Local Government Financing Vehicles Under Fire Again
If anyone suspected the new Chinese leadership would relax controls on local government spending in 2013, they were wrong. CBRC is preparing to issue a new guiding opinion with further restrictions on local government financing vehicles (LGFVs). When released, the new draft will strengthen provisions for controlling bank lending to local government financing vehicles put in place in a previous guiding opinion in 2010. New lending to LGFVs will be allowed under six conditions:
- State Council approval or central government approved projects
- Fee-generating highway projects
- Land reserve management institutions approved by the Ministry of Land and Resources
- Public housing projects
- Agricultural Development Bank water projects meeting central government specifications
- Any projects over 60 percent completion meet cash flow generating standards
The new CBRC measures will likely have a dampening effect on local government spending, as they are forced to spend within central government approved channels.
Since the late 1990s, more local governments in China began creating financing vehicles backed by land revenues and public assets to borrow money from banks or institutions investors for funding local projects. In contrast to state governments in the United States, provincial governments in China are banned from directly issuing bonds and cannot levy taxes on property or income. LGFVs gave China’s local governments the ability to raise money to fund off-budget expenditures.
However, the model came under criticisms in after the 2008-09 stimulus programs in 2010 when the National Audit Office revealed high levels of local government debt much of which was tied to bank borrowing by LGFVs. At this time, the State Council formally issued a regulation cracking down on local government financing vehicles, calling for strict monitoring of LGFV borrowing. The State Council was concerned that many LGFV loans obtained in the 2008-09 were poorly collateralized and project cash flow estimates were overstated.
The new State Council restrictions essentially halted lending to LGFVs. After this regulation, the Chinese Banking Regulatory Commission (CBRC) told banks to re-examine existing loans to LGFVs and re-classify as non-performing where necessary. In moving forward banks were told to follow the mantra “reduce the number of old loans and limit the number of new loans.”
Banks have listened. This month, Shang Fulin, head of the CBRC, disclosed that the size of bank lending to local government financing vehicles has only grown by 2 percent over the last two years.
Bank lending is not the only source of LGFV financing under fire. In December 2012, the Ministry of Finance, National Development Reform Commission, Peoples Bank of China, and China Banking Regulatory Commission issued a communique on curbing illegal financing by local governments. The communique called for an end to borrowing from non-financial institutions (trust companies, fund management companies, financial leasing, banking, etc direct or indirect financing) and individuals.
That essentially leaves corporate bond issuance as the only source of funding for LGFVs. Indeed, corporate bond issuance has been the primary source of funding for LGFVs since the State Council called for a significant crackdown and tightening of LGFVs operations in 2010. According to Barclays, LGFVs issued Rmb 1.3 trillion in corporate bonds over the past two years. In contrast, bank lending to LGFVs has only grown by 832 billion, about one-fifth lower than corporate bonds.
However, LGFV bond issuance is also on the chopping block. The majority of LGFV corporate bond issuance is in the form of enterprise bonds controlled by NDRC. At the end of 2012, NDRC issued new restrictions on enterprise bond issuance directed at LGFVs. The restrictions called for halting bond issuance for any enterprises with liabilities-to-assets ratios greater than 90 percent and closer scrutiny of the balance sheets of any enterprise with liabilities-to-assets ratios of 65-80 percent. Similar to the CBRC’s new lending conditions, the NDRC ruling relaxes issuance restrictions for financing projects related to central government favored projects – i.e. social housing projects.
The increasing restrictions on the activities of LGFVs are a reflection of the ongoing battle to control local government spending. Local government debt (including LGFVs) likely reached over 20 percent of GDP in 2012, compared with explicit Ministry of Finance debt of 15 percent. The central government – specifically the Ministry of Finance – would like to keep these local government debt levels stable. In order to do so it is attempting to increase the transparency of local government spending. First by shifting LGFVs financing only to projects explicitly or implicitly approved by the central government (NDRC approved projects, highways, public housing, rural developments, etc). Second by gradually shifting local governments to reliance on central government approved financing channels. For example, recently the Ministry of Finance announced it would increase the quota of bonds issued by the Ministry of Finance on behalf of local governments to Rmb 350 billion up from 250 billion in 2012.
The new measures by CBRC are a good sign that the new leadership remains concerned with aggregate debt levels and risk management in the financial sector. However, attempts to restrict informal financing by local governments without giving them much greater access to direct financing tools (such as local government bond issuance) or fiscal reforms to improve tax revenue sources will drive localities to continue to find ways to bypass central government spending restrictions. A more comprehensive approach to reforming local government finances should still be a priority.