Latest China bailout reveals risk of local government’s hidden debts; A Chinese local government has apparently used public funds to repay the debt of a private firm

Latest China bailout reveals risk of local government’s hidden debts

Tue, May 7 2013

By Gabriel Wildau

SHANGHAI (Reuters) – A Chinese local government has apparently used public funds to repay the debt of a private firm, in a case that raises fresh questions about whether recent estimates of local government debt properly account for the full range of local liabilities. It is not the first time local officials have bailed out a private enterprise, but the fact that the municipal government had formally guaranteed the debt highlights the lack of visibility on the extent of localities’ hidden commitments.Dealing with the systemic risk posed by local government debt is seen as one of the key priorities for the administration of China’s new president, Xi Jinping.

Asked if credit guarantees by local governments creates upside risk to his and other estimates of overall local debt, Dong Tao, chief regional economist for non-Japan Asia at Credit Suisse, said: “Yes, but it’s hard to quantify.”

In the latest case of an apparent bailout, CITIC Trust announced late last month that an unnamed party had agreed to purchase 1.3 billion yuan ($210.87 million) in high-interest loans to a steel plate manufacturer in Hubei province, in central China.

CITIC had packaged the loans into a wealth management product (WMP) for sale to wealthy investors at an expected yield of 10 percent. The investors will now be repaid in full.

Official media cited unnamed sources predicting the government of Yichang city, Hubei, was the buyer. A senior CITIC Trust executive had previously told Reuters it expected the city government to step in and pay the debt.

Trust lending and other forms of shadow banking have exploded in China in recent years, as banks strive to reduce their on-balance-sheet risk and savers flock to WMPs as a higher-yielding alternative to traditional bank deposits.

A large portion of trust loans have flowed to local governments, which use them to pay for infrastructure projects.

Estimates of local government debt range from Standard Chartered’s 15 percent of GDP at end-2012 to Credit Suisse’s 36 percent. Fitch put the figure at 25 percent when it downgraded China’s sovereign debt rating last month.

But the latest near-default highlights how localities may also be on the hook for a large amount of ostensibly corporate debt.

Analyst estimates don’t include contingent liabilities such as pledged collateral and other credit guarantees. The central government banned localities guaranteeing corporate debt at the end of 2012, but no one knows how many previously issued guarantees remain outstanding.

VERY ENTHUSIASTIC

When considering a possible loan to Yichang Three Gorges Quantong Coated and Galvanized Plate Co Ltd, CITIC was concerned about the risk, deputy general manager Li Zimin said at a press conference in January.

Quantong had racked up large debt during a period of rapid expansion and needed the loan to replenish working capital, not to finance new investment. But the local government’s support was enough to push the deal through.

“The government’s signals were very enthusiastic,” the official China Business Journal reported Li as saying.

The local government of Yichang city offered 1.87 million square meters of state-owned land with an appraised value of 3.07 billion yuan as collateral – more than twice the value of the loan itself.

In addition, the local government’s holding company for state-owned assets directly purchased the entire sub-prime tranche of the trust plan, accounting for 334 million yuan of the 1.3 billion yuan total.

After Quantong defaulted on a 75 million yuan interest payment due in December, Li said in January that CITIC was taking a two-pronged approach to seeking re-payment.

One the one hand, the trust company was working with the Yichang government, which Li said was preparing several options for a rescue. On the other hand, CITIC was making legal preparations to exercise its rights over the collateral.

When negotiations appeared to founder, CITIC announced it would sell the bad loan via public auction on April 28.

But hours before the auction was scheduled to begin, CITIC announced the debt had been sold and the trust plan’s investors would receive their promised payout.

Given that the auction plan was intended as a back-up plan if the government failed to produce a solution, the cancellation suggested that the government had stepped in.

“Planning the auction is just a way to pressure the government. They’ll find a way to pay,” a senior CITIC Trust executive told Reuters ahead of the planned sale, noting that Quantong employs 15,000 workers in Yichang.

An official at the Yichang finance office referred questions to the Quantong. An official at the Yichang State-owned Assets Supervision and Administration Committee said he wasn’t aware of the situation. The state-owned asset holding company did not answer calls seeking comment.

Quantong did not answer calls seeking comment.

DANGEROUS PRECEDENT

The CITIC case follows previous instances where Chinese local governments have stepped in to repay corporate debts incurred by both state-owned and private firms. Many of the bailed-out borrowers hail from industries like solar, steel, and textiles that suffer from overcapacity.

In January, a private firm, Shenzhen-listed Chaori Solar (002506.SZ: Quote, Profile, Research, Stock Buzz), avoided China’s first-ever domestic bond default with help from a Shanghai district government.

China is still waiting for the first case where investors in a bond or trust product suffer actual losses. Credit Suisse’s Dong believes defaults on shadow banking products are likely to rise over the next two years.

“For bank loans, it’s easier for the banks to roll them over if the loans go bad. That can cover (non-performing loans) for a while. But when it comes to shadow banking, it’s harder to do that,” said Dong.

Outside investors in bonds or trust products need to be repaid in full, Dong noted, whereas a bank can stay liquid even if it is forced to roll over bad loans. ($1 = 6.1650 Chinese yuan)