Anyone who follows China, knows that the country faces a particularly vexing problem when it comes to debt. This can be explained in a simple way: Beijing is attempting to deleverage and re-leverage simultaneously. Needless to say, this isn’t possible, but that hasn’t stopped China from trying, as is clear from the multitude of contradictory policies and directives that have emanated from Beijing over the course of the last nine months.
Nowhere is the confusion more apparent than in China’s handling of its local government debt problem. In an effort to skirt official limits on borrowing, the country’s provincial governments racked up an enormous amount of off-balance sheet liabilities. These loans carried higher interest rates than would traditional muni bonds and ultimately, servicing the debt became impossible, Market-Robots Blog reported.
In order to help provinces deleverage, Beijing launched a program whereby high interest Local Government Financing Vehicles loans can be swapped for new local government bonds that carry substantially lower interest rates.
In fact, yields on the new bonds are close to yields on general government bonds meaning provincial governments are saving somewhere on the order of 300 to 400 bps. But there’s a problem. Banks aren't particularly keen on swapping a higher yielding asset for a lower yielding one.
The PBoC’s solution was to allow the new bonds to be swapped for central bank cash which the banks could then re-lend into the real economy. The problem with this is that it transforms a deleveraging effort into a re-leveraging program. Shortly after the program was launched, the PBoC effectively negated the entire effort when it moved to loosen restrictions on the very same LGVF loans that caused the problem in the first place.
Fiscal Mismanagement
Admittedly, lengthy discussions about fiscal mismanagement across China’s various provincial governments does not make for the most exciting reading, but it’s hugely important from a big picture perspective.
Local government debt will account for an estimated 45% of GDP by the end of this year, IMF said. If one looks at what is classified as "general government debt", China's debt-to-GDP ratio looks pretty good–especially by today's standards. Simply counting central government debt and local government bonds, the country's debt-to-GDP ratio is just a little over 20%. Thus, if you fail to include the provincial LGVF debt burden, the effect is to dramatically understate China's debt-to-GDP.
China’s total debt-to-GDP (which includes corporate debt) is set to hit 250% of GDP by 2020.
Without reforms, growth would gradually fall to around 5% in 2020, with steeply increasing debt ratios.
The general government debt is slightly above 20% of GDP over the projection periods. Augmented debt, however, rises to about 71% of GDP in 2020 from less than 57% of GDP in 2014. Even with the favorable interest rate-growth differential, augmented debt rises over the medium term as the augmented deficit is assumed to decline gradually.
The augmented debt level is also sensitive to a contingent liability shock, which would push debt to near 100% of GDP in 2020. Such a shock, for instance, could be a large-scale bank recapitalization or financial system bailout to deal, for example, with a potential rise in NPLs from deleveraging. A combined macrofiscal shock would increase the debt-to-GDP ratio from about 71% to 78% in 2020.
