China: Hidden domestic debt, the elephant in the room

Chinese bureaucracyChinese bureaucracy

With the economic slowdown and equity market correction in China, hidden domestic debt has come to the attention of global markets again. Chinese local governments issued this domestic debt through off-balance-sheet channels. Most of it is from local governments in the less wealthy provinces, which borrowed to build infrastructure and develop property so they could keep their growth rates high. Last month, S&P Global Ratings issued a re-port stating that hidden debt in China is somewhere between CNY 30trn to CNY 40trn (USD 4.3trn to 5.8trn). By means of comparison, acknowledged local government debt sums up to CNY 18trn (USD 2.6trn) and central government debt to CNY 13.5trn (USD 1.9trn).

The vast majority of China’s hidden debt is in wholly owned shell companies, called Local Government Financing Vehicles (LGFV). Analysts at Julius Baer estimate that only around half of them are businesses with real, sustainable cash flow.

What creates additional concern is the fact that nearly 40% of the LGFV obligations will mature next year.

However, there are arguments to keep calm, analysts at the firm add.

We are convinced that the large majority will see central government support. In-deed, in 2018 there have been several LGFV defaults, whereas in all the earlier years there was only one. While this year there have been some small LGFV defaults, several larger LGFVs received last-minute financial support from the central government. By al-lowing a few smaller defaults, the central government appears to be trying to maintain a semblance of discipline.

Notwithstanding such a stance, with slowing economic growth and a deterioration in relations with the United States, China’s government does not want to risk contagion by allowing any large LGFVs to default; it has the means to provide all the support needed. According to in-vestment bank CICC, the central government holds some CNY 5trn (USD 720bn) in bank deposits, and the combined bank de-posits of provident and pension funds as well as of state-owned enterprises total approximately CNY 29trn (USD 4.2trn). Even though the data is not recent, according to the Chinese Academy of Social Sciences, there were around CNY 125trn (USD 18trn) in government assets at the end of 2015 (mostly land and state-owned enterprises); the bulk of that should still be around today.

Final conclusions from Julius Baer point that China’s hidden domestic debt is likely to be contained by the central government and therefore unlikely to spark a financial crisis or recession by its own. However, by rolling it over, the debt will linger on as a heavy burden on the economy and will need time to be resolved. This means that the central government will continue to weigh a heavy hand in this issue for the time being and have direct influence in the economy at a wide scale.

Consequently, it can no longer be said that China continues to transition to a more market-driven economy, one that would ultimately produce higher returns and make the country a better investment destination.