Friday, July 08, 2011

China's cities built on debt mountains

WUHAN: In the seven years it will take New York to build a 3.2km leg of its long-awaited Second Avenue subway line, this city of nine million people in central China plans to complete an entirely new subway system, with nearly 225km of track.

And the Wuhan Metro is only one piece of a US$120 billion (S$150 billion) municipal master plan that includes two new airport terminals, a new financial district, a cultural district and a riverfront promenade with an office tower half as high as the Empire State Building.

The construction frenzy cloaks Wuhan, China's ninth-largest city, in a continual dust cloud, despite fleets of water trucks constantly spraying the streets. No wonder the local Communist Party secretary, promoted recently from mayor, is known as 'Mr Digging Around the City'.

The plans for Wuhan, a provincial capital about 685km west of Shanghai, might seem extravagant. But they are not unusual. Dozens of other Chinese cities are racing to complete infrastructure projects just as expensive and ambitious, or more so, as they play their roles in this country's celebrated economic miracle.

In the past few years, the cities' efforts have helped government infrastructure and real estate spending surpass foreign trade as the biggest contributor to China's economic growth.

Subways and skyscrapers, in other words, are replacing exports of furniture and iPhones as the symbols of China's industrial prowess.

But there are growing signs that the long-running economic boom could be undermined by these building binges, which are financed by heavy borrowing by local governments and clever accounting that masks the true size of the debt.

The danger, experts say, is that China's municipal governments could already be sitting on huge mountains of hidden debt - a lurking liability that threatens to stunt the country's economic growth for years or even decades to come.

Just last week, China's national auditor, who reports to the Cabinet, warned of the perils of local government borrowing. And on Tuesday, the Beijing office of Moody's Investors Service issued a report saying the national auditor might have understated Chinese banks' actual risks from loans to local governments.

As Chinese growth has been one of the few steady engines in the global economy in recent years, any significant slowdown in this country would have international repercussions.

As municipal projects play out across China, the country's spending on so-called fixed-asset investment - a crucial measure of building that is heavily weighted towards government and real estate projects - is now equal to nearly 70 per cent of the country's gross domestic product. It is a ratio no other large country has approached in modern times.

Even Japan, at the peak of its building boom in the 1980s, reached only about 35 per cent, and the figure has hovered around 20 per cent for decades in the United States.

China's high number helps explain its meteoric material rise. But it could also signal a dangerous dependence on government infrastructure spending.

'If China is good at anything, it is infra-structure,' said Mr Pieter Bottelier, a long-time China expert at the Johns Hopkins School of Advanced International Studies in Washington.

'But right now, it seems the investment rate is too high. How much of that is ill-advised and future non-performing loans, no one knows.'

In the past decade, as economists have sought to explain China's rise, a popular image has emerged of Beijing technocrats continually and cannily fine-tuning the country's communist-capitalist hybrid. But in fact, city governments often work at odds with Beijing's aims. And in practice, some of Beijing's own goals and policies can be contra-dictory.

As a result, China's state capitalism is much messier, and the economy more vulnerable, than it might look to the outside world.

In the case of Wuhan, a close look at its finances reveals that the city has borrowed tens of billions of dollars from state-run banks. But the loans seldom go directly to the local government.

Instead, the borrowing is done by special investment corporations set up by the city - business entities whose debt shows up nowhere on Wuhan's official financial balance sheet.

Adding to the risk, the collateral in many of those loans is local land valued at lofty prices that could collapse if China's real estate bubble bursts. Wuhan's land prices have tripled in the past decade.

Dozens of other cities are following a similarly risky script: creating off-balance-sheet corporations that are going deep into debt for showpiece projects, new subway systems, high-speed rail lines and extravagant government office complexes. And they are doing it despite efforts by the central government in Beijing to rein in the excesses.

To limit the cities' indebtedness, Beijing has long prohibited municipalities from issuing bonds to finance government projects - the way New York and other US cities do as a matter of course.

Lately, too, China's central government has put tighter limits on state-owned banks' lending to the municipalities. But using their off-the-books investment companies, the cities have largely been able to elude Beijing's fiscal grasp.

This system is not a secret from Beijing, which now says there are more than 10,000 of these local government financing entities in China.

A recent report by the investment bank UBS predicted that local government investment corporations could generate up to US$460 billion in loan defaults over the next few years. As a percentage of China's GDP, that would be far bigger than the US$700 billion troubled-asset bailout programme in the US.

As frightening as that may sound, many analysts see no reason to panic - no imminent threat of an economy-collapsing banking crisis in China. That is largely because of Beijing's US$3 trillion war chest of foreign exchange reserves (much of it invested in US Treasury bonds), and the fact that China's state-run banks are also sitting on huge piles of household savings from the nation's 1.3 billion citizens.

Because all that cash is protected by government restrictions on money flowing in and out of the country, a global run on China's banks is unlikely.

The real problem, analysts say, is that municipal government debt in China has begun casting a large shadow over the nation's growth picture.

If instead of investing in growth, China had to start spending money to gird the banks against municipal defaults, some experts see a possibility of China eventually lapsing into a long period of Japan-like stagnation.