Murky world of local finance exposes holes in China’s stimulus programme

By Tom Miller

And lo, did Beijing wave its magic wand, and there was much rejoicing!

China’s economy grew 7.9 per cent faster in the second quarter of this year than it did during the same period last year. That means GDP expanded by 7.1 per cent in the first half and is now set to hit the government’s magic 8 per cent target for the year.

Beijing’s massive fiscal and monetary stimulus appears a roaring success. The combination of central government deficit spending and a tsunami of bank loans mean that the total amount of extra cash pumped into the economy above a business-as-usual scenario could be in the order of US$1,000bn this year alone.

But paying for stimulus projects is putting strain on local finances. Only around 30 per cent of the stimulus cash will come from central coffers, with the rest provided by local governments and companies, largely paid for by bank loans and bond issuances.

Many local governments and companies are finding it difficult to drum up the cash. A May survey of 335 stimulus-related investments by the National Audit Office found that local governments had stumped up less than half of their promised funds, compared with a 94 per cent figure for the central government.

Aside from bank loans, a large chunk of financing is meant to come from a new type of local government bond. Since local governments are technically banned from running budget deficits, the Ministry of Finance issues these bonds on local governments’ behalf.

The initial Rmb200bn programme, which includes issuances on behalf of both provinces and cities, is set to finish at the end of this month. Although the new bond issuances are a huge step forward for local financing, they have two principal problems.

First, poorer provinces may default on their bonds, leaving the central government to pick up the bill. In this event, the central government may respond by withholding fiscal transfers from central coffers.

Second, the Rmb200bn programme is far too small to provide sufficient financing for planned stimulus projects. For example, Guangdong only received a bond issue quota for a paltry Rmb2bn-Rmb5bn, less than 10 percent of what it wanted.

Municipal governments, which have enormous expenditure requirements but scant budgetary resources, look particularly vulnerable – especially as many already have considerable hidden debts and liabilities.

For the past decade, local governments have relied on land sales to fund investment. But with land rapidly running out and stimulus spending adding to the pressure, many are experiencing a funding squeeze.

The world of local finance is deeply murky. Since local governments are technically prohibited from borrowing, cities typically use quasi-legal Municipal Development and Investment Companies (MDIC) to invest funds on the government’s behalf.

Although MDICs are government-owned, they operate outside the municipal budget. The result is a tangle of grey financing that makes it impossible to establish the true budgets and debt positions of city governments.

City investment companies have recently been busy attempting to make up shortfalls by issuing their own “hybrid municipal” bonds. According to the National Development and Reform Commission, city-level investment companies tied to local governments issued 46 municipal bonds in the year to June 1, raising Rmb60.5bn.

The central government is betting that today’s spending will spur economic growth, which will in turn generate tax revenues to pay the bill. But many city governments will struggle to meet their stimulus commitments, and we can expect defaults on municipal bonds.

If provincial governments cannot pick up the tab, the central government will be forced to do so.

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