|Shandong is the red one. |
Map by Uwe Dedering. Wikimedia.
|Aesop's portrait of Xi Jinping |
"The Frogs Who Desired a King"
Illustration by Milo Winter (1919). Wikimedia.
I won't get into a full discussion of why reform is so urgent here--if you are curious I strongly recommend Michael Pettis' September essay, "What Does a 'Good' Chinese Adjustment Look Like?" which lays out the essential points in detail. More important for our discussion is the pace and scale that these reforms take. The 2013 Third Plenum was devoted to this question; financial analysts have been abuzz ever since discussing how well the Plenum's directives are being implemented. Of particular concern are the financial happenings at the county, city, and provincial levels. It was infrastructure spending by these governments that rode China through the recession, and that effort has left many of these governments over leveraged and left others liable for a host of non-performing loans. Reforming this system is necessary. It is also difficult, for it means slaughtering the favorite cash cows of powerful men and forcing China's wealthy and connected to face the risk inherit in their poor investments instead of shifting losses to the state.
Two views of China's local debt, by province.
Taken from Gabriel Wildau, "Half of Chinese Provinces deserve junk ratings, S&P warns,"
Financial Times (20 November 2014)
Any attempt to liberalize markets and end China's financial repression must start here. By extension, any attempt to assess the power Xi Jinping has over the Party must also start here. We will know that Xi Jinping has the level of control over his country that everyone says he does when local government finances see substantive reforms.
Thus my surprise when I came across this headline last week:
Authorities in Shandong said they won’t bail out the borrowings of cities or counties in the region, becoming the first province in China to follow the central government’s campaign to curb regional debt.
Shandong province, on the country’s east coast, banned all new debt raisings by local government financing vehicles, according to a statement dated Dec. 10 and posted on its website yesterday. Local governments should reasonably control financing demand for projects under construction, it said.
Questions about the future of LGFVs began in October when Premier Li Keqiang started to pare implicit guarantees for the regional financing units. The State Council said Oct. 2 that the finance arms can no longer raise funds for local authorities, and that the governments have no obligation to repay debt that wasn’t raised to fund public projects. 
LGFV stands for "Local Government Financing Vehicles" and are sometimes called LGFPs, or "Local Government Financing Platforms." The rationale of a LGFV is fairly simple. Local governments are under extreme pressure to produce high growth numbers and for the most part use infrastructure spending to reach these targets. However, local governments are not allowed to borrow money on-budget, meaning that if they cannot chalk up enough money from taxes or land sales to finance new infrastructure investment then they do not have the funds to invest in anything. The local governments' solution to this problem has been the creation of LGFVs, "independent" companies which are free to sell bonds, take out loans, and otherwise obtain the financing they need to complete whatever infrastructure project local party leaders believe are worth investing in. 
The perverse incentives in these schemes are easy to spot. Lenders are willing to support LGFVs because they carry an implicit guarantee that the local governments will help pay back their loans if the vehicle under-performs. With losses socialized and gains privatized all manner of frivolous or nonsensical investments are made. Last year a Nomura Securities research report on LGFV performance in 2012 reported that "35% of LGFVs experienced net operating cash outflows and hence have to rely on new borrowing to finance existing investment activities... ..The reported profitability of LGFVs is low and falling quickly, which means their capacity to repay debt is questionable. The median ROE [return on equity] fell from 4.1% in 2009 to 3.0% in 2012, far below the 7.5% median ratio for A-share listed nonfinancial companies." Servicing this debt places an immense burden on local governments. The exact numbers are hard to pin down. The Nomura report mentioned above estimated that outstanding LGFV debt is 311% of local government's total budgetary revenue; the Chinese Banking regulatory Commission claims the number is closer to 200%.  With 40% of local government debt set to mature within a year , LGFVs are now being described as China's "1.3 trillion dollar hang-over." 
This is why Shandong's announcement is so significant. It is hard evidence that the Communist Party of China is serious about liberalizing Chinese markets and that Xi Jinping's circle now has the power it needs to force through critical reforms all the way to the local level. As I said on twitter this week:
I think I am on record saying we'd know Xi Jinping has real power if this happened http://t.co/mZTqTgqnjU Well, now it's happened.
— T. Greer (@Scholars_Stage) December 19, 2014
That was all I originally had planned for this post. It's original title was"Xi Jinping -- Its Time to Take Him Seriously." Over the last week, however, I have discovered a few facts that have tempered this initial judgement.
|Land sales as a percentage of local revenue.|
Taken from Yuanyan Sophia Zhang and Steven Barret,
“Fiscal Vulnerabilities and Risks from Local Government Finance in China,”
IMF Working Paper 14/4 (January 2014), 12.
Beijing announced it would no longer bail out over-leveraged local governments in October. Shandong is the first--and so far the only--province to follow suit. Shandong is an interesting place. In historical terms Shandong is known as a cradle of Chinese culture and civilization--Confucius was born there and it was a hotbed of literary activity until medieval times. Today it is better known for its popping economy. It has a population of 90 million people who subsist at well above the national GDP per capita, the third largest total GDP of any Chinese provinces (second only to Jiangsu and Guangdong), and is the fourth largest exporter in the country. Its fiscal situation is fairly secure: while its total debt is one of the highest in the nation, its ratio of debt to provincial GDP is one of the nation's lowest. Another sign of the province's relative fiscal strength is that it relies less on land sales for revenue than most other seaboard provinces.
It is also run by Guo Shuqing.
Guo Shuqing is something of a rising star in the CPC. He became famous internationally when serving as the as the head of China's supervising agency for financial institutions, the China Bank Regulatory Commission. Mr. Guo's tenure at the CBRC was a time of rapid reform and frantic effort to bring the commission's practices up to international standards. So ambitious were these reforms that the Chinese media dubbed them "Guo's New Deal." He left the CBRC earlier this spring. As there is a strong expectation that those who ascend to the upper echelons of the Party will have already served both at the provincial level and for the central government, most folks interpret his current governorship in Shandong as a necessary stop on his rise to greater heights.
I don't think this interpretation quite has it right. Consider the write up from Caixin describing Guo's transition to governor back in May:
The term ['New Deal'] took on an extra meaning soon after Guo headed for his new position in March in the northeastern province, where he continues his appetite for reform.
According to the Shandong Financial Affairs Office, more than 30 officials from central government financial regulatory departments and central state-owned companies will be sent to Shandong for a temporary official exchange program. And each city in the province will appoint a deputy mayor to specially oversee financial affairs. Meanwhile, Shandong will select 34 officials to be trained in the central government's financial department under the exchange program.
At this key time in the country's structural economic reform and industrial upgrade, the implementation of Guo's New Deal has great symbolic significance.
In the past, few local government officials have had systematic knowledge in economics and finance. Among the cities' deputy mayors, who usually oversee regional economics, many did not go through academic training in relevant fields. With neither theoretical knowledge nor industry experience, these officials are not capable of providing forward-looking, regionally applicable policies. Allocating a deputy mayor who understands finance to each city is no doubt a groundbreaking advance, although its implications and effects remain unclear. Nonetheless, Guo's New Deal has brought fresh air to the political sphere. Finance and economics are essential to a region's development, so having governors with real understanding in these fields can decrease inefficiencies caused by policymakers' lack of knowledge. 
It was not just Guo that was sent to Shandong. An entire hand picked team from the foreign ministry was sent with him. It looks all the world like an experiment the Party is conducting to see if this liberalization thing can work out if a province is given the muscle it needs to push things through.
This makes the announcement that Shandong province will no longer bail out failing LGFV a bit less impressive. The first province to follow the Beijing's directive to limit loans and allow LGFVs to fail is the province run by one of Xi Jinping's favorite financial reformers with decades of experience pushing financial reforms through party organs, and who has stuffed the province he governs full of other reformers like him down to the city level. And all of this in one of the provinces least burdened with LGFV debt in the first place! Little wonder Shandong is the first province to run with new directives.
I am not confident provinces with much larger debt problems or much lower growth numbers will adopt these measure with such energy.
Watch Shandong. As this story suggests, Shandong is set up to be the testing laboratory for the fiscal and regulatory reforms the Party would like to implement throughout China. If reform cannot succeed there then there is little hope of it succeeding anywhere.
 Arthur Groeber, "Here is Xi's China: Get Used To It," China File (12 November 2014).
 The term "Xi Dada" (习大大) literally means "Xi Big-big," but is better understood as "Daddy Xi" or perhaps "Uncle Xi."
 I am afraid to say that I this use of Aesop's fable is not original. Unfortunately, I cannot remember which editorial or blog post it was that compared Xi Jinping to the stork and have been unable to solve matters through Google. If any of my readers happen to know the original source I would be glad to link to it here.
 Judy Chen and Penny Peng, "China's Shandong Province the First to Step up Curbs on LGFV Debt," Bloomberg (18 December 2014).
 The IMF has produced two reports on these vehicles that provide a valuable description of how they work and assess their impact on the Chinese economy. See Yuanyan Sophia Zhang and Steven Barret, “Fiscal Vulnerabilities and Risks from Local Government Finance in China,” IMF Working Paper 14/4 (January 2014). Yinqiu Liu and Tao Sun, "Local Government Financing Platforms: A Fortune or Misfortune?", IMF Working Paper 13/243 (October 2013). I also found the section on LGFV debt in Yukon Huang's "China’s Debt Dilemma: Deleveraging While Generating Growth," Carnegie Endowment For International Peace (18 September 2014) to be very useful.
 Ralph Sueppel, "The Sysmetic Risk of Local Chinese Government Debt," Sysmetic Risk and Sysmetic Value (28 September 2013).
 Ibid.; Tian Lin and Huo Kan, "Debt on Local Government Financing Platforms Forces Regulator Into Balancing Act," Caixin (6 March 2013).
 "China Won't Bail Out Debt-Laden Local Governments," Wall Street Journal (3 October 2014).
 Eliot Wilson, "LGFVs: China's $1.7 Trillion Hangover," Eurio-money (April 2012). This is a low estimate. The high estimates put LGFV debt at 3.3 trillion.
 Fu Jianli, "Guo Shuqing Gives Shandong "New Deal," Caixin (30 June 2014).