China's local governments dig themselves into a hole
Unfettered growth at financing vehicles leaves cities facing a debt crisis
YUSHO CHO, Nikkei staff writer
SHANGHAI -- Some 1,200km west of Shanghai lies the central Chinese province of Hunan. A 40-minute bus ride from the provincial capital of Changsha brings you to Ningxiang. The nondescript midsize city seems to have little in common with the showy image China is attempting to project with its various development projects, such as this year's focus on building sewage treatment systems and electric substations in villages. Yet a piece of paper issued in mid-August by the city government has sent shock waves throughout the nation.
"All collateral provisions for bond issuances and loans have been nullified," it read.
Like many of China's regional governments, Ningxiang set up a number of investment and loan companies, known as local government financing vehicles, to engage in fundraising and infrastructure development. These financing vehicles were created to circumvent a recently lifted ban on regional governments issuing bonds. To boost the creditworthiness of the financing vehicles, some governments handed over land for them to use as collateral for borrowing.
Nullifying collateral provisions takes away one means lenders have to recover their losses should a borrower default. It is not unreasonable in such a situation to imagine a financing vehicle intentionally letting principal and interest payments fall into arrears. This makes the Ningxiang government's announcement look suspiciously like a debt forgiveness order.
Once the media picked up the story, Ningxiang came under fire and quickly repealed the order, saying it had misunderstood the central government's policy. But the fact that the city issued such an order in the first place highlights how difficult the situation is for regional governments lacking industrial and financial resources. In Ningxiang's case, that impression is only reinforced by the less-than-impressive balance sheets of its financing vehicles.
One of those vehicles is Ningxiang National Economic and Technological Development Zone Construction and Investment. The company had 21.5 billion yuan ($3.33 billion) in total assets and 10.3 billion yuan in debt at the end of March this year. The company's pace of expansion -- total assets swelled 2.7 times from 8.1 billion yuan at the end of 2012 in about four years -- is extraordinary to the point of abnormal.
Ningxiang NETDZC develops industrial sites and the like and sells them to the private sector for a profit. Its 2016 development plan included the construction of a home appliances industrial park and industry-academia partnership facilities. For some projects, it is hard to see how the company can recoup its investment. By proceeding with development anyway, it can help shore up the city's economy, at least for a while. Yet Ningxiang's gross domestic product was 109.8 billion yuan while revenue was 6.5 billion yuan in 2016, meaning the debts of this one financing vehicle alone surpass the city's revenue.
The abnormalities do not stop there. Nearly 80% of Ningxiang NETDZC's total assets, or 16.8 billion yuan, is inventory, with cash accounting for no more than 800 million yuan. Given its roughly 1.8 billion yuan in current liabilities, such as accounts payable and interest payments due within a year, it is evident that the company faces a cash flow problem, even if it is not yet in dire financial straits. Furthermore, 181.03 million yuan of its pretax profit of 238.51 million yuan in 2016 came from government subsidies and tax breaks. The company began relying on government assistance some five years ago.
The financing vehicle has outgrown the local economy, holds excess inventory, is on shaky ground in terms of cash flow and depends on government support for more than 70% of its profit. In short, it is in a dismal state. A footnote in the company's financial report is cause for even more anxiety. It says that borrowing costs, or interest, can be counted as an asset when certain conditions are met.
The capitalization of borrowing costs, which is authorized under International Financial Reporting Standards, is not an unusual accounting practice. Under the procedure, the value of assets must be assessed at original cost or market price, whichever is lower. The question is whether the financing vehicle is assessing its inventory appropriately.
Almost the entire inventory of the company is land-related assets. Past data on its inventory is unavailable, but considering the bloated size of its total assets, it seems clear that sales have failed to keep up with the company's expanding scale of business. If sales have been sluggish, it is likely that the market prices of land are below the prices on the balance sheet. Sales of 77.16 million yuan in the first three months of this year were a paltry two-hundredth the value of inventory for the period. That figure also falls short of year-earlier sales of 94.8 million yuan.
Another Ningxiang financing vehicle is in more or less the same financial situation. Total assets at Ningxiang County City Construction Investment Group (Ningxiang County was renamed Ningxiang City in 2017), were 19.9 billion yuan as of the end of 2015, of which 9.9 billion yuan was inventory and 1.9 billion yuan was assets under construction. Government subsidies accounted for 81.45 million yuan of the company's pretax profit of 188.84 million yuan in 2015.
This financing vehicle appears to be less cash-strapped than Ningxiang NETDZC, but its expansion is similarly worrying. Its total assets have nearly doubled from 10.6 billion yuan at the end of 2013. It is highly likely that the company expanded operations even though it could not afford to in order to stimulate the local economy.
Ningxiang is not the only city with financial woes.
Several years ago, a development zone in Changzhou, Jiangsu Province, organized an inspection tour to lure foreign companies. The tour included a party held at a guest house built by the zone at its own expense. Women in deep-slit cheongsam carried trays of wine, and shouts of "Ganbei!" (cheers) broke among the partygoers out now and again.
Each of the women stood by one of the zone's executives. To get acquainted with these executives, party participants were expected to down endless glasses of wine. President Xi Jinping had just launched his anti-corruption campaign, but such scenes were still typical. The development zone bore the entire cost of the party, underscoring how urgently it needed to attract foreign investment.
One of Changzhou's financing vehicles, called Jiangsu Wujin Economic Development Group, posted an operating loss from at least 2013 until the January-September period in 2016. Nevertheless, it has continued to generate net profit, thanks to some 1 billion yuan in government aid every year. Its debt stood at 79.8 billion yuan at the end of September 2016, up from 58.6 billion yuan at the end of 2013, with properties worth slightly less than 25 billion yuan, over a fifth of total assets, offered to financial institutions as collateral. Changzhou, a much bigger city than Ningxiang, appears to have no trouble securing loans from banks, but its financing vehicles are as prone to unchecked expansion despite lackluster profitability as their Ningxiang counterparts are.
China's regional governments had incurred just over 15 trillion yuan in debt as of the end of last year. It is a huge amount, and it most likely does not include contingent debts that regional governments must shoulder if financing vehicles and similar entities default on bank loans. China last disclosed data for such contingent debts as of June 2013. This lack of transparency suggests that massive regional government debt may be the Achilles heel of the Chinese economy.
Chinese economic magazine Caixin estimates that regional governments' latent debt comes to 35 trillion yuan, more than twice the official figure. Once the economic pump-priming measures of real estate and infrastructure investment reach their limit and debt expansion runs out of room, China will find it difficult to sustain its rapid growth rate. When will that turning point come? If the financial quagmire facing the country's regional governments is any indication, it may come sooner rather than later.