, in Beijing November 8, 2010.

Credit: Reuters/Grace Liang

SHANGHAI (Reuters) - Beijing's plan to shift hundreds of billions of dollars worth of debt away from local governments and revamp the way they raise cash could help wean the world's second-biggest economy off trophy projects and other wasteful investments, paving the way for more sustainable growth.

That is, if things go according to plan.

Chinese regulators want to relieve provincial and municipal governments of 2-3 trillion yuan ($308-463 billion) in debt amassed through special financing vehicles used to fund infrastructure and other projects, sources with direct knowledge of the plan told Reuters on Tuesday.

While the most immediate impact will be to reduce the risk of a wave of defaults that some economists had warned could destabilize the financial system, another important element of the overhaul will be giving local governments direct access to the bond market, with broader implications for the economy.

"It's a very positive development," said Li-Gang Liu, head of greater China economic research at ANZ in Hong Kong.

"If this financing becomes more market-oriented, a lot of so-called image projects in local governments may not have enough funding, because investors might not like that. Basically, we would expect that resource allocation will become more optimal."

If provincial governments and those of major municipalities such as Beijing and Shanghai raise funds openly in the bond market, they should in theory be forced to make their finances more public, with any investments they make scrutinized carefully by ratings agencies and those buying the debt.

That should push up their overall cost of borrowing, especially for any projects whose returns are viewed as questionable by investors, the logic goes.

It would in turn become more difficult for local officials to find the cash to build lavish office buildings or pie-in-the-sky industrial parks that never get fully used -- just the type of wasteful investments authorities in the central government have tried to curb, with only limited success.

Ultimately, the economy would end up on more solid footing as a result, with less taxpayer money going into unnecessary projects only to turn into sour loans, and instead winding up in consumers' pockets or otherwise used more effectively.

Officials in Beijing have said for years that they want to guide the economy toward greater reliance on consumption, in line with other major economies, to break the current high reliance on investment, which in 2010 accounted for nearly 70 percent of gross domestic product.

"Investment-to-GDP has reached a very high level. This is unsustainable, and if we continue to see investment growth faster than GDP, which means a lot of the projects going forward are extra projects, they're not going to be as efficient as before," said Wei Yao, China economist with Societe Generale in Hong Kong.

RISK OF MORAL HAZARD

However, as with most reforms in China, change in this area is unlikely to come overnight.

Provincial governments have been able to access the bond market indirectly since 2009 under a program in which the finance ministry issues bonds on their behalf, guaranteeing their debt.

Moving to a model where local governments tap the bond market directly would probably be done in stages, with one possibility being that provinces in the more affluent east of the country start out under a trial program, said Yao.

However, even such a program is unlikely to be launched by the end of this year, as authorities work out the details.

When it does come, a big challenge for the market will be the risk of moral hazard, said Qiu Zhicheng, banking analyst with Guosen Securities in Shanghai.

While local governments might be issuing the debt in their own names, they and investors could end up working off the implicit assumption that the central government will bail them out again if they get into trouble, making it difficult to instill market discipline.

"Allowing local governments to issue debt is like letting a department within a company to issue debts," Qiu said.

The devil will also be in the details of how such bonds are implemented, analysts said.

"We'll have to see how these bonds are structured -- whether they're structured on a project-by-project basis, or whether for example Jiangsu (province) just gets the right to issue 10 or 20 billion yuan worth and then it's a pot and they can do whatever they want with the pot," said Stephen Green, China economist with Standard Chartered in Shanghai.

Still, anything that could unveil more detail about local government finances would be helpful, Green said.

"The more sunlight, the better," he said.

But even government-linked economists were somewhat skeptical about how much of an impact the changes could have in influencing the behavior of local governments.

The debt cleanup is not going to change one deep-rooted problem in the economy, said Yuan Gangming, a researcher with the Chinese Academy of Social Sciences: namely tension between local officials' drive for economic growth to help with their performance appraisals and the needs of Beijing to balance concerns over growth and inflation. "Local governments have different views and pursuits, and unlike the central government, local government officials don't think in a holistic or systematic way," Yuan said.

(Additional reporting by Zhou Xin and Langi Chiang in Beijing; editing by Vidya Ranganathan)

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