Two sessions eyed for local govt debt solution

The mounting debt incurred by China's local governments over the years will likely take center stage at this year's parliamentary sessions, set to begin on March 5.

"The debt issue has actually been around for years, and with the attention it gets, we are under a lot of pressure," a fiscal official from east China's Jiangsu Province said in a recent interview on condition of anonymity.

Most local government officials shy away from talking about the issue in public, but they expect a move from the central government to break the current unsustainable borrowing through the country's shadow banking system.

The meetings of China's top legislature beginning March 5 and political advisory body on March 3 could offer change.

The issue has already gained traction over the past year, following a nationwide audit of government debt and the central government's repeated pledges to keep the risk from turning into a full-blown crisis.

China's debt problem, though different from the troubles that threatened to send the U.S. government off a fiscal cliff or that roiled Greece into turmoil, has earned attention for its risk to the world's second-largest economy.

After various estimates put forward by agencies within and outside of China over the years, the Chinese government issued its own auditing results of local government debt at the end of last year.

This was followed by the results published by individual provinces and municipalities. These audits together confirm an emerging consensus that China's debt is generally manageable but could get out of hand if its structural problems and the lack of oversight are not addressed in a timely manner.

A first look at the size of China's local government debt by the end of June 2013 -- 10.88 billion yuan (1.79 billion U.S. Dollars) in direct liabilities and 6.99 billion in contingent liabilities -- places China below the 60 percent debt-to-GDP ratio, an internationally accepted threshold to trigger a risk alert.

But staying below the threshold doesn't mean authorities can be complacent, as a thorough analysis of who lends and who borrows, and at what cost, shows risks are going unchecked.

"It's not the size, but the lack of supervision that has got regulators' nerves," said Hu Yijian, a professor specializing in fiscal policy at Shanghai University of Finance and Economics.

Despite the massive infrastructure programs they are responsible for, local governments are not legally allowed to borrow funds on their own. The fiscal funds they receive from the central government and other sources of revenue, such as taxes, cannot meet their funding needs either.

This has forced local governments to use a back-door approach for funding that involves state-owned firms and local government financing vehicles. These companies have been rounding up funds for government projects ranging from roads and housing to education and welfare.

"Local governments have to resort to the back-door approach because direct financing was never an option," said another official in Jiangsu Province.

These entities that borrow on the government's behalf are not as sensitive to the cost of funding as normal businesses are because of the implicit guarantee of lucrative land sales or government bailout, should defaults occur.

Yet an economic slowdown has called into question some local governments' ability to service their debt. A research report by Nomura Securities shows that the interest rate of funds lent to two local government financing vehicles hit 9 percent for the first time in at least two years in January, outstripping economic growth in many provinces.

Also cause for concern is the fact that some short-term loans have been used to fund infrastructure projects that will not yield returns for years. Analysts say some local governments could have resorted to the unsustainable practice of using newly borrowed funds to meet short-term obligations.

In a sign of the government's resolve to take on the debt issue,the central leadership has made curbing the risk of local government debt one of the six economic priorities for 2014.

In a statement issued after the Central Economic Work Conference in December, authorities said they want both a short-term scheme to put the debt problem under control and a long-term framework for debt to grow sustainably.

This brings hope for building a nationwide municipal bond market where local governments can seek direct financing for projects.

Ma Jun, chief economist of Deutsche Bank, suggested direct bond issuance as a solution to the problem and called for a transparent system and a market-based approach to pricing risks.

Other economists say the country's growth-at-all-cost approach, which has kept the Chinese economy expanding at 10 percent for the past decade, has landed local governments in mounting piles of debt.

Government officials have incentives to borrow because, until now, their governance has mostly been evaluated by how much GDP they generate.

"The GDP-based evaluation is at the heart of local governments' debt problem," the Jiangsu fiscal official said. "Once the emphasis on economic achievement gets downplayed, it will help bring down the debt level of local government."

Calls to change the criteria for evaluating the performance of officials have prompted authorities to add more standards for official assessment.

Debt levels, pollution and public opinion are among a list of plausible indicators for a more comprehensive assessment of an official's governing ability at a time when the Chinese economy is shifting to a slower gear and a focus on quality expansion.