Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise
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The global financial crisis of 2009 posed the greatest challenge yet to localities: Beijing’s RMB4 trillion (US$486 billion) stimulus package required local governments to identify projects and come up with financing for two-thirds of project spending. For some time before the crisis, local governments had been leveraging their utilities, roads, construction brigades and asset-management bureaus by incorporating them into limited-liability companies. Under this legal guise, they could borrow money from banks and, taking advantage of bond-market reform, issue debt. According to the CBRC, by June 2009, there were 8,221 fund-raising platforms operating at provincial, regional, county and municipal government levels, of which the majority (4,907) were owned by county governments. Many of these entities had been established simply to take advantage of the government’s free-for-all lending boom. After all, if they could come up with the capital to meet Beijing’s demands, why not raise more to finance their own economic incentive programs? It is common wisdom in China that once the window of opportunity is open, it is open for only the briefest of moments and the wise person will grab all that is possible of whatever opportunity is on offer. It is also common wisdom that when the Party takes the responsibility, the regulators will sit silently on the sidelines. Thus, in 2009, conditions were perfect for local governments to do all in their power to raise funds, with little possibility of their being blamed for financial excess.
“Financing platforms”
In those easy days of 2009, local governments and their “financing platforms” (rongzi pingtai ) had almost-unprecedented access to credit. After a long discussion in 2008, Beijing decided that local governments would be officially permitted to run fiscal deficits. The symbol of this new thinking was the RMB200 billion (US$30 billion) in bonds issued in early 2009 by the MOF as agent for the localities. Even more important, however, locally incorporated investment companies and utilities were allowed to issue NDRC-approved enterprise bonds (qiyezhai ) and to these were added the new short-term PBOC securities, CP and MTNs. With the window wide open, local Party secretaries rapidly expanded their fund-raising platforms beyond simple “Municipal (or County) Investment Companies” to the incorporation of various entities such as water, highway, and energy utilities. China’s muni bond market was born.
Among the many new issuers in the inter-bank market were some 140 local-government incorporated entities (see Table 5.1). With such names as Shanghai Municipal Construction Investment and Development Co. Ltd., Wuhan Waterworks Group Co. Ltd. and Nanjing Public Utility Holdings Co. Ltd., these entities are similar to municipal-bond issuers in the US, but with one difference. In addition to issuing long-term bonds to match the maturity of long-term investment projects, these entities also eagerly issued short-term commercial paper and MTNs. In fact, it seems they have issued every sort of debt security for which they could obtain approval.
TABLE 5.1 Local “financing platform” debt issuance, June 30, 2009
Source: Wind Information; bonds include CP, MTNs and enterprise bonds; issuers do not include local manufacturing SOEs
In 2009, the amount of capital raised in the bond markets by these provincial, municipal and county entities totaled nearly RMB650 billion (US$95 billion), accounting for over 50 percent of enterprise bonds issued and 48 percent of total CP and MTN issues. The overall explosion in CP and MTN issuance in 2009 is explained by the lack of complex approval procedures and of the requirement of a bank guarantee; issues had only to be registered with NAFMII. Making it even more attractive, MTN underwriting fees and interest expenses were lower than for the NDRC’s bonds or even bank loans. Truly, 2009 was a bonanza for some local governments. Looked at carefully, the geographical distribution of these local issuers is quite limited; fully 66 percent of local government issuers and 76 percent of all money raised came from China’s richest locations: Greater Shanghai, Beijing and Guangdong. What can explain why Zhejiang, China’s richest provincial economy, has 19 local-government issuers down to even the county level, while Henan, China’s most populous province, only four? In discussion with market participants, it seems the answer is simply that money begets money.
So the other 8,000 less-fortunate localities depended, as has been the case historically, on their partnerships with local bank branches for debt financing. How do they borrow if their resources are so constrained? Figure 5.3 shows that one of the ways local governments capitalize their financing platforms is by contributing land and tax subsidies. The land, in turn, may be used as collateral for a bond issue or a bank loan.
FIGURE 5.3 Local-government funding alternatives
Source: Based on FinanceAsia, June 2009: 32
The more valuable the land, the stronger is the platform’s capacity for borrowing. The mortgaged land might be used as part of a large development for houses, office space or shopping centers. The stronger a local economy, the greater the potential profit of such a development and the greater the interest other investors may have in participating in the equity of the platform through wealth-management products developed by trust companies and sold to the banks’ high-net-worth customers (see Figure 5.4).
FIGURE 5.4 Trust-based financing for local financing platforms
In China’s many poorer localities, these sorts of opportunities do not exist. They simply cannot meet the minimum standards of the bond markets, so they borrow from banks, as they have always done. To do so, they cut corners. For example, Figure 5.5 illustrates how a local government may borrow from another local government and use the money to inject as capital in its financing platform. Once the capital is registered and the company is established, the local government takes back the money and repays the other local government. The financing platform exists, has nominal registered capital and business licenses and is fully able to borrow money from other banks.
FIGURE 5.5 The temporary debt-based equity capitalization of a local financing platform
PBOC and CBRC surveys found such local platforms had borrowed some RMB6 trillion (US$880 billion) by the end of September 2009, with nearly 90 percent of stimulus projects tied to bank loans.9 These same surveys also noted that these loans amounted to 240 percent of local government revenues and, in 13 of China’s 29 provinces and autonomous zones, liabilities exceeded total fiscal revenues. These local borrowings were found by the CBRC to account for 14 percent of total lending in 2009 and, for some banks, as much as 40 percent of total new credit issued. By year-end 2009, Beijing was publicly admitting to RMB7.8 trillion (US$1.14 trillion) in outstanding local-government bank debt.
If this widely reported figure is accurate, then local governments and their agencies have borrowed the equivalent of 23 percent of the country’s annual GDP. Analysts at China International Capital Corporation (CICC) put current debt levels at RMB7.2 trillion (US$1.1 trillion), peaking at RMB9.8 trillion (US$1.4 trillion) in 2011. But the report provides an even greater service when it states: “If the financing chain for the platforms is not broken, they will be able to dissolve potential credit risks in the course of current economic development trends.”10 In other words, as long as banks continue to lend, there will be no repayment problems. As will be discussed in this book’s conclusion, rolling outstanding debt when it matures—that is, re-issuing new debt to repay the old—is a principal characteristic of China’s financial system.
Provincial government semi-sovereign debt
As noted earlier, in March 2009, the MOF announced the issue of RMB200 billion (US$30 billion) of local-government bonds. These were rolled out rapidly, before a regulatory framework could be developed or the philosophy behind their credit ratings could be thought out. The thinking behind this seemed to be that as provincial governments are equivalent to ministries in the Chinese bureaucratic hierarchy, and thus represent the state, they would attract similar ratings. But most people know full well that Qinghai is different from Shanghai.
However, a spokesman for the MOF explained that although the debt would be issued in the name of the provincial governments
and approved as a part of their budgets, the MOF would act as their agent. More importantly, given this, the coupon on, and the risk of, the bonds would approach that of sovereign debt. In essence, the spokesman was attempting to sell the idea that provincial issues carried risk equivalent to the country itself. While this may be true in theory, in practice, it is not and many market participants did not accept the idea. Moreover, this was not the picture presented in the MOF’s own rules governing local debt issues. These stated explicitly that if the locality could not make repayment, the debt would be rolled forward over a period of one to five years, with the original principal amount being repaid in installments the local government could afford. In short, the original three-year bond might, in fact, have a tenor of eight years or longer.
Clearly, this was not central government debt. Despite widespread questioning in the market, the bonds were priced closely to MOF bonds of a similar maturity by the friendly primary-dealer syndicate. What might have happened to prices in the secondary market is unknown because there has been no secondary market. The fact is, these bonds have disappeared onto the balance sheets of the MOF’s primary-dealer group, that is, China’s banks.
CHINA INVESTMENT CORPORATION: LYNCHPIN OF CHINA’S FINANCIAL SYSTEM
If the inter-bank market somewhat resembles a pyramid scheme, it nonetheless plays an extremely important role in the PBOC’s effort to manage inflation through control of the money supply. In 2002, a policy disagreement blew up over how to cool inflation that was threatening at that point. This disagreement evolved over four years into a struggle over how to manage the inflationary impulse caused by China’s huge trade surpluses. Driven by enthusiasm over China’s joining the WTO, fixed-asset investment exploded from 2002, increasing on an annual basis by 31 percent, the highest level seen since Zhu Rongji’s heyday began in 1993 (see Figure 5.6). Memories of mid-1990s double-digit inflation caused the PBOC to issue short-term notes continuously into the market for the first time in China’s post-1949 banking history. From an initial issue equivalent to US$26 billion in 2002, this rose over the following years until 2007, when the PBOC soaked up nearly US$600 billion from the banks. The central bank also adjusted upward bank-deposit reserve ratios nine times and raised interest rates five times. These aggressive measures were effective temporarily, but by 2007, the explosion in foreign reserves and the consequent creation of new renminbi posed an almost insurmountable challenge.
FIGURE 5.6 Investment, FX reserves and money supply, FY2001–2008
Source: PBOC, Financial Stability Report, various
Others also remembered 1993 and how Zhu Rongji had aggressively intervened in the economy using administrative orders to close off all channels to liquidity. Zhu simply shut off all bank lending, closing down the economy for almost three years until inflation that had peaked at over 20 percent in 1995 was finally beaten. The group favoring administrative intervention in 2002 argued that the economy was not overheating, only specific industrial sectors were and this could be dealt with using specific policy means. Their argument carried the day and bank credit to those sectors was cut off. By 2004, both efforts had reduced the growth of investment and M2 just in time to begin dealing with the flood of US dollars pouring into the country from China’s booming trade surplus.
It was at this point in July 2005 that the PBOC succeeded in convincing the government to delink the RMB exchange rate from the US dollar and allow it to gradually appreciate. It was unfortunate that the predictability of the RMB’s 20 percent appreciation led to huge inflows of hot money and even greater liquidity in the domestic markets, not to mention an explosion in the stock index and high-end real-estate speculation. That both sides could claim success in this earlier anti-inflation campaign complicated things significantly later on after the outbreak of the global financial crisis in September 2008, when market forces fell dramatically from political favor. Despite the PBOC’s aggressive efforts to manage this flood of RMB, the data in Figure 5.7 suggest that the effectiveness of short-term notes began to decline after 2007. The growth in the money supply as measured by M2 had been stable at 16 percent, but it accelerated to 19 percent in 2008 and then 29 percent in 2009. For its part, the policy of appreciating the currency was canceled as soon as export growth turned negative in late 2008.
FIGURE 5.7 PBOC note issuance vs. growth in money supply (M2), 2001–2009
Source: PBOC Financial Stability Report, various; China Bond
This is the macro economic background to the political struggle over China’s financial framework that had been continuing since 2003. The struggle came to center on the establishment in 2007 of China Investment Corporation (CIC). It is ironic to consider that this sovereign-wealth fund, established to invest the country’s FX reserves overseas, was in fact used to dramatically restructure China’s own financial system. CIC is not the country’s first sovereign-wealth fund. SAFE Investment Co. Ltd., a Hong Kong subsidiary of the State Administration of Foreign Exchange (SAFE), has been actively managing a portion of China’s foreign-exchange reserves since 1997. So why establish a second fund? SAFE Investment is owned by the PBOC; CIC is owned by the MOF. Why would the MOF want to encroach on foreign exchange, which has clearly always been the legitimate turf of the PBOC? The answer seems to be that since the PBOC took over outright control of two of the four major state banks from the MOF, the MOF had the right to seek their recovery. In the end, the establishment of CIC is less about a sovereign-wealth fund than a battle over bureaucratic territory. The outcome of this particular round, moreover, is very clear: CIC is now the very lynchpin of the country’s domestic financial system.
RMB sterilization and CIC
The story of CIC’s capitalization shows that all institutional arrangements in China are impermanent; everything can be changed as a result of circumstances and the balance of political power. All institutions are in play, even the oldest and most important. The case of CIC also shows the extent to which China’s financial markets have been distorted by the pressures created by the country’s tremendous foreign-reserve imbalance. This distortion now extends beyond the domestic capital markets, both debt and equity, to the financial institutions that provide their foundation and beyond to the international equity markets and investors.
Since it was designed to invest reserves offshore, it might have been expected that CIC would receive its capital directly from foreign reserves, as had the state banks. China Construction Bank, Bank of China, Industrial and Commercial Bank of China and Agricultural Bank of China had each been at least partially capitalized from the foreign reserves by way of a PBOC-established entity called Central SAFE Investment, known commonly as Huijin. In 2007, a surging money supply threatened a major asset bubble and the debate about how to handle this—whether through monetary tools or outright administrative measures—became mixed up with the MOF/PBOC rivalry. The MOF claimed that the PBOC’s management of reserves produced too low a return; from this it was a quick jump to the MOF asking for its own opportunity and then to a discussion of how to capitalize CIC. In the end, the Party agreed to allow the MOF a chance; after all, in 2007, there were plenty of reserves to be managed. But there was no direct infusion of capital into CIC as had been the case with the banks. Instead, there was yet another MOF Special Treasury Bond.
This Special Bond was approved by the State Council in early 2007 and its size was a mammoth RMB1.55 trillion (about US$200 billion with 10- and 15-year tenors), as shown in Figure 5.8. Not only had the MOF accused it of poor reserve management, the PBOC also stood blamed for monetary growth that threatened an outbreak of inflation. The path these bonds took tells the tale of the PBOC’s political weakness. The MOF sold the bonds to the PBOC in eight separate issues through the hands of Agricultural Bank of China. Direct dealings between the two had been prohibited by law since 1994 when the Central Bank Law was enacted; prior to this, the central bank had too often been forced to finance the state deficit directly. But this bond was not for deficit financing. The P
BOC, for its part, bought the bonds from ABC and then, given their below-market interest coupons, forced them into the market, which consisted of the banks. This issue, therefore, drained a huge amount of liquidity from the banking system, an amount double what the PBOC had been able to achieve through its own short-term notes. This approach also relieved the PBOC of adding to a growing interest burden on its notes.
FIGURE 5.8 Step 1: MOF issues Special Bonds and drains market liquidity
While this seemed like an innovative idea, nothing is without cost, as shown in Step 2 (see Figure 5.9). Considering the monetary objective, the MOF had done the PBOC a favor and the transaction could have stopped there. CIC could have been funded through a separate transaction with Huijin using foreign reserves, if the PBOC had been willing to go along. The MOF, however, was out to extract its final pound of flesh and used the RMB acquired from the bond issue to buy US$200 billion from the PBOC/SAFE, again via the services of ABC. The MOF then used these funds to capitalize CIC. Aside from its economic objectives, the institutional effect of this transaction was the restoration of the financial system to the pre-2003 status quo and a further weakening of the PBOC and the market-reform camp. But there was more.