Local governments in China are prohibited from directly selling bonds and taking on bank loans. To finance the infrastructure projects, local governments have set up local governments' financing vehicles (LGFV) to raise money over the last decade. Growth in these borrowings has accelerated during the global crisis, when Beijing called for both local governments and banks to speed up the infrastructure investment so as to prevent a hard landing during the global economic recession. What is the size of the local government debt? According to an estimate of the National Audit Office (NAO), after 41,300 staff took three months to investigate 6,567 local government financing vehicle companies, that debt amounted to RMB 10.7trn.

The huge figure left serious concerns over the viability of many projects and the indebtedness of local government nationwide. However, the same analysis shows that the size of local government debt is manageable and the solvency risk is remote. First, assuming the higher number of RMB 14trn, plus RMB6.8trn of central government public debt, total government debt amount to RMB20.8trn, or 54% of GDP (2010). The ratio is much lower than the debt-laden EU countries and the United States. (See Chart 1)

Second, China has a stable source of fiscal revenue. The total public debt (central plus local) as a share of total government revenue is low. China has a total government revenue of RMB8.3trn in 2010. RMB20.8trn of total central and local debt is about two-and-a-half times total government revenue. This is better than around six-and-a-half times for the US. Moreover, government revenue grew 24.8% year-on-year to hit a record high of RMB10.37trn in 2011. The total debt-to-revenue ratio was expected to fall to two by the end of 2011. Moreover, the interest payment burden has declined over the decade (See Chart 2).

Third, the capital raised by local government financing vehicles is largely used, as intended, for infrastructure projects. Sixty two percent of the funds raised were used for urban infrastructure and transport projects. Land purchases accounted for another 10.6%. Together, then, infrastructure and land purchase takes more than 70% of the total debt. Unlike public debt in Southern Europe and other countries, which are used for financing government's operational expenditures, the increase in China's debt also increased government assets. The balance sheet stands unaffected and healthy. (See Chart 3)

Given the fact that China is witnessing rapid economic growth and increasing fiscal revenue and the amount of realizable assets held by local governments is quite large, the governments' ability to repay its debt is sound. The likelihood that local governments will default on their debts is low.

However, there is a liquidity issue. There is a mismatch between the maturity of the debts and the payback period of the projects. As indicated by Chart 4, more than 50% of local debt is set to mature by end of 2013, and another 17% will mature between 2014 and 2015. As 70% of the debt invested in infrastructure and land, the payback period is relatively longer. The projects will not generate sufficient cash flow in the next three to five years.

CBRC estimates that RMB 1.8trn of projects run the risk of defaulting in the loan repayment, amounting to 140 percent of local governments' revenue. Local government faced the risk of not being able to pay back the short-term debt. To avoid a bank default, Beijing has to take considerate actions to restructure the local debt.

Issue Local Municipal Bonds

The local government can issue municipal bonds and use the proceeds to pay back bank loans. The obvious advantage of this option is that each debt will be priced by the market according to its own specific set of credit ratings. This also established a platform for the local government to raise fund for future infrastructure in a more transparent and market-based fashion. Process of urbanization and industrialization is far from accomplished. There is much room for infrastructure construction. Enabling the local government to issue bonds help to sustain China's long-term growth.

Demand for local government bonds is not an issue. There are relative limited options of investments for the Chinese households. Chinese households have deep pockets. According to PBoC, more than 70% of Chinese household financial assets are still in cash and deposits. The funds sitting idle in individual deposit saving accounts amounts to RMB 27trn. Given the low real one-year deposit rate (0.3%), there will be strong demand for the local government bonds so long as they pay better returns. The scale of China's savings is more than sufficient to finance local bond.

China is testing the waters with municipal bonds. Shanghai became the first local government to sell bonds directly to investors in November 15th 2011. The city issued 3-year fixed-rate bonds worth 3.6 billion yuan and 5 year fixed-rate bonds worth 3.5 billion. Shenzhen, Zhejiang, and Guangdong provinces will also be eligible to sell bonds on a trial basis this year to alleviate their local governments' debt problems. What needs to be done is to set up a monitoring system to increase the transparency of local government finances and bring in rating agencies so that credit risks can be objectively priced.

Listing Public SOEs and Securitize Urban Infrastructure

Local governments own more than 20,000 state-owned enterprises (SOEs). Over 70% of them are making profits. Local governments also own toll roads, ports, and other commercially valuable assets. Selling off these firms can provide sufficient funds to fend off the solvency risks. It will also help to shift the focus of local government from business activities to public service. Public listing of local SOEs is the best way. Another solution is to securitize the assets in local governments' hands. Urban infrastructure and transport projects will create stable cash flow once complete, making them suitable for asset-backed securitization. Some projects have already been collateralized for loans or bonds, but utility companies such as hospitals, and land could also be target for securitization.

Securitization requires a mature capital market and may be the medium term choice for the local government. A more established legal system and monitoring system is essential for securitization.

Conclusion

China was not severely affected by the global financial crisis and subsequent economic slump. Facing a decline in the exports, Beijing launched a stimulus packaging to boost the investment in infrastructure. Concerns arose when the stimulus was withdrawn at the end of 2010. Local debt has been accrued via the local government financing vehicles (LGFV). Given the anxiety and uncertainty of LGFV mode of funding, I discussed short-term and medium-term solutions to address the issue. The sovereign risk is remote. However, local governments do face liquidity problems in paying back debts due in the short term. Developing a municipal bond market seems to the current favored option. Selling off the local SOEs and securitizing urban infrastructures could be solutions in the long run. These options will play an important role in solving government financing, enhancing infrastructure construction, expediting the development of urbanization, driving domestic demand, and improving the international competitiveness of China's economy.

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