Vice Chairman of Chinese Accounting Association Warns Chinese Local Debt Could Create Bigger Crisis than US Housing Implosion

On the one hand, Bloomberg today tells us retail demand for stocks is as hot as ever:

“Over the last few weeks, every down move has been met with buyers that have come in,” Brad Sorensen, director of market and sector analysis at San Francisco-based Charles Schwab Corp., said by telephone. His firm has $2.08 trillion in client assets. “People on the sidelines are waiting for a pullback to get into the market that they’ve missed for the past six months. We’re seeing more of that today.”

On the other, we have someone well-placed in China telling the world that its local debt is a train wreck waiting to happen, a classic Minksy Ponzi unit, but the timing of the unraveling is uncertain. And the source is an authority and not the sort one would expect to make remarks like that casually.

The Financial Times tells us the alert comes from Zhang Ke, vice chairman of the Chinese accounting association, who said his accounting firm, ShineWing, had virtually stopped signing the financial statements for bond sales by local governments. He described the debt as “out of control” with the potential to cause a bigger-than-housing-crisis level bust. But since the obligations can still be rolled, who knows when the dubious debt will fall under its own weight. As the article explains:

Local government debts soared after 2008, when Beijing loosened borrowing constraints to soften the impact of the global financial crisis. Provinces, cities, counties and villages across China are now estimated to owe between Rmb10tn and Rmb20tn ($1.6tn and $3.2tn), equivalent to 20-40 per cent of the size of the economy.

Last week, Fitch cut China’s sovereign credit rating, in the first such move by an international agency since 1999. On Tuesday, Moody’s cut its outlook for China’s rating from positive to stable.

Local governments are prohibited from directly raising debt, so they have used special purpose vehicles to circumvent these rules, issuing bonds under the vehicles’ names to fund infrastructure projects.

Investment companies owned by local governments sold Rmb283bn of bonds in the first quarter of 2013, more than double the total for the same period last year. Such an increase would normally be expected to boost the economy, but China’s growth unexpectedly slowed to 7.7 per cent in the first quarter of 2013.

Mr Zhang said many local governments had invested in projects from public squares to road repairs that were generating lacklustre returns, and so were relying on financing rollovers to pay back their creditors. “The only thing you can do is issue new debt to repay the old,” he said. “But there will be some day down the line when this can’t go on.”

Zhang pooh-poohed the value of perceived guarantee by provinces and local authorities and says his firm will sign off on deals only when they see sufficient cash flow.

Now as the FT points out, ShineWing has a competitive axe to grind, since it is trying to break into the big leagues of international accounting firms. But this could also be self preservation. Do you think in a wealth-destroying local government bust that the national government would behave charitably towards the enablers, particularly since it has been trying to rein local borrowing in?

In an interesting bit of synchronicity, MacroBusiness has a new exclusive from Michael Pettis on the local debt issue which casts more light on this issue.

By Michael Pettis, finance professor at the Guanghua School of Management at Beijing University. Cross posted from MacroBusiness

[Saul] Eslake has argued as late as last September that he expected China to continue growing strongly over the next few years, and further claimed, in a 2011 report, that Chinese demand for hard commodities will rise quickly for at least another eight years and probably a lot longer:

But I believe that, even on quite conservative assumptions (which entail some slowing from the growth rates it has recorded over the past two decades), China’s demand for commodities will continue to grow strongly until at least 2019, and may not start to fall away until 2024; while in India, where the commodity-intensive stage of economic development only began in earnest in 2007, it is likely to continue well into the 2030s.

…Eslake says that while the full extent of China’s debt is unclear, much of it is owed by one part of the government to another. “There is the potential for writing off unsustainable obligations that doesn’t necessarily exist in other situations,” Eslake said. “I’m not disputing there are problems there and there is an opaqueness about the size, breadth of the debt problem, but it doesn’t automatically follow that China is facing its own Lehman Brothers moment.”

I am not sure what Eslake means by claiming that much of the debt “is owed by one part of the government to another”, but to the extent that this statement is correct it is pretty meaningless and to the extent that it means anything at all it is simply wrong. Although there are a number of intermediaries in the debt process in China, some of whom are indeed government entities, broadly speaking Chinese debt is owed by a group of borrowers that consists mainly of local and provincial governments and their financing vehicles, state-owned enterprises, real estate developers, large manufacturers, and other government related entities (the PBoC, the MoF, the various development banks, etc.).

These debts are owed mainly to Chinese households, either indirectly in the form of bank deposits and wealth management products intermediated by the banks, or, to a lesser extent, directly in the form of mutual funds, insurance companies, pension funds, and so on. To the extent that there is intergovernmental debt, this mainly occurs as agencies intermediate depositors and the ultimate borrowers.

…When solvency is the problem, implicit losses have to be resolved one way or another, and the costs must ultimately be assigned to some sector of the economy. Insolvency is a risk whenever the economic benefits created by an investment are less than the economic costs associated with the investment. In that case the investment makes a country poorer, but failure to recognize bad debt allows the county to feel richer when the investment is made. How the investment is financed can affect the stability and liquidity of the borrowing entity, but it cannot create or eliminate the original loss.

…Who pays for the transfer? In the past in China – and usually in every case in the world – the loss is paid for by the household sector, either in the form of busted deposits, taxes, or hidden transfers, of which the financial repression tax usually is the most important. China’s last banking crisis was paid in this way. Fifteen years ago China’s banking system was insolvent, with estimates that up to 40% of total loans were effectively non-performing had they been correctly identified.

The banking system was cleaned up over the next decade partly by implicitly granting massive debt forgiveness to borrowers in the form of extremely low interest rates (perhaps negative in real terms for most of the past fifteen years), which allowed the borrowers to “grow out” of their debt burden, and partly by the very wide spread mandated by the PBoC between the minimum lending rate and the maximum deposit rate, which guaranteed banks a huge profit. After 10-15 years of this, China’s domestically financed bad debt seemed miraculously to resolve itself.

But there was no miracle, and I think this what confuses Eslake and others like him who did not understand how the bad debt was actually resolved. There was simply an annual – if hidden – transfer of resources equal, according to my back of the envelope calculation, to between 5% and 8% of GDP from households to banks and borrowers. Did this have an economic impact? Of course it did.

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  1. Can't Help It

    Actually it’s pretty often that Bloomberg and for that matter Yahoo News etc to have seemingly contradictory articles side by side or a number of articles apart. As a programmer one can almost guess the logic behind its recommendation engine i.e. article A is about country X (based on tags, etc) and article B is also about the same country -> output two or more articles about country X in a sidebar. In theory it sounds great because it’s not biased, but in practice you get the feeling that the website is catering to just about anybody with minimal editorial supervision.

    1. Jim Haygood

      ‘On the one hand … retail demand for stocks is as hot as ever … on the other, [China’s] local debt is a train wreck waiting to happen.’

      Is this in fact contradictory? What we see in practice is that every financial crisis, overseas or domestic, prompts fresh easing from the Federal Reserve.

      For instance, the Asian crisis of 1997 and Russia/LTCM crisis of 1998 only accelerated the Internet bubble, as the Fed slashed rates in late 1998.

      Similarly, should Europe’s solvency crisis and Japan’s competitive devaluation be followed by a Chinese debt crisis, all that means is that QE4evah will be enlarged, extended and supplemented.

      In no way is this meant to endorse such a foolhardy policy. But when the central bank has fallen into the hands of delusional check kiters who believe they can print their way back to prosperity, it is a reasonable bet that asset inflation will follow. Our assignment — should we decide to accept it — is to ascertain which Bubble asset will inflate the fastest.

      As I mentioned a few days ago, it’s now more likely than not that the Fed will succeed in bulling the S&P index up to 2000. A Chinese debt crisis would only add another log to the blazing currency fire.

      Remember: it don’t have to make sense!

      1. Tax Lawyer

        Wait a minute I am missing something. In the US we solve this problem by the Fed buying crappy paper to prop up banks. Well, China has this immense sovereign wealth fund. Can’t they just use this to solve the problem?

  2. Ptup

    “There was simply an annual – if hidden – transfer of resources equal, according to my back of the envelope calculation, to between 5% and 8% of GDP from households to banks and borrowers. Did this have an economic impact? Of course it did.”

    One of which was lord only knows how many billions of dollars of ordinary savings streaming into purchases of empty condos in empty cities, both of which still sit empty. How many more are being built?

    1. Winslow R.

      As Mosler says, bank lending in China is just an extension of government fiscal policy.

      When Morgan Stanley broke into the Chinese banking market, I thought perhaps the banksters will now change the system. So far it hasn’t changed, though articles like these are written by people that hope it soon will.

  3. peace

    Thank you, Yves, Pettis and FT’s Rabinovitch, for deciphering another layer of Chinese debt (provinces, cities, localities). Pettis succinctly explains the previous debt forgiveness: reduce loan interest and national growth “allowed the borrowers to “grow out” of their debt burden.” So, investors learned that debt was not risky. The question now is whether the current provincial-city-local debt crisis is too large to resolve or hide in a similar manner. Especially when the debt is estimated at “($1.6tn and $3.2tn), equivalent to 20-40 per cent of the size of the economy”

  4. john kissinger

    China is simply following the (larger) example of how the Fed is saving insolvent Wall Street and other banks by taking from savers/retirees and giving to banks… Japan went down this road for two decades, not much growth to show for it… European imports are down, wonder how this will affect Asian export model… IMO China electricity and truck transport growth a better gauge of GDP growth than official stats, maybe 5% and falling…

  5. Ignacio

    If the losses in local government, and others debt are passed again to households rebalancing of the chinese economy will be very difficult indeed.

  6. Synopticist

    The China bubble is bound to go pop at some point. Like in the US and most of the rest of the West, they’ll be able to partially re-inflate it with a mixture of QE and pre-existing money. They have all those foreign currency reserves, after all.

    What they wont be able to do is replace all that lost wealth, spent on insane building projects and other mal-investments.

    Who’s going to buy middle and upper-middle class homes when most of the population earns less than 5 thousand bucks a year? Who’s going to rent them at top-end prices? Where’s the wealthy houshold creation going to come from? Most young middle class Chinese couples, people in their twenties with good jobs they likelly got through their parents contacts, will already have their parents houses to inherit. They have a one child policy for goodness sakes.

    And as for the millions upon millions of construction jobs, what the heck will replace them? Same as Ireland and Spain. Nothing.

    1. fajensen

      China is very different to Ireland and Spain!

      This debt is *very* internal to China: There are exchange controls in place and China does not have to worry about foreign asset-strippers buying government compliance.

      Not that this is even a possibility: The Chinese Government always favours a “China First (or bullet in head)”-policy.

      China contains an combustive mixture of tough, agressive and combatative people, it is not uncommen that a manager or an official seen to be acting unfairly is lynched! The Chinese government is always very concerned about “social stability so we will certainly not see IMF-style austerity programs imposed as “The Solution” in China and probably not millions of households losing their savings either.


      If the Chinese government needs wages to be higher for the debts to be repaid and “social stability” preserved then wages will be raised accordingly!

      If the government decides that maybe some of the lenders were irresponsible, then losses will be eaten by lenders.

      Macroeconomics is a lot more about religion/politics than actiual economy and the Chinese can take advantage of that. The Chinese Empire has lasted for 5000 years, they probbaly have records of similar situations in the past.

      1. Claudius

        Sometimes it may not be possible to remind someone, about how special they are. After reading your comment, I am taking a chance to tell you that you are special, and I hope your special-needs are met.

  7. Claudius

    Local Government Financing Vehicles (LGFVs; created, primarily, 2008–2009 in concurrence with central government’s stimulus package), are limited-liability companies financed by local government asset pools (composed mainly of land). Backed by these assets, these companies act as intermediaries by securing bank loans and funneling the money to local governments. Additionally, they are allowed to run fiscal deficits and local investment companies and utilities are allowed to issue enterprise bonds approved by the National Development Research Council (NDRC).
    Local banks are involved heavily in LGFVs, the impact being, primarily, in the form of non-performing loans (NPLs). Still, it’s difficult to gauge the impact of local government debt on the banks, as in March 2012, China Development Bank Corporation reported that “almost none” of the bank’s loans to LGFV had gone bad. Additionally, the Industrial and Commercial Bank of China (biggest commercial lender), said the bank’s LGFV loans had a non-performing rate of 0.75 percent, compared to an overall rate of 0.95 percent.
    However, in 2010, the CBRC began requiring banks to analyze LGFV loans through: “stringent classification of loans, clarification of debt repayment parties, enhanced cushion, sufficient provisioning and prompt write-offs”; that requiring banks to: “classify their LGFP exposures through cash flow analysis, and take ex ante remedial actions to mitigate the associated credit risks” and recommending the re-categorization of LGFV loans into corporate loans if they met cash flow standards and were verified by the funding platform, lender and local government (CBRC Annual Report 2010, pp. 47, 56).

    Additionally, to prevent defaults, in 2011, the CBRC announced that LGFVs meeting collateral requirements would be allowed a one-time extension on their loans. Further, in 2012 local banks were allowed to adjust repayment schedules and let borrowers roll over existing debt into new loans. Finally, the CBRC asked banks not to lend money to LGFVs, report on their current loans to commitments and work out a plan for covering LGFV debt, including raising cash.
    In 2011 and 2012, Chinese banks launched a major restructuring of the system, which reallocated 2.2-3.5 trillion Yuan ($320–500 billion) of debt from local governments onto State Banks. The State Banks will move them off their balance sheets as asset management company (AMC) bonds.

    This is where ShineWing (Zhang Ke) and the big four, Big Four, RSM China and BDO audit companies come into the picture. The principal mainland business for ShineWing has been audits and consultancy to both the LGFVs and the local banks who loaned the money; helping to “facilitate” what the State Banks and the National Audit office see as many of the most troubling LGFV issues. Indeed, so “involved” has ShineWing been in helping local government establish the “right kind” of LGFV that of the 2,853 county level governments that run 4,763 LGFVs, ShineWing was hired by all 2,853 counties, and involved in establishing 3160 of them.

    Zhang Ke is regarded as something of a “character” in Beijing – but intensely disliked by the big accounting firms for his “competitive zeal” at the county level. Regarded as a “street fighter”, he’s built up ShineWing through very rapid expansion on the back of the counties-LGFVs and local bank business. And, now, that is coming to an end, what’s especially worrying for Zhang Ke is that instead of audit being bottoms up, the State Banks vis-à-vis RSM China, BDO and the big four will take the audit more top down. It’s likely that not only will the type of LGFV vehicle structures be revealed (a political and legal worry, perhaps) but also and “deficiencies” in the previous audits. All that “ignorant” local government officials can do is point at the audit sign-off of ShineWing.

    Zhang Ke is, it appears, jumping ahead of the curve in messaging his (known) concerns before any political fallout. Along side this, Zhang Ke has nowhere to take his business; if he can’t get a license to audit H-shares (now a bigger audit pie since HK has had to open itself to being audited by mainland audit firms) before any LGFV fallout, and he certain won’t after.

  8. sd

    Groups of investors from China have bought a lot of SF residential properties in the San Francisco area over the last few years. More so than usual. Meanwhile, SF is experiencing a run up in housing prices…

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