Chinese local government debt is looking more and more like a bubble about to pop

Today in shaky financial dealings which have the potential to upend the global economy: Chinese local government debt.
Speaking to the Financial Times, Zhang Ke, a senior auditor at Chinese accounting firm ShineWing, warns that local government debt is “out of control” and may lead to a bigger financial crisis than the US housing market crash.
“We audited some local government bond issues and found them very dangerous, so we pulled out,” Zhang, who is also vice-chairman of China’s accounting association, told the FT “Most don’t have strong debt servicing abilities. Things could become very serious.”
Debts soared when Beijing loosened constraints on local government borrowing in 2008 to help authorities weather the global financial crisis. Local authorities, from provincial governments to village councils, are estimated to owe between 10 and 20 trillion yuan ($1.6-3.2 trillion), or the equivalent of 20-40 percent the size of the Chinese economy.
Though Beijing has attempted to reign in local government borrowing, Zhang says the situation is “out of control” and the nature of the debt means it’s difficult to predict when the bubble may pop.
Local governments are officially forbidden from issuing bonds to help pay off their debts, but this hasn’t stopped many from turning to innovative and highly complicated financial instruments to circumvent the restrictions.

The bonds are generally rated from A+ all the way to AAA, with duration running from 3 months to 20 years, and coupons that go from 3.4 per cent to 9.4 per cent.
All this suggests that most of these bonds trade as if they were explicitly state-backed. That’s nothing new – as shown by China’s forays last year into what looked like CDOs containing a load of junk debt packaged up into AAA-rated bonds.
But history tells us that fake municipal bonds are not bullet proof, as demonstrated by the collapse of the Guangdong International Trust Company in the wake of the Asian financial crisis.

“In times of fiscal stress, these bonds have a greater risk of default and the local governments could simply allow them to fail, passing the loss to investors,” ANZ’s Liu Ligang and Louis Lam told the FT.

Investment companies owned by local governments sold Rmb283bn of bonds in the first quarter of 2013, more than double the total for the same period last year. Such an increase would normally be expected to boost the economy, but China’s growth unexpectedly slowed to 7.7 per cent in the first quarter of 2013.

The inability to properly issue bonds, combined with lacklustre returns on many infrastructure investments – including public works and road repairs – means that local authorities have resorted to “[issuing] new debt to repay the old”, according to Zhang.
Michael Pettis, finance professor at the Guanghua School of Management at Beijing University, says that it is Chinese households who will bear the brunt of the suffering when the local government debt bubble finally pops:

In the past in China – and usually in every case in the world – the loss is paid for by the household sector, either in the form of busted deposits, taxes, or hidden transfers, of which the financial repression tax usually is the most important. China’s last banking crisis was paid in this way. Fifteen years ago China’s banking system was insolvent, with estimates that up to 40% of total loans were effectively non-performing had they been correctly identified.
The banking system was cleaned up over the next decade partly by implicitly granting massive debt forgiveness to borrowers in the form of extremely low interest rates (perhaps negative in real terms for most of the past fifteen years), which allowed the borrowers to “grow out” of their debt burden, and partly by the very wide spread mandated by the PBoC between the minimum lending rate and the maximum deposit rate, which guaranteed banks a huge profit. After 10-15 years of this, China’s domestically financed bad debt seemed miraculously to resolve itself.

Pettis points out that far from miraculously resolve itself, China’s bad debt was only alleviated by an annual transfer of resources equal “to between 5% and 8% of GDP from households to banks and borrowers”.