Risks mount as local govts skirt rules to take on greater implicit debts

Source:Global Times Published: 2017/6/5 17:13:39

Beset by backdoor borrowing

Despite central government controls, implicit local government debts, assumed through methods such as Public-Private Partnership projects and government investment funds, are growing in China. Experts noted that there are several reasons for the growth of implicit local government debts, including a central government-imposed cap, an evaluation system for officials that encourages local governments to amass debt, as well as a lack of accountability.

Photo: CFP

China's central government has made fighting implicit local government debts a priority in its larger battle to reduce risks in the financial system.

Since the fourth quarter of 2016, the central government has rolled out several policies to get local government debts under control. On November 14, 2016, the State Council, China's cabinet, released an emergency plan to deal with risks from local government debts. About a month later, the Ministry of Finance (MOF) issued guidelines for classifying local government liability risks.

On May 3, six government ministries jointly issued a notice to further standardize local government borrowing and financing.

This standardization could result in a comprehensive network to manage local government debts, according to a report by Caixin Weekly magazine on May 29, citing Zhao Quanhou, a research fellow at Beijing-based Chinese Academy of Fiscal Sciences (CAFS).

But despite these measures, some local governments are still taking on debt through Public-Private ­Partnership (PPP) projects, government investment funds and government procurement contracts.

Implicit debts typically refer to liabilities that are not legally recognized. Usually, they are not included on the balance sheets of local governments.

By the end of 2015, local governments had taken nearly 35 trillion yuan ($5.14 trillion) in implicit debts, according to expert estimates, despite a 16 trillion yuan cap that the central government placed on local government debts that year.

No figures for implicit local government debts for 2016 could be found in domestic media.

"The risks [of implicit debts] are spreading," a source close to the MOF told Caixin Weekly.

Skirting the rules

According to the Caixin report, government-led investment funds are a major channel for implicit local government debts.

The number of government investment funds grew from 76 in 2014 to 1,013 in 2016, according to data from Beijing-based financial advisory services provider Zero2IPO Group.

Those funds have directed money to infrastructure construction and the real economy. Various funds such as urbanization funds, aviation industrial investment funds and rail traffic industrial investment funds have emerged as new financing platforms for local governments.

For government investment funds, local governments are only allowed to make equity investments in projects, but many local governments secretly provide collateral such as land and real estate, which in turn increase their liabilities, according to the Caixin report, which cited a research note from Guizhou-based Huachuang Securities.

"Government investment funds are a mess," a person close to the National Development and Reform Commission told Caixin Weekly. "It's time to clean them up."

PPP projects provide another avenue to rack up implicit debts. As of the end of March, China had more than 1,700 PPP projects with 2.9 trillion yuan in investment, according to the MOF.

The central government introduced PPPs early in 2014 to help establish a modern financial system, but in reality some local governments have provided fixed returns or taken up fallback responsibilities, which has increased their debt risks.

The joint notice by the six ministries stressed that local governments cannot establish investment funds with borrowed capital. It also prohibited local governments from promising to buy back social capital's investment principal in PPP projects and government investment funds.

Such government actions have led many banks to cut back on investing in local government investment funds and PPP projects. For example, an unnamed top manager at a major bank told the Caixin Weekly that the bank has cut back the scale of investment in government-led industrial funds because in many cases governments don't pay as much as they promise.

A medium-sized trust company's president said the company had looked into investing in PPP projects in 2015, but eventually gave up ­because the company couldn't get ­access to projects with clear cash flows.

"We wanted to participate in projects with a clear commercial model and cash flow such as sewage treatment plants and toll roads, but the local government told us: 'Don't do those projects. Let's work on a public square.' How can I earn money from a public square?" the company's president was quoted as saying.

Small cap, little accountability

The pressure for local governments to urbanize is one factor driving the growth of implicit debts, said Zhao, the research fellow at the CAFS, because the central government has capped the amount of explicit debts they can accumulate, forcing them to turn to other avenues for financing.

The source at the MOF didn't agree with this explanation, however. "Governments will naturally spend more if they can," the source said, adding that no government has ever acknowledged it is spending too much.

The central government's budget for 2017 has exceeded 20 trillion yuan, which is relatively high, the source noted.

Implicit debts are also growing because the performance of local government officials is still, to some extent, tied to economic growth, which will cause infrastructure investment to exceed a reasonable scale, Zhao said. As long as evaluations of officials take economic growth into account, an incentive will remain for them to push for infrastructure investment beyond what is reasonable.

As the evaluation system evolves and indicators such as economic growth play less of a role in an official's performance, this incentive will diminish, Zhao said, though the process will take time.

A lack of accountability also allows implicit government debts to grow.

In January, the MOF informed five local governments in China that they needed to rectify irregular borrowing activities and punish officials for misconduct. However, only two cities - Qianjiang in Southwest China's Chongqing and Zoucheng in East China's Shandong Province - have so far made their accountability results public.

The Caixin report cited a source who said it is very difficult to determine how much money is involved in illegal local government borrowing.

As for accountability, the measures the MOF is currently taking are more like a warning than actual punishment, the source said.

This article was based on a report by Caixin Weekly.


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