1. City Investment Companies and Land Finance

• By law, local governments cannot get debt from banks, and before 2015, could not issue debt securities, so if they wanted to invest, must form a special company. Most of these companies are wholly government owned, and called "local government fundraising platforms." Their official names often have "construction investment" or "investment development" in it, so they're also called "city investment companies." They often have 3 characteristics
  • Land use rights from the government
  • P&L reliant on government subsidies (ie subsidies can greatly exceed profits). While this might mean the projects are uneconomical, but it's not that surprising because if they were economical then the government wouldn't need to step in. Many times, its the second and third order effects that are considered.
  • Implicit guarantee from government means these enterprises can take on a lot of debt and so are considered "riskless."
  • Most of these companies are not tourism related but basic infrastructure and industrial related such as industrial parks.
    • In developed cities the government will often do everything such as the leasing after development but in more remote areas it's often contracted out to private business in a Public-private partnership AKA PPP (eg 华夏幸福 is such a company)
      • PPPs are not rare elsewhere but in China, there are a ton of them and the scale is large. Up to 5/2020, there are 9575 PPP projects totaling 15Trn RMB, but only 40% were started. And capital tended to come from other SOEs or these fundraising platforms, not private enterprise (which is only 30%).

1. Local Government Debt

• As made obvious by Chapter 2, local government operations really depend on land prices. Local debt really exploded in 2008-9. Due to the US Great Financial Crisis, China put out a 4Trn RMB plan, 1.2 from central, 2.8 from local. To accommodate this plan, restrictions for the type of fundraising platforms above and bank loans were loosened.
  • In 2008, there were only 3000 fundraising platforms, by 2009, 8000, and about 60% were provincial level (first class) platforms. Debt flowed. Within just a few years, they accumulated staggering amounts of debt which is still a big risk
• In the 1980s and 90s, most of urban construction needed money from the government. After 1994 tax reform, local government's lives got even tougher because:
  • Needed to have a company to get debt, since government cannot directly get bank loans
  • Lots of projects such as sewage don't make money or even lose money but are necessary, so "bad" projects have to be bundled with profitable ones
  • Not enough revenues, so have to figure out how to extract full benefits from land
  • This is how the fundraising platforms / city investment companies were born. The first one was in 1998 for Wuhu city in Anhui province from CDB China Development Bank
    • In 2002, government allowed this platform to use benefits from land transfer rights as collateral for loans
    • Before 2008, most of these loans were from CDB, after 2008 commercial banks got involved, by 2018, total loans were 2Trn from CDB, 2Trn from the 4 large banks, city commercial banks 2.2Trn and other cooperatives / financial institutions 1Trn.
    • For city banks, most of them are owned by the local government. The issue is, unlike CDB which is a strategic bank, city commercial banks get their money from deposits which are short term vs their projects which are long term, so the time horizons are different, introducing risk. Example: Baotou Bank going bankrupt in 2020.
  • The other avenue besides bank loans is debt securities. But here are the risks:
    • Debt securities from these platforms typically circulate just within banks, not very liquid, risk still concentrated in the banking system
    • Market thinks this debt is low risk due to implicit government guarantee when in fact the project is often high risk. Yields are high. (Which is illogical when you think about it, if "risk" is low.)
• No one knows the true indebtedness of local governments. Scholars think it's about 40-50 Trn RMB, or 50-60% of GDP, with 30-40% of that as "invisible" debt, not easily discovered. While this is not low, it's not particularly high since America is at 107% (2018) and Japan at 237%. And a lot of China's local government debts did go into infrastructure investments or real assets. However, ROI might be very low, less than 1%.
  • China also owes very little external debt, just $307Bn, 2% of GDP.
• However, can't just look at the total amount, should look at individual debtors, and we can see that Central Western region is in a much worse situation than the East
  • In 2017, except fro Beijing, Shanghai, Guangdong, Fujian, Sichuan and Anhui, no platforms could even pay for the interest payments without government subsidy. If the economy goes south, the governments won't be able to help either
• Reforms have been going on since 2010. By 2019, most of it has been completed. Here are 3 types of reforms:
  • 1. Local governments can use bonds to swap out of these platforms' bank debts and securities. This helps by:
    • Reducing interest rates from 7-8%+ to 4%
    • Government debt have much longer periods, more in line with these projects
    • Technically governments are more creditworthy than these platforms
    • But swaps need to be approved by the central government and is not very flexible
  • 2. Disconnect these fundraising platforms from the government, so that the government is not fundraising through them, nor are they the implicit guarantors. Public or infrastructure goods can be spun out and local governments can take over, or continue constructing using PPP. If we want to stop rampant debt, then we must cut off the "implicit guarantee." In recent years, these guarantees have all been ruled invalid, and the Finance Ministry has started looking into problematic guarantees in 2017.
  • 3. Restrict banks (mostly shadow banking) from capitalizing these platforms.
  • 4. Put responsibility on the officials. Make over indebtedness is a lifetime liability. But the problem is a lot of them just invested in nonperforming projects, and didn't actually commit a crime. Why do they do that?

1. Local Government Officials Working in Investment and Promotion

• Government bureaucracy gets a lot of talent. In 2010, of urban citizens 25-59 years old, 22% had gone to college (including vocational), but in the government this number is over half. For 25-40yr old government employees, it's 70% vs 30% for city dwellers.
  • Central government civil servants = 6% of total, if we include all business units, it is just 4%. That is much lower than US (19%), Japan (14%), Germany (11%), and OECD average (41%).
• Local government heads have limited years in office, so to quickly accelerate economic growth, they typically increase investment amounts, launch large projects
  • City party secretaries and mayors have an average tenure of 3-4 years, but even the fastest basic infrastructure projects need 2-3 years, so there's always rush to investment at the beginning of office, but every year about 30% of the cities will change secretaries or mayors
  • In order to get money they typically sell land, and new land will have to come from suburbs, increasing sprawl ...
  • Before 2016, once you leave your post, you are no longer responsible for the debt incurred while in office, and usually your successor is looking to invest their own projects
  • 2013, it was made explicit by the Central Committee that total production value cannot be used as sole KPI, and in 2019 promotion of bureaucrats was made more multi-faceted
• Some folks also blame some of these situations on nepotism. While that may be true, it's probably not a big reason. For most civil servants, none of these KPIs matter. Those with titles above provincial level make up only 1% of total, so most people are not there to get promoted, but for the job and its benefits, meaning that they will be unlikely to let senior level shenanigans get too far.
• A huge problem with land finance and government investment is severe corruption. From 2008-13, nearly half of the reported corruption cases were related to land development. Through 2019, cases have been opened against 156K provincial and above bureaucrats, 414 cadres in central government and 18K departmental cadres.
  • On corruption — it has co-existed with high economic development. It's also changed over time ...
  • In the 80s most corruption cases were around the dual-price system, in the 90s around loss of state owned assets, and in the 21st century, land development has become the mainstream
  • 2 types of corruption: stealing from the people via random fees, and bureaucrats in league with merchants to make money together, ie related parties, and this latter one could co-exist with economic development for some time. But ultimately, this distorts the economy and heavily weights investment, distorts the relationship between investment and loans, increases income inequality, and creates webs of interests that destroy the market.
  • Deleveraging will help with anticorruption, and anticorruption efforts will not stop until the reforms are done. Progress has been made. Harvard's survey of 30K citizens show that from 2011 to 2016, the number of folks believing their local governments are relatively clean increased from 35% to 65%. Respondents scored the central government 83, versus provincial 78 and village level 70

Recommended reading:

• The Chinese Mayor, 2015 documentary
• China's Gilded Age, 2020