China warned of growing ‘land loan’ threat

By Geoff Dyer in Chongqing

Published: March 28 2010 18:27 | Last updated: March 28 2010 18:27

The Guanyinxia forest stretches up to the mountains north-west of the big central Chinese city of Chongqing. Most is protected land. “Our purpose is mainly preservation – not to make money,” says Liu Siyang, Communist party secretary of the government bureau that manages the forest.

Yet the same forest has a double life in the commercial world. It has been used as collateral by a company controlled by the local government forestry bureau to help secure a Rmb300m loan it took out last year from a state-owned bank, which was then spent on infrastructure projects in Chongqing.

Deals such as this are leading analysts to look more closely at local government finances in China. Some are beginning to warn that not only is China’s debt position much worse than advertised but that the banking system could also be heading for a big problem if many of these loans turn sour.

“This will eventually require a massive bail-out from the budget and the foreign exchange reserves,” says Victor Shih, an academic at Northwestern University in the US.

Over the past year China has pulled off a feat that seems remarkable in an era of commonplace double-digit budget deficits. The economy grew 8.7 per cent after the government launched a huge stimulus programme, yet the debt-to-gross domestic product ratio has barely budged from its modest level of about 20 per cent.

The catch is that most of China’s stimulus came not from conventional fiscal spending but from bank loans issued by state-owned financial institutions. New loans last year more than doubled to Rmb9,600bn, equivalent to nearly a third of GDP.

Local governments have only limited opportunities to borrow money, but they can set up special investment companies, such as the one operated by the Chongqing Forestry Bureau, which can use public land as collateral to raise loans. Officials have privately admitted that a significant chunk of last year’s bank loans went to these investment companies.

Such companies were pioneered in the early part of the last decade in Shanghai and Chongqing but there are now more than 8,000 across the country.

While the banking regulator puts local government debt at Rmb6,000bn ($878bn €655bn £590bn), Mr Shih estimates it is nearer to Rmb11,400bn, with another Rmb12,700bn of loans committed over the next few years. If these loans are included, he estimates, China’s debt-to-GDP ratio was 71 per cent at the end of 2009 and will be 96 per cent by 2011.

“The notion that there is not any leverage in the Chinese real estate market is false,” he says. “That might be the case for people buying houses, but local governments are leveraged in a big way.”

How much of these debts will go bad is guesswork. Mr Shih reckons the companies owned by big cities such as Beijing and Shanghai will be fine, but smaller towns and rural districts could struggle and that non-performing loans might reach Rmb3,000bn.

Huang Qifan, mayor of Chongqing, has also raised concerns. “For the Chongqing municipal government, there is no debt problem at all,” he said last week. “But we should pay more attention to some district governments.”

There are reasons not to fear the worst. A large part of the potential bad debts are from commitments to lend over the next two years. A portion of those loans cannot be halted without leaving half-built bridges, but the government is already taking some pre-emptive steps, warning banks to reduce lending to local governments and pledging to slow new infrastructure projects.

In the medium term, Beijing is discussing two reforms that could help. Ha Jiming, an economist at China International Capital Corporation, says the auth­orities could significantly expand the municipal bond market, providing a more stable financing channel. Officials are also examining a property tax to boost local government revenues .

Finally, the local governments can make up for losses at their investment companies by selling land.

Yet, as the Guanyinxia forest indicates, not all of the land used as collateral is commercially viable. And the volumes could become huge. Stephen Green, an eco­nomist at Standard Chartered in Shanghai, estimates that the collateral used to back loans issued to these investment companies is equivalent to three times all the land sold over the past five years.

“It is hard to see how this game can continue without an unhappy ending,” says Mr Green.

“If land values fall or the market stagnates . . . this game can never be brought to a successful close.”