China takes new steps to defuse local debt risks

As the rapid buildup of local government debt makes headlines, Chinese authorities are not shying away from the challenges they face.

On Wednesday, in its latest move to standardize local government debt issues, the Ministry of Finance (MOF) announced a program that allows local governments to issue special bonds to support the construction of toll roads.

Similar to a program on land reserve bonds rolled out in June, the toll road bonds program offers local governments a low-cost financing alternative after the country banned them from borrowing through local government financing vehicles (LGFV), an off-budget financing channel.

"This is a more standardized and transparent financing option that will help prevent and defuse debt risks in the transport industry," said the MOF in a statement.

"Besides lowering financing costs and keeping the debt level within a proper range, the special bonds will also break down huge investments into pieces, attracting smaller private investors," said Wang Yangong, a senior engineer with the Transport Planning and Research Institute at the Ministry of Transport.

China's local government debt soared during an investment and construction binge following the global financial crisis in 2008. Well aware of the risks, authorities have rolled out a string of measures to reduce the local debt burden.

The MOF dubbed the special bonds program an instance of "opening the front door," allowing local governments to issue debts through proper channels. At the same time, authorities are "blocking the back door," ramping up efforts to correct irregularities on local debt issues such as financing through fake public-private partnerships (PPP).

Latest checks by the National Audit Office (NAO) have found that debt balances that local governments have committed to repay with public funds in selected provinces, cities and counties have climbed 87 percent compared to the level in mid-2013, but the overall risk is controllable, according to a report delivered last month by Hu Zejun, head of the NAO.

"It's inevitable to have risks associated with debt issues. From an international perspective, the rise in debt levels is well below the warning line," said Jiang Jianghua, head of the audit research institute under the NAO.

According to Jiang, the NAO has been conducting inspections on local governments, reporting irregularities in local debt issuance as soon as violations were found.

So far, the NAO has found some cases involving fake PPP programs, illegal borrowing through LGFVs, and other violations.

"Increasing transparency is the best way to contain risks in local government debts. The biggest risk is opacity," Jiang said.

Realizing the danger that hidden debt could bring, China has drawn a clear line between local government debt and the liabilities of LGFVs.

According to the new budget law that took effect in 2015, local governments are no longer obligated to pay off the debts owed by these financing companies.

In the absence of government guarantees, investors now have to weigh the risks carefully before putting money into LGFVs.

"Since 2015, many projects financed by these channels have generated considerable cash flows. Now, LGFVs will rarely accept projects that do not generate cash flows at all," said Zhao Quanhou, director of the financial research center at the Chinese Academy of Fiscal Sciences under the MOF.

To further reduce the level of outstanding debt, China initiated a debt-for-bond swap program in 2015, allowing local governments to exchange higher-cost loans with lower-cost bonds, saving them interest costs while also giving lenders higher liquidity on their receivables.

According to data from the MOF, by the end of 2016, local government debt balance totaled 15.32 trillion yuan (about 2.3 trillion U.S. dollars) while the central government debt balance reached 12.01 trillion yuan. The total government debt account for about 36.7 percent of the country's GDP, well below the warning level by international standards.

Still, authorities should further step up efforts to rectify local debt irregularities while local officials should be held accountable for related violations, Jiang said.

While such measures can "block the back door" for illegal debt issuance, the permanent cure to contain the debt risks will be reallocation of governmental responsibilities, moving some of the liabilities of local governments to higher-level authorities, Zhao said.

For example, a county-level government will no longer take on all the responsibility of investing in public projects if the provincial or even central government is able to invest, effectively reducing the debt burden it bears, Zhao said.