By George Lei, Bloomberg markets live reporter and strategist
A Case for Bailout as $13 Trillion Local Debt Looms: China Today
China has dealt with its mounting local government debt problem by kicking the can down the road so far, with a mixture of measures such as maturity extension and interest rate reduction.
The tinkering, however, has increasingly strained the banking system with an inevitable squeeze on earnings. Beijing may soon have to make the difficult choice on whether to bail out local governments and preserve a healthy banking system or else be confronted with mass defaults and potential financial instability.
Chinese banks have a 94 trillion yuan ($13 trillion) exposure to local government debt, making up about 29% of total assets, Goldman Sachs estimates. Even assuming a steady default rate — and that’s a big if — the US brokerage still expects bank earnings to worsen over the coming years. Lending rates are coming down on both new and rollover government debt, resulting in poorer financial metrics such as net interest margin and return on equities.
A Bloomberg report on Monday perfectly illustrated the situation: Industrial & Commercial Bank of China Ltd. and China Construction Bank Corp. now offer 25-year loans to select local government financing vehicles, in contrast to the standard 10-year tenor for corporate lending. Some deals even came with payment waivers in the first four years, though the interest will be accrued for later, according to people familiar with the matter.
Between 2023 and 2025, the effective interest rate on local government debt is forecast to fall by an average of ~30bps each year, leading to an average annual ROE drop of 100bps, according to a July 4 report authored by Dr. Shuo Yang, a Hong Kong-based analyst at Goldman Sachs (Asia) LLC. With earnings under pressure, Chinese banks simply cannot maintain a healthy balance between proper provisions for bad debt, adequate core capital and high dividend payout at the same time, Yang concluded. Things would be even worse if default rates climb.
Axing the dividend may appear to be the easy choice, compared with potential financial risks stemming from bad debt or inadequate capital. Yet that will be horrible news for markets at a time when the Hang Seng China Enterprise Index is lagging almost every major gauge in the world. It will also be a slap in the face of policy makers, who a few months ago were pushing state-owned enterprises to improve their ROE and value creation.
Economists at both home and abroad have been calling — to no avail so far — for the central government to expand its own borrowing and tackle the local-debt mess. If Beijing insists on no bail-out and forces local authorities to resolve their own debt problems, it may have to grapple with not only mass defaults but also banking crises in the years to come.
