Guaranteed Government Bailouts: Is The End Nigh?  

One of the main distortions in the Chinese economy is that local state-owned enterprises (SOEs) can borrow at artificially low interest rates, which affects credit allocation throughout the economy. Investors widely believe that local governments will always bail out troubled firms, an implicit guarantee that meant investors did not need to price in the risk of default. This is why the recent spate of local SOE defaults sent jitters among investors, because it appears that the previous assumption no longer held and a wholesale repricing of risk is in order. 

On the one hand, Beijing has been increasingly moving away from implicit guarantees on state assets and has become more tolerant of defaults. This is ultimately a positive development for the Chinese economy because it gets rid of a major distortion. But a sudden change to the prevailing belief of guaranteed bailouts invariably will be disruptive and spook markets.  

On the other hand, declaring the end of the implicit guarantee is still premature for several reasons. For one, some of the latest defaults are not as surprising. As I’ve been highlighting, the deteriorating fiscal health of local governments has already chipped away at their ability to bail out local firms, particularly among the more debt-laden provinces. Not only are those provinces less able to bail out firms, investors are also less willing to hold bonds of struggling firms.     

More surprising was the case of Henan’s Yongcheng Coal, a gigantic triple-A rated SOE that suddenly defaulted on its bond in early November. That default roiled China’s bond market because it happened to a firm in a relatively fiscally sound province, upending the notion that defaults will be limited to financially struggling regions.   

While the impact of this case could well lead to a systemic repricing of bonds, it has not shaken the foundation of the local government implicit guarantee. That foundation is built on bank lending, which is about five times larger than bonds as a source of local financing. Because bonds pale in comparison to bank financing, that also means bond investors are a much less important interest group than state banks for local governments. So long as the relationship between local governments and banks holds, a form of implicit guarantee will persist. 

First, banks have disproportionate influence over local finance because they provide around two–thirds of total credit and are the biggest holder of local government bonds. This means local governments have reciprocal and entrenched relationships with banks and generally want to placate them. For instance, even a fiscally struggling local government controls many valuable resources, and it can award banks with fiscal deposits or financing opportunities for future infrastructure projects as compensation. 

So even if bond holders start to discount the implicit guarantee, banks won’t be much deterred by these defaults because they can recover their lending to local SOEs in more ways than one. In fact, when regions have experienced large–scale defaults, bank lending actually increases relative to other forms of financing (see Figure 1).  

Figure 1. More Defaults, More Bank Lending (% of new lending)   Note: This shows the average percentage of new bank lending in total new credit for each region before and after a spate of defaults. For Tianjin and Liaoning, the data shows the three years before and after defaults took place in 2016-2017. For Shanxi and Inner Mongolia, the data shows the two years before 2013-2014 and after 2015-2016. Defaults in those regions are correlated with shorter boom and bust commodity cycles.
Source: Wind and MacroPolo. 

The recent SOE defaults may have rocked the bond market, and the eventual outcome will lead to some local SOEs paying higher interest rates. But the local government implicit guarantee problem that distorts credit allocation has not been resolved. For that to happen will require a more fundamental reset of the relationship between local governments and banks. That paradigm is starting to shift, but there is still quite a distance to go. 

Houze Song is a research fellow at MacroPolo. You can find his work on the economy, local finance, and other topics here.