As the global recession doused export demand in the end of 2008, China turned to bank loan-fueled investment to bolster its growth. That’s been particularly true for local governments. Under pressure to deliver high economic performance, but unable to issue their own bonds, local governments have sought financing—typically for infrastructure and real estate development—by hook and, increasingly, by crook. As the central government has tightened credit, though, local government financing platforms (LGFPs) have taken to issuing corporate debt instruments called “enterprise bonds” to keep themselves flush.
Though regulators issued rules in December to make it harder for LGFPs to use government-owned assets as collateral, the impact is yet unclear. Net enterprise bond financing last month hit 220 billion yuan ($35 billion), up from 44 billion yuan in January 2011, according to the People’s Bank of China (link in Chinese). How much of the proceeds ended up in the hands of local governments is unclear. But in 2012, LGFPs raised 636 billion yuan in enterprise bonds, up nearly 150% from 2011, according to Caixin. And LGFPs made up up 45% of all bond-issuers (paywall) in China last year, as Carl E. Walter and Fraser J.T. Howie recently highlighted. The government affiliation of these bonds means that pricing seldom factors in the underlying risk of the projects they are funding, as Caixin reports.
This has been great for local governments. But it could be terrible for bondholders. And who, exactly, might those be? State-owned banks. As Walter and Howie put it, China’s bond markets are “little more than thinly disguised loan markets” (paywall):
The most important thing to understand about China’s financial markets is that the big five state banks are nearly the only source of capital, simply because they control 70% of all retail deposits. These banks hold over 60% of all outstanding bonds, including government, policy-bank and corporate bonds. Other state-owned entities hold a further 30%.
In short, the explosion in enterprise bond issuances is leaving China’s financial system even more vulnerable to default by local governments than it already was. And that’s saying something. Shang Fulin, chairman of the China Banking Regulatory Commission, recently said the banking industry now faces 130 trillion yuan in risky assets (link in Chinese). The CBRC estimates that commercial banks will have more than 120 billion yuan in non-performing loans (link in Chinese) on their hands by the end of 2013. At the end of 2012, banks extended the payment deadline of 3 trillion yuan in loans plus interest (paywall) that local governments owed. That’s a big can to kick down the road. And it’s only getting bigger.