Summary
Chinese financial and economic authorities are planning a bailout package for the country’s heavily indebted local governments, according to Reuters report. Details resemble a Finance Ministry plan announced in March 2010, but the leak suggests that grave debates are under way among China’s leaders about how to manage growing risks to financial stability before the leadership transition in 2012.

Analysis
China’s central government is preparing a plan to manage massive local government debt problems, according to a May 31 Reuters report. Though the plan and its details remain unconfirmed — even Chinese language reports are citing Reuters as the sole source — the report suggests that a major attempt is under way to address the greatest immediate challenge to China’s financial stability. In March 2010, China’s Ministry of Finance announced a plan to overhaul local government finances. Little progress has been reported since, but the details from Reuters correspond closely to the overhaul plan and suggest it is nearing implementation.

The report cites unnamed sources with direct knowledge of the plan, claiming that Beijing will adopt a range of measures to clean up local governments’ financial books, which have become overburdened with debt since the massive nationwide credit binge launched to combat the global financial crisis in 2008. Local governments set up local government financial vehicles (LGFVs) to borrow from banks and manage development projects because the governments themselves, with very few exceptions, are not allowed to issue bonds and finance projects in such a manner.

In mid-2010, the China Banking Regulatory Commission (CBRC) revealed that of about 8 trillion yuan (about $1.23 trillion) in loans to LGFVs, an anticipated 25 percent would go bad, while another 50 percent was tied to projects that were unprofitable but were supported by local governments’ regular revenues. In May 2011, a Chinese news report cited the Ministry of Finance as saying that by 2009, local debt had reached 2.79 trillion yuan and that outstanding local loans had reached 7.38 trillion yuan, or about 226.4 percent of total local government revenue. After the local debt problem ballooned in 2009-2010, Beijing revealed that it would conduct investigations into local government finances to determine the scope of the problem.

According to the May 31 Reuters report, Beijing’s investigation concluded that local governments had accumulated a tally of 10 trillion yuan worth of debt, and that about 2 trillion (or 20 percent) of it was expected to go bad, roughly in line with the earlier CBRC estimate. Consequently, the CBRC, along with the Ministry of Finance, the National Development and Reform Commission (NDRC), and presumably the central bank and other bodies, are planning a combination of measures to address the problem. These include:

• Two to three trillion yuan worth of debt would be transferred from local governments to major state-owned banks.
• The central government would shoulder some of the burden by paying off loans and taking debt onto its books.
• State-owned banks, including some of the top four state-owned commercial banks, would have to write off an unspecified amount of the bad debt and accept losses.
• Provincial and municipal governments would be granted legal permission to issue bonds to cover debts and finance projects going forward.
• The government would oversee an entire overhaul and consolidation of the LGFVs.
• The report also referred vaguely to “new” companies that would be set up to accept some of the debt transfers, perhaps asset management companies. It also spoke of new allowances for private investors to invest in areas in which they were previously not allowed invest, though it was unclear whether this would be to purchase debt or to finance future economic projects.
• The plan is expected to be implemented in June and completed by September, though one source said it could take longer.

Therefore, it would appear that the Chinese government is preparing a bold new bailout for local governments, along the lines of the large bailout of debt-ridden state-owned banks in the late 1990s and early 2000s that ultimately was estimated to have cost more than $600 billion. The beneficiaries of the rumored new bailout would be the local governments rather than state banks, which would be burdened by the new debt loads in a way that would likely adversely affect lending. Such a bailout would put more burdens on the public balance sheet at the expense of the taxpayer, counteracting policy goals of boosting household wealth and consumption. The fact that through this plan local governments would obtain permission to issue bonds to finance their operations would be a major policy move if it proved to have nationwide applicability, though Beijing has allowed certain local governments to test bond issues in the past three years.

Ultimately, the leaked details of the plan are imprecise. There is little outside verification, and such a plan inevitably will entail fierce debate, revisions and modifications. But the details correspond very closely to the plan the Ministry of Finance announced more than a year ago. Notably, the leak suggests the Chinese leadership may still be seeking to tackle the local debt problem now, ahead of the 18th Communist Party of China congress in the fall of 2012, when the next generation of Chinese leaders will be appointed. A bailout for the massive local government debt problem was inevitable; the question was always the timing. While the current leaders may be the best suited to oversee such a large bailout due to their authority and experience, there is reason to think they would prefer to avoid major risky reforms, lest the situation prove unmanageable and damaging to their legacy.

All that can be determined at present is that a bailout plan for local governments is still being discussed. Are China’s leaders debating this now because they believe that with global recovery continuing and over $3 trillion in foreign exchange reserves, they have the advantage? Or are they being forced to tackle the problem now because of exigencies related to the slowing pace of economic growth and extensive systemic financial risks? If a bailout is implemented in this time frame, the extent to which Beijing will use its cash surpluses for recapitalizations is unclear. Moreover, it remains to be seen whether it will attack financial problems directly or merely use expedients to preserve financial stability in the short term, even at the cost of building up greater risk in the long term.

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