Monday, September 26, 2011

Possible Solutions for China LGFV Debt Problem

Following on from our previous articles about Inside Chinese LGFV debts and Potential Risks of Chinese LGFV debts published in last month, some readers wrote to us and expressed their concerns about this problem. We, however, trend to believe that the current problem of LGFVs (Local Government Financing Vehicles) is not too big an issue for the People's Republic of China (PRC). Why? Let us further explain it and outline the methods that have been used to minimize the LGFV risks, and also some possible solutions for the LGFV debt problem:

(1) Upon the request of the China Banking Regulatory Commission (CBRC) last August, Chinese banks have recognized the potential risks and losses in lending to LGFVs under a risk-based 5-category loan classification and have been requested to give at least 200% provisional coverage for any LGFV lending classified as high risk.

(2) In April this year, the CBRC published a regulatory notice requesting Chinese banks to reduce their current LGFV loan balances and limit the size of new LGFV lending. Under the CBRC rules, LGFV lending agreed before 30 June 2010 but not yet released at the time can only be granted to the LGFVs under three conditions, one of which requires that the liability of a project financing firm must be less than 80% of its assets.

(3) Banks in many areas in the PRC including Chongqing and Guangdong have also lifted their thresholds for LGFV lending. To comply with CBRC rules, new LGFV lending should be covered by cash flows generated from the projects. To minimize the risks of using overvalued land as collateral, Chinese banks have also been building a safeguard by imposing a maximum loan-to-value (LTV) ratio not exceeding 50%.

(4) CBRC has also stressed stricter LGFV lending management that can preclude county governments to raise funds through their project financing firms.

(5) In fact, PRC does not lack of past experience in dealing with its public debts. In the 1980s and 1990s, the PRC central government, headed by the reputable premier Zhu Rongji, did act very decisively to impose reforms on both Chinese local governments and the banking sector. With a strategy named "cutting with one stroke", the PRC central government instructed the banking sector to halt credit expansion towards local government investment projects. To avoid local governments borrowing from informal banks, thousands of these informal banks were forced to shut down. During that period, the Chinese local governments had many promising projects became "failed development" with half-built skeletons, while the Chinese banking sector also experienced spikes in non-performing loans (NPLs). Local governments could not even launch any new investment projects, and Chinese banks also suffered from the costly consequences for their reckless lending to local governments. Since the financial institutions inside a planned economy always trends to give easy credits to any state-owned borrowers such as the LGFVs, the PRC central government has to engineer credit crunches periodically in order to remind people regarding the risks of excessive leverage in the whole system. Although it is somewhat awkward, the method to introduce periodic credit crunches has been effective in control of the overall leveraging size in China.

(6) PRC is also not lacking of solution to remove bad loans from its banking system. In 1999, Beijing set up four asset management companies (AMCs) for absorbing non-performing loans (NPLs). After a decade, however, these AMCs achieved only 20% recovery rate of their portfolios as most of the bad loans were borrowed by state-owned enterprises. Because over one-third of the bad loans were actually acquired at face value, all the AMCs were apparently bankrupt from the start. Any write-off of their assets either could force the China Ministry of Finance (MoF) to assume the debts of AMCs, or could force the Chinese banks that hold bonds of AMCs to take losses. As a result, due to the political reasons, no default of AMCs ever happened, at least technically. In 2009, debts of AMCs were rolled-over for another decade and these AMCs have then survived. Now the AMCs can also be used to buy debts from LGFVs.

(7) The use of AMCs is not the only choice for Beijing. China Ministry of Finance (MoF) might set up special "co-managed accounts", just like what was done during the re-structure of Agricultural Bank of China (ABC stock codes: 1288.HK, 601288.SH). This kind of special co-managed accounts could acquire bad loans at face value, but using only the IOUs ("I OWE YOU" refers to a debt liability without formal document support) from MoF as payments. These IOUs can be carried as "restructuring receivables" on the balance sheets of Chinese banks. From the MoF's point of view, these IOUs are only contingent liabilities and hence are not a part of PRC national budget, and these IOUs are repaid by bank dividends instead of tax revenues. As few voices can question its financing activities, Beijing can then continue its path of increasing leverage and put on the backs of the next Chinese generations.

(8) Another new method: Chinese commercial banks have recently been selling these LGFV debts to trust companies which bundle them as wealth management products and then sell them off to corporate and even retail investors. The sales of this kind of wealth management products are in large volumes but with little transparency on the real quality of the underlying assets. Banks now have every incentive to quickly get LGFVs off their balance sheets because CBRC has been aware of this problem and has started imposing tighter banking regulatory control.

(9) One more "possible solution": default as is and let investors to assume their own responsibility. In fact, for many other emerging markets, default is not something unusual. It is just because now the PRC becomes more and more powerful, a little chance of LGFV default can still be influential to global economy. In reality, we believe the LGFV default risk will largely depend on macroeconomic policies, the development in the PRC property market, as well as the overall strength of the individual local government finances (i.e.: revenue at the local government level, transfer payments from central government, and revenue from land use transfers etc).

(10) No matter what the possible solutions should be, emphases must be put on three areas to resolve the LGFV debt problem effectively:

(i) New debt burden has to be kept under tight control, and hence the growth in fiscal investments must be carefully managed.
(ii) Local government economic growth must be maintained in order to get sufficient fiscal incomes.
(iii) Fiscal expenditure must also be controlled in order to ensure fiscal surplus.

With the above possible solutions for China LGFV debts, this problem is not likely to pose immediate threat to the country and should still be manageable. In fact, if you compare it with many other developed (like the U.S., Europe) or emerging (like Russia, Brazil etc) economies, you can hardly conclude that the PRC public debt is at a dangerous level. More importantly, similar to Japan, China debts are internal and are not foreign (external) debts. As a result, NPLs (non-performing loans) in the Chinese banking sector should not cause a real crisis. The LGFV losses should still be small enough for the China to compensate by continuous economic growth, although there will unavoidably induce a slow down in economy.


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