If you read one article this week, it should be the Bloomberg piece that came out yesterday on local government debt in China. In fact, you should read it right after listening to my radio discussion earlier this week on the same topic, because the Bloomberg report builds on several of the themes that were raised during that conversation, particularly the role that land and anticipated land sales play in rationalizing otherwise bankrupt lending practices.
Bloomberg reporters Henry Sanderson and Michael Forsythe traveled to three out-of-the-way cities in China to get a concrete sense of how much local governments are borrowing, what the money is going toward, and whether anyone should be worried. Here’s what they found:
- Loudi, a city of 4 million in the rugged foothills of central Hunan, issued RMB 1.2 billion ($185 million) in bonds to finance an Olympic-size gymnasium and swimming complex and other projects intended to transform the town — which lies along a planned high-speed rail line, but would otherwise be considered the boondocks – into a “major transport hub.” Despite sparking a construction frenzy, the city’s investment unit reported RMB 187 million ($30 million) net negative cash flow in the first half of 2010, with no sign of positive cash flow in sight. But local officials (and apparently bond buyers) aren’t concerned, because the debt is guaranteed by 18 tracts of land valued at $1.5 million an acre — four times what a similar plot in Loudi sold for in May, and a price similar to one of Chicago’s wealthiest suburbs, with a per capita income more than 100 times Loudi’s.
- In Cangzhou, a city of 7 million along the coast just south of Beijing, Hebei Bohai Investment Co. has issued RMB one billion ($155 million) in bonds to build a mega-port and unspecified “green” projects. The land backing the deal (valued at three times what the government paid for it barely a year ago) is so marginal that officials can’t be bothered to even know where it’s located. “It’s somewhere north of town, I don’t exactly know where,” says one, “It’s like the land outside the city, you know, with the big piles of salt.” The investment company’s total debt of RMB 7 billion ($1.1 billion) before the latest bond issue was greater than the city’s annual revenue of RMB 5 billion — a debt to revenue ratio higher than that of Vallejo, a California town that had to file bankruptcy in 2008. CICC’s assessment: “This issuer’s own profit and cash flow is very little, its cash shortage is extremely big, its debt load is very heavy, and it doesn’t possess the ability to pay this bond … [the local government’s fiscal income] is very limited, there will be a lot of pressure on it to support the payment of this bond.”
- Yinchun, a remote forest region along China’s northeast border with Siberia, sold RMB 1.2 billion ($186 million) in bonds backed no collateral at all, just “a pledge from the local government and possible future land sales.” The money is being used to demolish traditional wooden homes to make way for new apartments, as well as building an airport, a reservoir, and parks, “one featuring faux Corinthian columns topped by winged warrior princesses and bronze sculptures of chariot-riding local gods.”
Now here’s the kicker: Dagong, the domestic Chinese rating agency, rates both the Loudi and Yinchun bonds one level higher than U.S. Treasuries. Supposedly, these are a “safe harbor.” In contrast, CICC, the leading Chinese investment bank, takes a much harsher view, rating many of the bonds as junk.
Perhaps we’re all being too cynical and Loudi, with its high-speed rail connection, will live up to its dreams. But the thing that really gave me a knot in the pit of my stomach as I read the article was the casual lack of concern that the officials who were interviewed displayed toward proceeds and repayment, an attitude all too common when playing with OPM — Other People’s Money. Heads, we win. Tails, somebody else loses. For me, the tone itself raises all sorts of red flags.
The article touches only briefly on who is buying and holding all these bonds. Traditionally, China’s domestic corporate bonds have been held almost entirely by the banks, with no secondary market to speak of, effectively rendering them bank loans in disguise. Now it appears that a whole host of mutual funds, investment trusts, and private wealth management vehicles are getting in on the action. Some are drawing on giddy and naive retail investors, others are getting their funding — in a variety of murky ways — from the banks themselves, as a way around lending constraints. Either way, the exposure is extensive, not very transparent, and worrisome – which may help explain why the China Securities Regulatory Commission is getting ready to run stress tests on China’s brokerages.
Scary stuff, and good reporting.