Anyone who follows China knows that the country faces a particularly vexing problem when it comes to debt. The way we explain it is simple: Beijing is attempting to deleverage and re-leverage simultaneously. Needless to say, this isn’t possible, but that hasn’t stopped China from trying, as is clear from the multitude of contradictory policies and directives that have emanated from Beijing over the course of the last nine months.
Nowhere is the confusion more apparent than in China’s handling of its local government debt problem. In an effort to skirt official limits on borrowing, the country’s provincial governments racked up an enormous amount of off-balance sheet liabilities. These loans carried higher interest rates than would traditional muni bonds and ultimately, servicing the debt became impossible. In order to help provinces deleverage, Beijing launched a program whereby high interest LGFV loans can be swapped for new local government bonds that carry substantially lower interest rates. In fact, yields on the new bonds are close to yields on general government bonds meaning provincial governments are saving somewhere on the order of 300 to 400 bps. But there’s a problem. Banks aren't particularly keen on swapping a higher yielding asset for a lower yielding one. The PBoC’s solution was to allow the new bonds to be swapped for central bank cash which the banks could then re-lend into the real economy. The problem with this is that it transforms a deleveraging effort (the local government refi program) into a re-leveraging program (the LTRO component). Shortly after the program was launched, the PBoC effectively negated the entire effort when it moved to loosen restrictions on the very same LGVF loans that caused the problem in the first place.
Admittedly, lengthy discussions about fiscal mismanagement across China’s various provincial governments doesn’t make for the most exciting reading, but it’s hugely important from a big picture perspective. Why? Here’s why:
That's from the IMF and as you can see, local government debt will account for an estimated 45% of GDP by the end of this year. If one looks at what is classified as "general government debt", China's debt-to-GDP ratio looks pretty good - especially by today's standards. Simply counting central government debt and local government bonds, the country's debt-to-GDP ratio is just a little over 20%. Thus, if you fail to include the provincial LGVF debt burden, the effect is to dramatically understate China's debt-to-GDP.
Below, find two charts from the IMF, the first showing China's actual debt-to-GDP (i.e. including LGFV financing) and another showing China's total debt-to-GDP (which includes corporate debt and which you'll note is set to hit 250% of GDP by 2020). We've also included some color from the Fund's debt sustainability analysis.
From the IMF:
Without reforms, growth would gradually fall to around 5 percent in 2020, with steeply increasing debt ratios.
The general government debt is slightly above 20 percent of GDP over the projection periods. Augmented debt, however, rises to about 71 percent of GDP in 2020 from less than 57 percent of GDP in 2014. Even with the favorable interest rate-growth differential, augmented debt rises over the medium term as the augmented deficit is assumed to decline gradually.
The augmented debt level is also sensitive to a contingent liability shock, which would push debt to near 100 percent of GDP in 2020. Such a shock, for instance, could be a large-scale bank recapitalization or financial system bailout to deal, for example, with a potential rise in NPLs from deleveraging. A combined macrofiscal shock would increase the debt-to-GDP ratio from about 71 percent to 78 percent in 2020.