China Curbing Lending of Local Governments

As suggested in this February 25th Wall Street Journal article ("China Feels the Pinch From Tighter Credit"), Chinese central bank regulators are curbing lending to the country's regional governments. These actions, along with a myriad of other policy iniatives including raising the reserve requirement twice this year, prohibiting lending by state banks for the last week in January (after 1.4 trillion yuan of new loans were extended - 20% of the 7.5 trillion yuan target for the entire year), and eliminating the practice of banks selling loans to off-balance trust companies, all reflect increasing concern by government officials that China's overheated economy needs to be restrained. 

While local governments are generally prohibited from incurring debt, most set up local companies to take on outside financing. Comforted by their land holdings and an implicit guarantee from the central government (sounds similar to how Fannie/Freddie were able to access cheap capital!), many of China's largest banks lent freely to these investment companies to finance significant infrastructure development.

As noted in the article:
Estimates of the total debt accumulated by investment vehicles set up by local governments range from six trillion yuan (around $878 billion) widely cited in the Chinese media, to the 11 trillion yuan calculated by Northwestern University professor Victor Shih. Those sums—on the same order of magnitude as all the official debt of China's central government—have drawn high-level concern.
Liu Mingkang, China's chief bank regulator, followed up in a nationwide conference call with bank executives on Jan. 26, telling them to "fully assess and effectively guard against risks from local government financing platforms."
The Shanghai Securities News reported Wednesday, citing unnamed sources, that banks had been ordered to stop issuing new loans to investment vehicles that are backed only by local governments' future revenue and have no registered capital.


While most skeptics of a potential Chinese credit bubble point to the country's ample foreign currency reserves and relatively low level of government debt to GDP,  it is important to realize how much debt resides "off-balance" in the form of loans to these local investment companies (which as noted before have the implicit guarantee of the federal government).  The first evidence of a deflating credit bubble will be when one of these regional governments can't roll over their debt.  Many will point to the "excesses of this one local investment company" and give the standard refrain uttered at the beginning of the suprime meltdown that "the blowup is isolated and will not spread to the rest of the economy."  However, as the events of 2007-2009 taught us, bad loans from one sector of the economy inevitably restrict lending to other seemingly healthy parts of the economy as banks work to restore their capital reserves.  The systemic problems caused by China's highly concentrated quasi-government banking system will only heighten the spread of this contagion.
 
A February 9th op-ed piece in the Wall Street Journal Asia edition ("China's 8,000 Credit Risks") by Professor Victor Shih does an excellent job explaining the mounting problems of China's regional investment companies.