l Global Research l On the Ground | 10:30 GMT 29 June 2011

China Build it, and someone else will pay for it

We present our estimate for Chinas total public debt 71% of 2010 GDP Chinas debt stacks up well against other countries, especially when growth is factored in LGIV loans are now reportedly beginning to default; the government needs a clear resolution framework Today we present our latest estimates of government debt in China, including local government and local government investment vehicle (LGIV) liabilities. Our results are outlined in Table 1. We guesstimate that public debt in China at year-end 2010 was around CNY 28trn, some 71% of GDP. This includes official central government debt, policy bank debt, estimates of local government and LGIV debt, Ministry of Railway debt, and the carried costs of the last round of bank restructuring.

Stephen Green, +852 6168 5020

Stephen.Green@sc.com

How we did the maths

We used the recent National Audit Office (NAO) estimates as our baseline for local government debt, but also made adjustments. The NAO, the China Banking Regulatory Commission (CBRC) and the Peoples Bank of Chinas (PBoC) estimates of local government debt differ in scale and definition. The NAO has reportedly taken a strict definition of LGIV debt, including only formal liabilities entered into by local governments for their own infrastructure-building platforms. Its estimate is CNY 4.97trn, while the CBRC and the PBoC appear to have taken a broader view, including informal guarantees on LGIV debt offered by local governments. The CBRC estimate is CNY 9trn, the PBoC has implied up to CNY 14trn. The NAO estimate is thus likely an under-estimate given that formal guarantees have never had legal status and that when push comes to shove, the authorities will need to protect the banks. We have therefore added CNY 4trn to the NAO estimate of LGIV debt, shown in Table 1, to generate a total of around CNY 9trn LGIV debt (plus CNY 5trn local government debt). One could debate this adjustment. Some may argue that the adjustment is too small and that LGIV debt is actually nearer CNY 15trn. However, we take the view that the CBRC/PBoCs estimates probably include debts defined by NAO as local government (not LGIV) debt. Chart 1: Public debt is less worrying where growth creates tax revenues Public debt, % of GDP, 2009 against average nominal GDP growth 2009-15
14 Average nominal growth, 2009-2015, % y/y 12
India China Brazil Thailand Singapore* Australia Malaysia Turkey Canada Norway Poland Germany Ireland US UK Spain France Portugal Iceland Belgium Italy Greece Egypt

10 8 6 4 2 0 -2 20 40 60

80 100 Public debt, % of GDP

120

140

Note: Database does not include local government debt, whereas for China we include all known public debt; *including CPF; Sources: IMF, World Bank, Standard Chartered Research
Important disclosures can be found in the Disclosures Appendix All rights reserved. Standard Chartered Bank 2011 research.standardchartered.com

On the Ground

We do not include some items that are border-line public debt

A number of things are not included in this number. We do not include outstanding PBoC bills, which totalled CNY 4trn (USD 606bn) at year-end 2010, some 10% of GDP, since this is backed by the USD 3trn+ in foreign currency reserves. We do not include liabilities of state-owned enterprises, since these should be commercial loans (though we do not deny that the government would likely move to support them in the event of difficulties). We do not include estimates of future pension and other social insurance liabilities, about which there is little information. We do not include possible NPL generation in the banking system in addition to the LGIVs. And we do not include NPLs that have already been transferred into co-managed (bank and MoF) accounts in the case of at least one large state-owned bank, which in theory will be paid down using bank profits.

It is big, it will be painful, but it is survivable

Chinas debt-growth dynamics look pretty good compared with many other economies In Chart 1, we have plotted government debt numbers against each economys average nominal GDP growth rate over 2009-15, using IMF forecasts. We have included most large economies. The bigger the debt and the slower the growth, the worse the situation: in the bottom right-hand corner, Greece and Italy are in a bad place. The best-placed countries are at the top left: Australia and Thailand. China is not badly placed and certainly not badly enough placed to warrant all the talk of imminent collapse that has been filling the airwaves. Using a conservative assumption of 10% nominal GDP growth over 2011-15, and assuming total nominal debt remains stable, Chinas debt ratio should fall to 45% of GDP by 2015. Other positives include the fact that total government budget revenues are running at 24% of GDP, and rising as a proportion of GDP. This number excludes off-budget and other revenues (including land-lease sales) that the government receives add those in and one finds a government with revenue streams of some 30-35% of GDP, which is pretty good for a developing economy. And then there is the other side of the government balance sheet the governments industrial assets and land holdings, which are large and valuable. The value, however, is even harder to calculate than the liability side of its balance sheet, given the lack of relevant information. Such assets would be hard to liquidate in a crisis, but given that they have considerable scale, they should ultimately be very useful over the medium term.

How the work-out will occur

Defaults are already being rumoured which should hasten discussions about a resolution mechanism Reports of LGIVs in Yunnan province and Shanghai telling their banks that they can only repay the interest, rather than capital, on their loans signal the beginning of a wave of difficulties, we believe. There are likely thousands of anxious bank branch officers, LGIV CFOs and local government officials out there. We assume that the LGIV loans are mostly bullets, and 3-5 years in term, so the pressure for repaying principal has not yet hit. But it will begin in 2012-13. The interest burden of around 6% on local government/LGIV debt is much higher than the 2% that the MoF is currently paying on outstanding central government debt. If one assumes that local governments and their vehicles have total debt of CNY 14.7trn (as we do in Table 1), and that all of it is bank debt, then the interest due this year will be around CNY 880bn (USD 134bn). This is a tremendous amount of money, equivalent to 21% of local government tax revenues in 2010. (This would be a big number even if we had clear evidence that local finance bureaux had budgeted for these payments, which we do not.)

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Table 1: Our estimates of China's total public debt, year-end 2010

Type of debt MoF bonds CNY bn 6,750 % of GDP Comments 17% Outstanding official MoF debt. Almost entirely domestic. It has remained in the 15-20% of GDP range in recent years. We estimate that interest payments were CNY 130bn in 2010. Mostly China Development Bank debt. Some 40% of LGIV debt is CDB-funded so we need to adjust for double-counting below. Local government debt 5,730 15% Education, health and other debts by local state organs, as estimated by the National Audit Office (NAO) in June 2011. Much of this debt was present before 2008, and is the result of mismatched expenditure and spending rules local governments are responsible for most health and education spending, but receive only a small portion of total tax revenues. In recent years, many more unfunded mandates have been pushed down to the lower levels of government. Local government investment vehicles 4,970 13% NAO estimate, restricted to clear local government liabilities to government-controlled vehicles. Informal commitments of LG support etc. were excluded by the NAO. The CBRC estimate for LGIV debt, based on a wider definition of LGIV liabilities, is around CNY 9trn (see below). According to the NAO, some CNY 2.5trn of LGIV debt is collateralised by land, and thus land sales could generate some cash for repayment. However, this is dependent on (1) the land being properly valued, (2) the land being sold, (3) the land not being used as collateral on another LGIV's debt, and so on. The vast majority of LGIV debt is bank loans; there are some CNY 420bn worth of outstanding LGIV corporate bonds/MTNs, etc. Adjustment for CDB -1,988 Since CDB debt is already included in the LGIV debt numbers, we need to adjust for CDB loans to LGIVs. Ministry of Railway 1,800 5% Outstanding bonds and bank loans to the Ministry of Railways (MoR), as reported by Caixin. The MoR receives funds from the MoF budget as well as rail-use fees, and still borrows in its own name. Made up of CNY 600bn in publicly issued bonds, with the rest in bank loans. AMC/MoF 1,120 3% Estimated liability of MoF for unresolved bank NPL resolution by Asset Management Companies, based on a 20% recovery rate of CNY 1.4trn transferred in 1998. Additional two tranches of NPLs transferred to AMCs and bank/MoF co-managed accounts, adjusted for 20% recovery. The MoF's liability for AMC liabilities has not yet been completely clarified. USD 3.9trn Additional LGIV debt, according to CBRC/PBoC survey. The CBRC has estimated close to CNY 9trn in outstanding bank loans, while the PBoC has implied that the total could be higher, up to CNY 14trn. Some of this debt may be included in the NAO estimate of local government (not LGIV) debt. So here we add CNY 4trn, which we believe should be in the ballpark. Total #2 28,198 71% Total formal and informal public debt. See notes below for details. Source: Standard Chartered Research Notes: 1. We do not include outstanding PBoC bill issuance, which totalled CNY 4trn (USD 606bn) at year-end 2010, 10% of GDP, since this is backed by the USD 3trn+ in foreign currency reserves. We do not include liabilities of state-owned enterprises. We do not include estimates of future pension and other social insurance liabilities. We do not include possible NPL generation in the banking system in addition to the LGIV debt. 2. We use the National Audit Office estimates as our baseline for local government debt, but also make adjustments. The NAO, CBRC and PBoC estimates of local government debt differ in scale and in terms of definitions. The NAO has taken a strict definition of LGIV debt, including only formal liabilities entered into by local governments, while the CBRC and PBoC appear to have taken a broader view, including informal guarantees on LGIV debt offered by local governments. The NAO estimate is thus likely an under-estimate given that formal guarantees have never had legal status, and that when push comes to shove, the central authorities will need to protect the banks. However, one needs to be careful about simply adding the CBRC/PBoC estimates to the NAO estimate, since these estimates may include debts defined by NAO as local government (not LGIV) debt. 3. Total budget revenues are running at 24% of GDP, and rising. This number excludes off-budget and other revenues (including land-lease sales) that the government receives. Using a conservative assumption of 10% nominal GDP growth over 2011-15, and assuming total nominal debt remains stable, the debt ratio falls to 45% of GDP by 2015.

Policy bank bonds

5,192

13%

AMC/MoF

624

2%

Total #1 Additional LGIV (CBRC/PBOC)

24,198 4,000

61% 10%

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On the Ground

Land sales around the country continue to do much better than many had feared, and should be providing precious cash flow. But interest payments will mount up, the credit markets will become less welcoming (quotas for debt issuance by LGIVs are being squeezed), and banks are under instructions to stop extending credit to LGIVs (although they still appear to be doing so), so it is no longer easy to take out new loans to repay old loans. At some point, the legacy will have to be recognised (as we forecast in On the Ground, 24 March 2010, China After the party, the headache.) And if that were not bad enough, local governments have strict instructions to start 10mn units of social housing this year which we have shown mostly relies on commercial bank loans and land that would otherwise have been sold (see On the Ground, 4 April 2011, China Spare a thought for social housing). It is the LGIVs that seem to be expected to bear this additional burden. The CBRC has done its best to limit banks liabilities So how will this game end? In the past two years, the CBRC has been encouraging the banks to define and ring-fence LGIV loans, ensure they have a proper legal claim to pledged collateral, and to categorise LGIVs into three types according to their ability to cover interest. In Q1-2011, the regulator required banks to introduce differentiated capital risk-weightings (RW) for different levels of LGIV loan-interest coverage. For example, a LGIV paying all of its interest gets a 100% RW while one with zero coverage gets a 300% RW. Two of the major listed banks have said that more than 65% of their LGIV loans are 100% interest-covered. However, one bank official was quoted in New Century magazine as saying that all the banks in his province say that interest coverage on their LGIV loans is high, with the implication being that it is really not. According to CBRC numbers, some CNY 2-3trn of its estimated CNY 8-9trn in LGIV loans are not able to cover interest. Another CNY 4-5trn is able to meet some or all of the interest owed, but there is a question about who is actually paying the interest (the suspicion being that a related firm or the local finance bureau is paying, or that the funds are coming from another loan). LGIV loans on which all the interest is being paid are being reclassified from LGIV loans (which are subject to special CBRC rules) to standard corporate loans. Banks have an incentive to do this since it reduces the requisite capital and regulatory hassle. We assume CNY 4-6trn of LGIV loans will not be paid back and that all local government debt will need to be assumed by the central government As we have explained before, there is a game associated with how LGIV loans go bad and/or get resolved. No one wants to be the first in the country to have a LGIV blow up in their district. As a result, whenever a LGIV is unable to cover its interest, a small meeting will likely be held between the LGIV, the bank and the local government to find a way to resolve the issue. Loans will be extended; new collateral offered; assurances made. As the pressures build, such meetings will become ever more difficult. We assume that at least CNY 4-6trn of LGIV loans and possibly much more will ultimately not be repaid by the projects, and this shortfall will need to be addressed. In addition, the central government will have to assume the CNY 5.7trn of local government debt. At some point, the central government will have to enter the field it cannot have rumours circulating about hundreds of LGIV defaults undermining confidence in the banking system. However, the end game is tricky because: From the MoFs perspective, banks made big profits from lending to these projects, and at no point were local governments legally allowed to guarantee bank loans; loans going bad are thus the banks problem. But only up to a certain point: this problem has scale and so the assumption is that the MoF will have to step in. But it will not want to carry the debt all on its own.
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On the Ground

Local governments would argue that the stimulus package was not their idea they were in effect mandated to fund a massive infrastructure programme during 2008-10 to rescue the country from the global recession, without any meaningful support from the MoF budget. What were they supposed to do? The banks have an argument similar to that of the local governments it was a national emergency and they were expected to help. However, at the same time, some were clearly more careful than others.

The resolution mechanism is still unclear but it is now needed

It is hard to believe that discussions are not already ongoing on a resolution framework, in addition to principles already laid down by the CBRC and MoF. One is now needed. A 31 May Reuters report that CNY 2-3trn would be taken onto the MoF balance sheet with the banks taking a haircut seems to have been referring only to an internal MoF research paper. Other ideas must be being discussed. In the next note, we will examine how the resolution mechanism might be set up.

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Nicholas Kwan Head of Research, East

10:30 GMT 29 June 2011

10:30 GMT 29 June 2011

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