【原创】China’s Local Government Debts and Bond Market

Table4 shows that up to the end of June 2013, local government debts totaled10.885917 trillion yuan. Among these, bank loans reached 5.525245 trillionyuan, accounting for more than 50.76% of the total local government debts. If short-termfinancing bonds, accounts payable, trust financing, borrowings by otherentities or individuals, construction, delayed payment, financing bysecurities, insurance industry and other financial institutions, andfund-raising are all considered as short-term debt capital, such short-termcapital totals 2.78479 trillion yuan, accounting for more than 25.58% of thetotal local government debts. In this regard, local government debt is mainlycomposed of short-term debt capital.

 Comparingthe sources of capital in Table 4 with the input direction of capital from Table1, it is clear that there are mismatches in maturity, i.e., short-term debts areused for long-term projects. For example, projects such as municipalconstruction, transportation facilities, subsidized housing, education, publichealth, water conservancy, and eco-development require medium- to long-termcapital investment, but the actual sources for these projects are short-termdebts. This mismatch of debt maturity not only causes local governments to spenda lot of time and energy on raising funds every year and to run short ofavailable funds, but also forces them to “rob Peter to pay Paul” in theirefforts to allocate and coordinate capital. Furthermore, the mismatch of debtmaturity influences the schedule and efficiency of project construction andcauses a series of risks and other unforeseen consequences.

To endthe dilemma of the mismatch of debt maturity and overcome the correspondingshortcomings, an alternative policy path is to increase the scale of localgovernment debt. This can be accomplished by raising the proportion oflong-term debt, changing the pattern of relying on short-term credit funds, andusing medium- to long-term capital raised by the same duration bonds to supportlocal governments in all kinds of infrastructure construction. This policy pathis also helpful to reduce the cost of local government debt financing and speedup the development of China’s bond market.

4. The DifferentCharacteristics of Fiscal Debt

Some people tend to directlycompare the debt balance with local government revenue when they assess localgovernment debt. Thus, they tend to claim that the surge in local governmentdebt will lead to numerous repayment risks. However, in reality, the range oflocal government debt is much wider than the fiscal scope.

Firstof all, as shown in Table 5, financing platform firms and state-owned sole-proprietorshipsor state-holding enterprises are independent organizations responsible for repayingtheir own debts, according to TheProperty Law, The Company Law,and The Enterprise Bankruptcy Law. Ifthey are unable to repay the principal and interest on maturing debt, theyshould initiate the liquidation process. Therefore, these debts are not part oflocal governments’ debt. As shown in Table 5, financing platform firms’ debtsreached 5.231808 trillion yuan by the end of June 2013, accounting for 50.07%of total local government debts, but these debts should not be localgovernments’ liabilities. Correspondingly, these company debts should not becomea part of local governments’ contingent liabilities. However, in Table 5, debtsowed by financing platform firms and state-owned sole-proprietorships or state-holdingenterprises with possible government paymentresponsibility reached 4.874222 trillion yuan, accounting for 72.56% oftotal local government debts. From another perspective, if responsibility for thesecompanies’ debts is imposed on local government finance, it is in conflict withThe Countervailing Regulation of thePeople's Republic of China. In so doing, it is not conducive to thecreation of a market environment for fair competition and it is unfavorable forthese companies to succeed in international competition.

Secondly,institutions responsible for their own revenues and expenditures belong to thecategory of institutions that function as enterprises. For them, the 256.255billion yuan debts with government guaranteeresponsibility and the 346.291 billion yuan debts with possible government rescue responsibility shallbe repaid through their own efforts, rather than by local governments. Otherwise,being responsible for their own revenues and expenditures becomes meaninglessfrom a financial perspective. Thus, their debts should not be included in localgovernments’ debt.

Lastly, theCNAO’s AuditFindings on China’s Local Government Debts published in June 2013pointed out that the debts used for urban construction including rail transportation,water, heating, electricity, gas, expressways, and airports not only formedcorresponding assets, but also yielded considerable operational profits. Debtsused for the construction of subsidized housing including public-rent housing,low-rent housing and affordable housing also yielded corresponding assets, rentsand incomes from the sale of housing. This shows that the related debts offinancing platform firms and state-owned sole-proprietorships or state-holdingenterprises do not need to be repaid or guaranteed by local governments. As aresult, these debts should not be directly linked to local government fiscalrevenue or used to calculate debt ratios.

Source:The National Audit Office, AuditFindings on China’s Local Government Debts (2013).

Fiscal revenueusually refers to the total amount of income gained by the government through taxationand other methods within one year. In addition to revenues included in budgetschemes, local government revenues also include local government income (suchas income from local governments’ funds), state-owned equity income fromstate-owned sole-proprietorships or state-holding enterprises, income fromselling assets, and other income. This income cannot be simply covered bybudget income, nor can it be reflected by debt ratios calculated from budgetincome. On the other hand, in economic practice, economic agents usually do notuse their operational profits to repay debts. Debts can be repaid by any cashincome and other sources of funding. Financing platform firms, state-ownedsole-proprietorships or state-holding enterprises, and institutions responsiblefor their own revenues and expenditures in Table 5 can use the cash flowgenerated from their economic activities to pay debts due. Therefore, thesedebts shall not be included in the debt burden of local government finance or inthe list of debts with government repaymentresponsibility. Furthermore, China's local government investment in thepast has already formed a large number of assets, among which are many high-qualityassets and assets with good cash flow. If necessary, current debts can be repaidthrough selling these assets. Therefore, sources for debt repayment are notconfined to fiscal revenues within the budget.

To repaymaturing debt is to pay a current debt. If long-term debt capital is investedin physical assets, local fiscal debt balances can be calculated by counting thecapital amount of funds raised by long-term bonds at a given time (a specificyear). In this regard, future debts which do not need to be repaid currentlycan be excluded from the current fiscal debt burden. For example, for a 10-yeardebt of 10 billion yuan, in the first year the debt can be excluded in thefiscal debt, in the second year 1 billion yuan can be included in the fiscaldebt, in the third year 2 billion yuan can be included in the fiscal debt andso on until in the tenth year when the whole 10 billion yuan will be included.This calculation method not only matches actual economic activities, but alsodistinguishes fiscal debts which form assets from those that do not. As aresult, the fiscal repayment ability and its change over time can be betterreflected, so that different societal sectors will not be concerned with thevarious risks caused by the increasing fiscal debt and local governments willenjoy a relatively relaxed environment for infrastructure construction.

In sum, incalculating financial indebtedness, we need to provide specific analysis toparticular cases. On the one hand, the calculation should follow the rules of amarket economy and the requirements of the legal system. It should also avoidlisting debts that belong to the different responsible agents of thestate-owned economic sectors under the category of local government financialburden. On the other hand, it should list the debt proportionally year by year,on the basis of the asset formation of fiscal debts and the mechanism of thebalance sheet. In so doing, long-term debt capital can be better used tosupport local government infrastructure construction, effectively alleviating aseries of supply-demand gaps in education, culture, health care, infrastructure,housing and pensions during the urbanization process, boosting consumption, promotingthe structural upgrade of consumption, and building a comprehensive well-offsociety.

5­. Changing thePattern of Local Government Debt by Using Long-Term Bonds

Table4 shows both the general structure of local government debt funding sources andthe serious repayment pressure on a yearly basis. In fact, local governmentsface a serious contradiction. On the one hand, they need to ease a series ofsupply-demand gaps in education, culture, health care, infrastructure, housing,water and gas supply, and environmental protection, among others, in economicand societal operations through increased capital investment. However, due toshortages in fiscal capabilities, local governments can only launch theseinfrastructure construction projects through borrowing debt capital.Consequently, it is inevitable that the amount of debt and the debt ratio bothincrease. On the other hand, the increase of the debt amount and the debt ratiowill lead to increased repayment pressure and higher insolvency risk; theshorter the maturity period of borrowed debt capital, the greater the risk ofinsolvency. In light of the large mismatch between local government financialcapabilities and administrative responsibilities, issuing long-term bonds maybe the most viable option.

Threemain considerations support issuing long-term bonds to relieve thecontradiction between local governments’ financial ability and administrative responsibilities.First, China's urban construction is still in its heyday, and this process maylast another 15 years or longer; after that, along with the completion of urbanconstruction, local governments’ investment in infrastructure construction willgradually decrease. For capital raised by long-term bonds, there is no need topay principal before the maturity date (only to pay the yearly interest), sothis capital can meet the investment demand of the construction peak and reducethe repayment pressure of these investment capital at the same time. Comparedwith short-term capital such as bank loans that are the main sources of currentlocal government debt, as shown in Table 4, long-term bonds not only guaranteethe stability of capital operation and stabilize financial support to relatedconstruction projects, but also reduce the overall cost of financing and weakenthe influence of volatility in economic operation brought by macroeconomicpolicy adjustment. Secondly, the principal of long-term bonds will be eroded byprice inflation in economic development. Even if the price inflates only 3.7%per year, the principal’s original value will be zero at the end of a 20-yearterm. In the process of China's economic development, the Consumer Price Index(CPI) increased 4.80 times and the Retail Price Index (RPI) multiplied 3.35times in the 34 years from 1978 to 2012, with the Producers Price Index (PPI)increasing by 2.93 times in the 27 years from 1985 to 2012. If this upwardprice trend continues over the next 15 years or so, then the actual value of a15-year long-term bond will be zero at the end of the term, which will greatlyabate repayment pressure. Third, in the next 15 years, as long as theoperational efficiency of the projects funded by long-term bonds is about 5percentage points higher than the debts’ interest rates, the cumulative totalprofits will make it possible to repay the maturing principal. As a result,issuing long-term bonds not only satisfies the need of the demander of capitaland related consumption needs and promote the improvement of related supply-demandgaps, but also realizes the ability to repay maturing principal and interest.It is not difficult to see that these functions of long-term bonds cannot beachieved by simply using bank credit or other short-term loans.

In encouraginglocal governments to issue long-term bonds, the following eight specificproblems need to be addressed:

First,defining who can be issuers of bonds. From “category of debtor principals”under Table 5, it is clear that financing platform firms and state-ownedsole-proprietorships or state-holding enterprises are independent legalinstitutions. According to The CompanyLaw and other laws, they are qualified to issue bonds and they can issue long-termbonds on their own. As a result, they shall be permitted to issue their own long-termbonds, according to the needs of urbanization construction projects. Moreover,in projects not run by companies, program-based bonds can be issued. Namely,the cash flow of these projects can be used to repay debts, with credit supportfrom local governments. For instance, the issuance of long-term bonds withguarantee is a good option for the construction of certain purely publicproducts (such as urban roads or green space); the guarantor can be state-ownedsole-proprietorships, urban construction companies, local government funds, orlocal fiscal revenues.

Second,public disclosure of information. From the perspective of reform, the issuanceof long-term bonds should change from the approval system to the registrationsystem. Under the registration system, disclosing information publicly is acore mechanism. Therefore, the government needs to clarify what informationshall be disclosed publicly in bond issuances and use the latest technologysuch as big data and cloud computing to enhance information disclosure in orderto gain the confidence of investors.

Third,clarification of the bondholder-investor relationship. For a long time, thevast majority of Chinese bonds have been issued to banks and other financialinstitutions, making many bonds that do not conform to banks’ risk preferencehard to be issued. Moreover, the creditor cannot supervise the debtoreffectively with banks as intermediaries. To change this situation and realizebonds’ multiple functions in financial operation, bonds have to become directfinancial products. Thus, the bondholders should mainly be urban and ruralresidents and entity enterprises.

Fourth,clarifying the conditions for bond issuance. In issuing bonds, localgovernments should choose conditions that are suitable both for projectinvestment and project investors. In particular, local governments should becognizant of the long duration of long-term bonds and of the fact that manyconditions may change before the term matures, so they have to choose moreappropriate issuing conditions that give the creditors and debtors morechoices.

Fifth,defining the distribution area. In order to reduce the degree of concerns aboutbond risk, local bonds may be issued to the public and entity enterpriseswithin a specific region (such as within a province or a city), especially forlocal bonds based on particular projects.

Sixth,clarifying issuance channels. In order to reduce borrowing costs and thuspromote the development of local financial markets, local governments canconsider utilizing the Internet as an issuance channel and sell long-term bondsto the public and entity enterprises openly.

Seventh,strengthening credit ratings. Credit ratings are an indispensable mechanism forbond issuance. China’s credit rating of bonds is immature and underdeveloped.It can only gradually become mature in the development of the bond market and incompetition within the credit rating markets.

Eighth,developing a system to cope with issuance failure. Local governments shouldinitiate a bond failure process and ask debtors to repay the earlier creditors’principal and interest. In so doing, it not only saves the issuers’ reputationand protects them from falling into a more severe dilemma, but also avoids thephenomenon of premature bond issuance.

Theissuance of long-term bonds requires consideration of a series of otherquestions such as the construction of the trading market and a liquidationmechanism for bonds that cannot repay debts due. For local government bonds,the relationship between central and local finance in a fiscally centralizedregime should also be considered. From this perspective, the development of thelong-term bond market is a complicated system, which unavoidably is faced withmany difficulties. Until these difficulties are addressed, the trouble willremain. Consequently, it delays not only the tapping of potential of economicdevelopment and the level of development, but also the upgrading of rural andurban residents’ consumption patterns, the improvement of people's livelihood,and the realization of a comprehensive well-off society. Thus, in order to trulysolve people’s most direct concerns about interest problems, the governmentmust make policy choices that overcome the difficulties in the developmentprocess.

References

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