Why Chinese Local Governments Are Issuing So Few Bonds

Something strange is going on with China’s local governments. President Xi Jinping recently declared local government debt to be one of the greatest threats to the country’s financial stability, and over the last 12 months, Beijing has unleashed a wave of regulations to try to rein it in. And yet, based on official data, local governments appear to be a model of fiscal rectitude. Far from engaging in some debt-fueled binge, local governments officially borrowed far less in 2016 than they were entitled to. Under an annual quota allocated by Beijing, local governments could have issued a further 620 billion yuan ($95 billion) worth of bonds in addition to what they actually sold (see Figure 1).

Figure 1. Total Local Debt Issuance vs. Issuance Permitted by Beijing
Source: Ministry of Finance.

Behind the veneer of prudence, however, local governments have been skirting Beijing’s rules, amassing debts far in excess of what they’re allowed. They have done so by borrowing through opaque, hard-to-track channels.

That fact, in and of itself, is hardly surprising. For two decades, China’s subnational governments have dependably flouted rules designed to prevent them from borrowing at all. The more the central government choked off financing channels, the more local officials discovered creative ways to get around the problem.

What is surprising this time is that, despite being able to openly and legitimately borrow from formal channels, at interest rates far lower than other types of available financing, local governments are not making the most of their opportunity. This discrepancy between actions permitted and actions actually taken seems to be the result of a muddle of political incentives that are shaping the behavior of subnational officials in contradictory ways. And this highlights some of the difficulties Chinese leaders face in designing effective fiscal reforms.

On the one hand, Beijing has been trying to rein in the growth of local government debt by warning that excessive borrowing will negatively impact officials’ career prospects. To that end, since 2014, Beijing has included an assessment of borrowing decisions in cadres’ annual performance reviews, effectively making whether or not they have borrowed prudently into the Communist Party’s version of a key performance indicator.

And that was not all. In July 2017, Xi took things a step further, warning that local officials would continue to be held accountable for borrowing decisions even after they had moved away from the jurisdictions where they had once served, and borrowed money for the units they led. This was a considerable broadening of the threat since officials could now be held accountable for past decisions made in places for which they were no longer responsible. In fact, Xi warned that officials would be held accountable for these past decision for their entire lives, although, to be sure, it is unclear just how such monitoring could be carried out.

Still, these shifting political incentives led to some unintended consequences. Instead of driving officials to exercise greater fiscal prudence, they have instead responded by, in many apparent cases, fostering the appearance of tightening their belts without meaningfully doing so. That is because economic growth—which has to be supported by more borrowing—has been retained as the single most important factor governing officials’ promotion prospects.

The results are, not surprisingly, rather different from what Beijing intended: local leaders have tried to prove that they are embracing an agenda of fiscal prudence, even going beyond what Beijing has asked of them, while continuing to stimulate growth by raising debt surreptitiously.

Up until 2015, Beijing had not permitted local governments to borrow at all, a stricture local authorities also roundly ignored. That year the central government moved to bring local authorities’ borrowing under control by demanding they provide a comprehensive accounting of their debt holdings. In return for coming clean about how much they had borrowed, local authorities were allowed to exchange their debt—a complex mix of bank loans and shadow banking finance—for bonds. The Ministry of Finance determined that, at the end of 2014, local governments had amassed 15.4 trillion yuan (~$2.3 trillion) worth of debt.

This figure became the base against which Beijing would calculate how much additional debt local governments could accumulate in the future. For 2015, the center decided that it would allow local governments to raise their combined debts to 16 trillion yuan (~$2.4 trillion), an increase well below the pace of previous years. And yet even then, there were signs that local authorities were playing politics with their debt levels. Not only did local governments come in under the 2015 cap, they reported having only 14.8 trillion yuan (~$2.2 trillion) worth of debt, which—if taken at face value—meant that they were deleveraging.

Indeed, local officials had fiddled with debt figures and merely reclassified some of their loans, so that these no longer appeared in official statistics. In 2016, local government debt crept up a little, but still remained below the 2014 level (see Figure 2). Even provinces like Guizhou, which is known for its investment-fueled model of growth, claimed to have less debt at the end of 2016 than two years earlier.

Figure 2. Total Local Government Debt
Source: Ministry of Finance.

But here is the long-term challenge: local governments’ decision to engage in a charade of fiscal responsibility comes at a cost—literally. That’s because bond financing is far cheaper than any other form of debt available to local governments. Given how opaque local government borrowing has become, it’s impossible to estimate just how much local authorities currently pay in interest on debt raised through informal channels, but back in 2015, when Beijing first decided to legitimize bond issuance for local financing, bonds were on average 6.5% cheaper than other types of debt local governments were using at the time.

So, by choosing to issue fewer bonds, local governments are deliberately forgoing cheaper financing and opting for more expensive borrowing.

When Beijing moved to rein in local government debt in 2015, it initially looked like a success. That success now appears to be little more than smoke and mirrors, and Beijing has found itself scrambling to bring under control a problem it thought it had already resolved.

POSTSCRIPT:

Some readers have pointed out that the Ministry of Finance (MoF) data I used in this story is different from that in the Wind Financial database. In particular, the Wind data suggests local government new borrowing is, in fact, almost equal to the quota. We don’t subscribe to Wind, but the Chinese press has reported on the Wind data here, which I’ll use to explain the discrepancy here.

The confusion arises because MoF assigns two bond issuance quotas each year to the provincial governments. One caps the amount of bonds local governments can issue to cover their budget shortfall in that year (which is the quota I use); the other limits the volume of bonds local authorities can issue to replace existing debt.

Under the two quotas combined, local governments were entitled to issue about 6.7 trillion yuan worth of bonds last year. According to MoF, actual issuance came to 6.06 trillion yuan. Wind calculates total issuance at the comparable figure of 6.04 trillion yuan. Where the two data sources materially differ is in regard to which quota was undersubscribed. (see Figure 3).

The finance ministry says that 5.5 trillion yuan worth of bonds—the full value of the quota—were used to repay existing debt, while Wind data suggests only 4.87 trillion yuan was sold for that purpose. Inversely, Wind calculates that local governments used almost the full value of the other quota—all 1.18 trillion yuan—toward covering their 2016 budget shortfall. The finance ministry puts the figure at about 560 billion yuan. In both cases, the difference between the combined quota and total bonds issued comes to about 620 billion yuan—the figure we report above.

Nonetheless, the question of just what the 620 billion yuan wasn’t used for is of vital importance. Whereas the repayment of existing debt doesn’t contribute to growth, new additional borrowing stimulates the economy.

I don’t know how Wind calculates its data, but I assume that it’s based on information local governments disclose in their bond prospectuses. Meanwhile, MoF is privy to information on how the money raised from bond issuance is actually spent. It is for this reason that I believe MoF data is a better reflection of actual local bond issuances.

Figure 3. Total Local Government Bond Quotas vs Actual Issuance
Sources: Ministry of Finance; 21st Century Business Herald.