“China’s Own Subprime Mortgage Crisis”

agencies have taken action on China over the past two weeks, expressing concern over the risks posed by excessive government borrowing, as Fitch cut its long-term local currency rating and Moody’s lowered its government bond outlook. In a Thursday column for the South China Morning Post, Hu Shuli urged local governments in China to open their books and reform their financial structure to avoid a crisis:

The extent of the risk from local government has been a topic of hot debate. It is hard to tell when, where and how it could destabilise the system, given the opacity of government operations. Some analysts are worried about the sluggish growth of government revenues. Meanwhile, many people both in and outside the government believe the risk of default is low because the central government would pick up the pieces if things go wrong.

This view is mistaken. The central government is not obliged to guarantee local government debt.

Besides, with the economy slowing and the growth of fiscal revenue also easing, the central government may in fact have no ability to bear the burden of debt in case of a systemic meltdown. The debt will instead be monetised, and the people will have to foot the bill. This is China’s own subprime mortgage crisis in the making.

The credit rating agencies aren’t alone in their worries – A senior Chinese auditor warned this week that local government debt is “out of control,” according to the Financial Times. And Reuters reports that Stephen Green, a research analyst for Standard Chartered in Hong Kong, wrote a research note describing a recent meeting with the manager of a local government financing vehicle (LGFV) in a second-tier city:

“We asked how they got a bank loan, given that they were primarily engaged in a public infrastructure project. To this, the indignant finance manager replied that they were not an LGIV,” Green wrote, using an alternate acronym for LGFV.

“The consequence is that some of the ‘corporate’ leverage we estimate above should probably be moved to the government’s balance sheet. But we have no idea how much,” Green wrote.

In reality, the scale of local government debt may not simply be unknown, but also unknowable, at least at the moment.

Official statements over the last year suggest that even the government itself hasn’t yet decided which debt it will treat as sovereign obligations in the event that an LGFV lacks the ability to service its own debt.

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