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On July 19th a major U.S. city, Detroit in Michigan, defaulted on its bonds and declared bankruptcy. With liabilities of over $18 billion this is the largest bankruptcy of a local government in U.S. history. The bankruptcy was expected. Detroit had been declining for years. What is still very uncertain is the impact Detroit's bankruptcy will have on other parts of the $3.7 trillion U.S. municipal bond market. But there is more to it than that. Problems in municipal debt markets are not limited to the U.S. On the contrary they are worldwide and in one country, China, they are potentially much worse.

The reasons for Detroit's demise are many and varied. The most obvious is the decline of the U.S. auto industry. No doubt over the years the city's woes were also due in large part to mismanagement and corruption. But the main problem has to do with pension liabilities and healthcare costs. Generous benefits have been doled out over the years by city politicians to insure the good will of politically powerful civil service unions. The pension plans were never adequately funded. As Detroit's population declined from a high of nearly two million in 1950, to about 700,000 today, the shrinking tax base could no longer make up the difference.

It would be easy to dismiss Detroit as a unique event specific to the demise of the car industry, but the political incentives to promise generous benefits without finding the money to pay for them exists everywhere. American states estimate that their pension funds are only 73% funded and this is based on a discount rate that has been termed optimistic, but might be better referred to as simply irrational. A more accurate estimate might be closer to 48%. The total might be as high as $2.7 trillion or 17% of American GDP.

Many states are far more profligate than others. Illinois is the worst with an unfunded pension system equal to 241% of its annual tax revenue. It is hardly alone. Connecticut owes 190%. For Kentucky the number is 141% and New Jersey is 137%. Not all the states are in such bad shape. Some actually reformed their pension plans. Nebraska has an obligation of only 7% of its annual tax revenue. It is followed by Wisconsin, New York, and Florida, with 14%, 15% and 18% respectively.

As might be expected, the bankruptcy of Detroit will be exceptionally messy and take years of legal maneuvering as various creditors including pensioners and bondholders face off for access to a shrinking pool of assets. The process will create important legal precedents, but it won't be the last. In the state of Michigan, where Detroit is located, there are five more towns in the same situation. There are many more municipalities just like them all across the country.

So far the municipal bond market in the U.S. has hardly reacted to Detroit's problems, but this may be a false sense of security. At issue in Detroit are general obligations bonds that are supposed to be supported by the tax payers. They are generally considered exceptionally safe because the politicians can make good just by raising the taxes. But this choice is becoming harder as pension liabilities grow. They now make up an average of 22% of state budgets, providing less money for roads and education. Eventually elected officials or their unhappy constituents will decide that their cities should not be held hostage to older promises or the bond market.

America is not the only country where local governments have cash flow problems. In fact on a relative basis it might be dwarfed by China. There are no municipal bonds in China. Chinese cities have been barred from issuing bonds since 1994, but that does not mean that they didn't borrow money. Local governments got around the problem by establishing local government financing vehicles (LGFV). There are more than 10,000 of these things. They were established to fund construction of roads, sewage plants, subways, and other infrastructure projects commanded by Beijing to help stimulate the economy. LGFVs may hold as much as 20 trillion yuan in debt ($3.2 trillion). According to former Finance Minister Xiang Huaicheng this figure has doubled since 2011. It equals about 40% of nominal GDP, about twice the level of municipal debt in the U.S. But no one really knows what the real amount is.

Even the central government is unsure. Beijing began an urgent national audit to determine local governments' true debt levels at the end of last month. This is not surprising. In 2012 alone growth of the debt in the shadow banking system including LGFVs increased by an explosive 55.3 %. Since many of these infrastructure projects have little or no income, they could easily default. The central bank Governor Zhou Xiaochuan said in March of this year that as much as 20% of the local debt is risky.

The bill is also about to come due. Some 127 billion yuan ($21 billion) of the LGFV notes will expire in the second half of this year, double the 62.7 billion that matured in the first six months. The market is also beginning to take notice. China bond data shows that the yield premium over top-rated notes for one-year AA debt, the most common rating for LGFVs, widened to 67 basis points at the end of July, the highest level since January 16. The comparable gap in India is 47.

Although bonds of Chinese companies have defaulted specifically Suntech, which went into bankruptcy earlier this year, there have not been any defaults of publicly traded bonds since the central bank started to regulate the market in 1997. This may change. Next year, 208.8 billion yuan of LGFV debt comes due, up 10 % from this year and 122% from 2012. Moody's Investors Service, Chinese rating services and brokerages are beginning to warn that some of the LGFVs might go under. Haitong Securities Company, the second-largest listed brokerage, recently forecast that a default could occur in the next six to 12 months. In the past the central government would bail out the locals, but the current administration is bent on reigning in excessive, inefficient and dangerous lending.

The reason why the situation in the U.S. and China are so similar is that the incentives and disincentives are similar. Local leaders in both countries were rewarded for lavish spending and borrowing. The Americans were reelected year after year by mollifying public service unions and handing out patronage. They didn't have to raise taxes because they could borrow the money. In China the leaders were rewarded for implementing Beijing's demands for growth and infrastructure spending. Chinese leaders also didn't have to rely on taxes. They simply borrowed from local state owned banks, which helped create the LGFVs. Both the Americans and Chinese could borrow at rock bottom prices because investors always assumed that a entity government would pay them back. In addition both countries have pursued ultra loose monetary policies, which has exacerbated the problem and delayed the reckoning. The incentives that exist in China and the U.S. are similar to those all over the world. In time there will be many places just like Detroit.

Source: Default: Local Government Debt In The United States And China