China Seeks Clearer View of Government Debt Mountain

Local Governments Have Borrowed a Pile of Money in Recent Years, Leaving Even Beijing Wondering How Much

By SHEN HONG

Updated Oct. 20, 2013 9:36 p.m. ET

SHANGHAI—In the next few weeks, the Chinese government is expected to release the results of an ambitious effort to calculate a seemingly simple figure: just how much the country's local governments have borrowed from banks and investors in the past few years.

Estimates vary so widely they are almost meaningless. Government officials, analysts and economists have offered numbers that range from 15 trillion yuan to 30 trillion yuan ($2.46 trillion to $4.92 trillion), which equals nearly 30% to 60% of gross domestic product.

"The most scary thing is that even the central government doesn't really know how large the size of the local government debt is," said Hu Yifan, economist at Chinese brokerage firm Haitong International.

The size of the debt and the uncertainty about how much is out there also underscore a major risk facing the Chinese financial system: how little control the central government has over borrowing by cities and towns.

China's National Audit Office last counted the country's local government debt at the end of 2010, when it put the figure at 10.72 trillion yuan, or 27% of GDP. But borrowing has exploded since then as local governments have sought to keep growth going as Beijing scaled back the huge stimulus it launched to offset the global financial crisis. U.S. state and local government debt, by comparison, stands at $3 trillion, according to the St. Louis Fed, which equals about 18% of GDP.

"Local government debt has been growing at a speed of nearly 20% a year in the last couple of years. If this trend continues, it will definitely bring about systemic risks for China's economy," said Nomura economist Zhiwei Zhang.

The numbers matter a lot to Beijing. Analysts say it could be on the hook for a significant portion of that debt if it goes bad, and yields on many of the bonds reflect the expectation that the central government would back the bonds. If the debt is backed by Beijing, they argue, it should be considered part of China's national debt, pushing that total to a worrisome 200% of GDP, up from 129% at the end of 2008, according to Fitch Ratings. The U.S. debt-to-GDP ratio is 82%, according to the World Bank, not including state and local debt.

Another worry is who would lose if some of that debt went bad. According to Standard & Poor's, 80% of local government bonds are owned by Chinese investment firms, which manage money for individuals and insurance companies, and some of the bonds have ended up in wealth-management products sold by banks to individuals. Foreign investors have negligible access to the bond market at the moment.

Beijing has enough cash to prevent bonds from defaulting and absorb losses if they do, and there is no immediate threat of a local government debt crisis. The worry among economists is that the debt will weigh on economic growth by constraining further investments. There is also worry that the central government will let some local governments default to show that it won't back all of this debt, potentially triggering a selloff in these bonds, hurting investors.

A 1.5 billion yuan ($246 million) bond issued last month by a small, poor region called the Qiannan Buyi and Miao Autonomous Prefecture illustrates Beijing's dilemma. Located in a mountainous area of Guizhou province in southwestern China, Qiannan is known for phosphorite, black sticky rice and delicious quail.

The money from the bonds is set to fund the construction of roads, bridges and tunnels, but the prefecture couldn't come close to making the payments without getting big cash subsidies from higher-level governments. Even though the subsidies aren't guaranteed, the prefecture is paying a 6.9% yield on the seven-year bonds, far lower than all but the biggest Chinese companies pay.

The regional government itself didn't actually issue these bonds, because of long-standing rules that prohibit local governments from running deficits or borrowing. Instead, such governments create companies called local government financing vehicles to get around the restrictions, one way that borrowers are skirting the will of Beijing's regulators. New bonds issued by these entities rose last year to 1.09 trillion yuan from 400 billion yuan a year earlier, according to data provider WIND Info.

In this case, the prefecture used a company called Qiannan Prefecture State Capital Operating Co. to issue the debt. The company, which is one of thousands of local government financing vehicles in China, builds infrastructure for the prefecture but doesn't make much money in that business. Last year, it generated enough cash to cover just half of its debt payments. To make up the shortfall, it relies on subsidies from the prefecture, which itself relies on subsidies from higher-level governments to pay its bills. Investors in the bonds are effectively relying on two sets of subsidies, neither of which is guaranteed, to get their interest payments.

An official from the company, who declined to reveal her name, told The Wall Street Journal, "We issued the bond on behalf of the government. Please direct any questions to them." Officials at the Qiannan government's Finance Department couldn't be reached for comment.

In a survey of 36 local governments released in June, China's state auditor said that among the 223 financing vehicles run by these governments, 151 of them failed to generate enough revenue to cover their annual debt repayment. "Because of their inadequate repayment ability, some provincial capitals had to borrow new debt to pay for their old debt," the state auditor said.

Analysts raise several concerns. First, they argue that because local government debt will likely be backed by Beijing it should be considered part of China's national debt. Local bond-rating agencies routinely give these bonds high ratings because of the expected central government backing. So far, there haven't been any defaults by local government financing vehicles.

Second, because much of this debt is backed by land owned by the local governments, a decline in land prices could wipe out some of the collateral on the bonds.

"Since many local governments use land as collateral for their debt, a potential fall in China's property market will pose huge risks to them," said Terry Gao, a senior analyst at Fitch Ratings.

That puts Beijing in a difficult situation. If it continues to try to push down property prices, which have been climbing rapidly, it risks leaving itself saddled with more bad debt from local governments.

In Qiannan Prefecture, income from land sales fell by more than 40% in each of the past two years, according to a report by Chinese bond-rating firm Pengyuan Credit Rating Co., citing data it obtained from the local government.

The last big concern is that governments spent the proceeds of the bonds on unnecessary projects that are unlikely to boost local growth, which would make it harder to pay off the bonds.

Beijing has sent a number of inspection teams around the country to tally the outstanding debt, and the results of the survey, which is widely expected to be released late this month or early next month, will likely serve as a key factor in new economic policies to be unveiled at the next Communist Party meeting in November.

Local government financing vehicles don't rely completely on the bond market to raise money. They have borrowed 9.59 trillion yuan ($1.57 trillion) from banks through the first quarter of this year, according to the latest data available from China's banking regulator and state auditor.

Regulators slowed the pace of that lending, which led the borrowers to turn to bonds and, more recently, to China's so-called shadow banking system, where they have borrowed an estimated 2.39 trillion yuan through the end of the second quarter, more than double the amount from a year earlier. Shadow banking consists of wealth-management products and other products sold to investors, often arranged by banks but not included on their balance sheets.

Write to Shen Hong at hong.shen@dowjones.com