China
Concerns about China's ‘High' Debt Unwarranted
March 31, 2010

By Qing Wang | Hong Kong & Steven Zhang | Shanghai

Post-Crisis Balance Sheet Deterioration Inevitable

When discussing China's coping with the impact of the Great Recession, we have characterized the effort as ‘translating strong balance sheet into decent-looking income statement', as has been reflected in the massive expansion of bank lending and the government capex spending program. The most acute phase of the crisis is over and China indeed delivered a decent-looking income statement in 2009, or a ‘policy-induced de-coupling' as we have called it. It therefore should be expected that the underlying ‘balance sheet' of the economy must have deteriorated to some extent.

In this context, there are rising concerns of late about China's high debt level - an indication of balance sheet deterioration - and its attendant negative consequences for the economy and financial markets. For instance, a piece of often-cited evidence in this regard is that the total amount of bank lending increased by Rmb9.6 trillion, or equivalent to 30% of GDP in 2008, bringing the share of outstanding stock of bank credit to GDP to 127% by end-2009, one of the highest levels in the world. Indeed, it is this high and rapidly rising ratio in China that tends to cause concern among market participants.

Debt: Bank versus Non-Bank; Gross versus External

The unusually high bank credit as a percentage of GDP in China reflects more the rather simple structure of China's financial intermediation than the level of indebtedness in the economy. In China, about 85% of financial intermediation is conducted through banks, while equity and bond markets only account for about 10% and 5%, respectively. This is in sharp contrast to both G3 and more advanced emerging market economies, where bond and equity markets play a much greater role.

This bank-dominated financial market structure suggests that the overall debt level in China tends to be overstated in comparison to other economies, if one focuses on the outstanding amount of bank lending only. Indeed, China's overall debt level stood at only 170% of GDP. This ratio is substantially below the levels in industrialized economies, where the debt ratios typically range between 250% and 500% of GDP. The fact that the average gross debt levels in BRIC counties are much lower than those in industrialized countries primarily reflects the underdevelopment of financial and capital markets in the former, in our view. 

Indeed, high gross debt in an economy indicates sophistication of its financial and capital markets as well as overall indebtedness. Moreover, gross debt is a useful indicator in assessing macroeconomic risks to the extent that a potentially serious asset price deflation does not allow selling assets to pay off debt, as has been the case during the Great Recession as well as other major financial crises in history.

However, in the absence of a serious asset price deflation, a more relevant concept of indebtedness for a country as a whole should be its external debt level, because domestic debt tends to be offset by domestic assets. Given the same level of indebtedness, external debt tends to make a country more vulnerable to the vagaries of international interest rates and exchanges that are beyond the country's controls. And a country needs to generate sustainable foreign currency revenue (i.e., through exports) in order to service its external debt.

Measured by external debt, China's indebtedness is one of the lowest in the world. This substantially reduces the risk of a ‘macro margin call' on China due to potential negative external shocks. While the relevant risks would be less to the extent that a country is able to issue the external debt denominated in its own currency, this has been the privilege for only a handful of economies in the world (e.g., G3).

Peeking into the Black Box: Local Government Debt

While Chinese local governments are prohibited by law from running a fiscal deficit and borrowing, it is widely believed that local governments have incurred a large amount of debt through explicit or implicit guarantees to bank loans borrowed by the local government financing platforms (LGFPs). An accurate estimation of local government debt level in China is hampered by the lack of reliable data. And not surprisingly, lack of transparency on this front has yielded a wide range of estimates of the potential magnitude of debt incurred by local governments, with some China observers pegging the debt level at as high as Rmb11 trillion at end-2009 and Rmb20 trillion by 2011.

However, we believe that these estimates vastly exaggerate the real underlying situation. Despite the lack of readily available data, China's rather simple, bank-dominated financial intermediation makes estimation of LGFP debt not as difficult as it seems, as almost all local government debt is directly or indirectly incurred through bank loans. In particular, instead of taking a bottom-up approach to collect the relevant information from various sources, we should be able to pin down a rough magnitude of debt incurred by the LGFPs, as long as we can have a good understanding of the structure of bank lending.

Specifically, the total outstanding amount of renminbi loans stood at Rmb40 trillion at end-2009. We can deduct from this total amount the items we can identify as unlikely to be incurred by the LGFPs - including, for instance, household loans, short-term loans, medium & long-term loans extended to real estate developers, and other types of medium & long term loans - and attribute the residual amount to that borrowed by the LGFPs. Under this approach, we estimate that the outstanding amount of loans borrowed by the LGFPs stood at about Rmb6.1 trillion, or 15% of total bank lending and 18% of GDP.

We test the robustness of the above estimation by examining the total amount of infrastructure investment over the past few years. This is because the LGFPs are set up to primarily carry out infrastructure investment projects that are financed largely by bank loans. Specifically, first, the total infrastructure investments in the past six years (2004-09) amounted to Rmb19 trillion. We choose a time horizon of six years as there was limited borrowing by the LGFPs six years ago, and the bulk of bank borrowing incurred six years ago, if any, should have been either repaid or already classified as NPLs. Second, we assume that fixed asset investment (FAI) that is financed directly out of the government budget all belongs to the infrastructure FAI category. Third, land sales revenue collected by local governments is all used to finance infrastructure projects.

Based on these assumptions, we estimate that the total amount of infrastructure investment during 2004-09 that is financed by sources other than state budget and land sales - i.e., SOEs and private companies - stood at Rmb9.8 trillion. While the SOEs typically account for 45% of the total FAI in terms of financing, we assume that as much as 70% of Rmb9.8 trillion is financed by the SOEs, given that it is infrastructure investment. This implies that about Rmb6.8 trillion out of Rmb19 trillion may have been financed by the SOEs.

While this figure is higher than our early estimate of Rmb6.1 trillion, it is close enough to provide us additional comfort with and confidence in our original estimate. In particular, the discrepancy could at least be explained by the following two factors: a) LGFPs also raise funds through issuing ‘municipal investment bonds' (MIBs), which is not captured by bank lending data. We estimate that the outstanding amount of MIBs at end-2009 was about Rmb400 billion; and b) a small number of major infrastructure investment projects are carried out by central instead of local SOEs.

It is worth noting that the fact we are able to provide a more precise estimate of local government debt does not change the overall gross debt level for the economy as a whole, and it only helps to demarcate the boundary between government and business sectors in terms of debt liability.

A Fiscal Check-Up: A Balance Sheet Prospective

While government debt - including that incurred by local governments and some contingent liabilities - has indeed risen rather rapidly in the aftermath of the crisis, it does not threaten fiscal sustainability or pose systematic risks, especially when the asset side of the fiscal balance sheet is taken into account.

When contingent fiscal liabilities are factored in, we estimate that total government debt in China would reach as high as Rmb16.8 trillion, or about 51% of GDP as of end-2009. Besides the debt incurred by local government through the LGFPs, there are two other main types of contingent fiscal liabilities in China: a) non-performing loans incurred by large state-owned banks before they were restructured and recapitalized; and b) the transition costs of pension reform. According to IMF estimates, the loss stemming from NPL disposal is about Rmb3.6 trillion and the transition cost of pension reform is about Rmb1.6 trillion. Shouldn't we then be concerned about China's fiscal sustainability?

The seemingly high government debt - after contingent liabilities being factored in - substantially overstates the true threat to fiscal sustainability in China, in our view. This is because the asset-side of the balance sheet of the Chinese governments is remarkably strong. This distinguishes the Chinese governments from many other governments in the rest of world, who do not own many assets and whose ability to incur and service debt only hinges on one key factor: their capacity to collect tax revenue on a flow basis.

First, Chinese governments own sizeable liquid assets: cash. The outstanding central government treasury deposits in the banking system stood at Rmb2.2 trillion at end-2009, or 6.7% of GDP, and this number has been increasing rapidly in the last five years. Moreover, the deposits owned by other government and semi-government agencies in the banking system stood at Rmb3 trillion, 8.8% of GDP at end-2009, and, similarly, this number has been increasing steadily in the last five years.

Second, according to official statistics, Chinese central and local governments combined own Rmb17 trillion worth of equity (instead of assets) in terms of book value in the SOEs as of 2008, or equivalent to 51% of 2009 GDP. This is roughly equal to the total amount of government debt (including contingent liabilities).

But to what extent can government stakes in the SOEs be counted on as valuable assets to back-up the liabilities? Aren't the SOEs typically as poorly run and loss-making in China as in many other countries? The answer is ‘not really'. Three decades of economic reform have fundamentally transformed the SOE sector in China, and the SOEs in China today couldn't be more different from the stereotype of SOEs under a planned economy. For instance, during 2003-09, Chinese industrial enterprises of above designated size made total profits of Rmb14 trillion, of which 37% was contributed by the SOEs. Another case in point is that the total market value of the state equity holdings in the large public-listed companies in three sectors - banking (i.e., CCB, BOC, ICBC), oil (i.e., PetroChina, Sinopec, CNOOC), and telecom (China Mobile, China Unicom) - is worth about Rmb8.8 trillion, equivalent to 26% of GDP in 2009.

Third, don't forget land. Non-agricultural land is legally owned by the state in China. While agricultural land is in theory collectively owned by the farmers, it is effectively under control of the government as well, because the government can take over land from farmers at substantially lower cost than the market value would suggest. We do not attempt to estimate the market value of the land controlled by the government, which is a daunting task. But land that is directly or indirectly owned by the state is the largest and most valuable asset under the control of the governments, in our view. Just to give a rough idea: the official statistics show that the cumulative revenue from land sales accrued to the state budget during 2004-09 amounted to Rmb5.7 trillion, or equivalent to roughly 17% of GDP in 2009.

A Fiscal Check-Up: A Stress Test of Debt Sustainability

We construct a stress test to show that China's debt situation is quite sustainable over the medium and long run under our base case scenario, but is sensitive to different growth trajectories under alternative scenarios.

We make a few key assumptions in constructing the stress test. First, the primary fiscal deficits (i.e., excluding interest payments) in 2010-11 will be 3% of GDP per annum and 2% in 2012 and 1% in subsequent years. Second, the government will pay 5% interest on its explicit debt in the next five years, despite the government having been able to raise debt at much lower cost (i.e., below 3%). Third, Rmb3 trillion of the Rmb7.5 trillion new loan targeted for 2010 are made to finance the LGFPs and this amount will be reduced to Rmb2 trillion in 2011-12 and Rmb1 trillion in subsequent years as fiscal stimulus phases out and reform is implemented to privatize the LGFPs.

We examine three different scenarios: under the base case scenario, we assume that GDP growth is 11% in 2009, 9% in 2010, 8% during 2012-15 and 7% during 2016-2020; under the high growth scenario, we assume 10% GDP growth over 2011-15 and 9% over 2016-20; and under the low growth scenario, we assume 6% GDP growth over 2011-15 and 5% over 2016-20. And the GDP deflator is assumed to be constant at 3.5% over time across different scenarios.

Under our base case scenario, government debt will peak at 53% of GDP in 2012 and start to decline gradually over time toward 50% by 2020. Under the high growth scenario, government debt will peak at 52% of GDP in 2012 and start to decline rapidly over time to well below 45% by 2020. However, under the low growth scenario, government debt keeps rising over time to above 60% of GDP by 2020, which is not unusually high by international standards but does suggest that concerns about China's debt is not entirely unwarranted if China's growth outlook deteriorates sharply.

It should be noted that in conducting the stress tests, we assume that the government will not resort to divestment to pay down the debt, despite its sizeable cash deposits and the vast amount of other assets. The fact that both central and local governments own a large amount of assets (e.g., cash reserves, SOEs, land) only makes China's already benign fiscal position by international standards - as suggested by the conventional liability-side indicators - stronger.

A Fiscal Check-Up: A Cash Flow Perspective

As we have demonstrated, the overall government debt sustainability over the long run is not an issue. There remains concern that local government may run into cash flow difficulty in servicing the loan. While there are several ways of measuring adequacy of cash flows in servicing the debt, we choose an indicator that we believe is most relevant in this context: interest expense on LGFP debt as a percentage of local government on-budget expenditure.

Debt incurred by the LGFPs is off the regular budget and mainly for financing investment projects instead of current expenditures. Before these projects come to completion and start to generate cash flows, the local governments are ultimately obliged to pay interest expense on the debt incurred by the LGFPs out of its on-budget revenue by reducing other on-budget expenditures or finding other off-budget revenue sources. This indicator therefore measures the extent to which the regular on-budget expenditures need to be squeezed to make room for this additional interest expenses or quantifies the pressures on local government to find other off-budget revenue sources.

We do not include amortization of the principal of the loan in this analysis, because: a) to our knowledge, much of the LGFP debt is bullet loans; and b) as long as interest expenses can be covered, the debt situation will be stabilized, which buys time to work out the debt payment through privatization of the underlying assets or sales of other state-owned assets. This is the ultimate solution in the event of a default on the LGFP debt, in our view.

Under the base case scenario, local governments' on-budget expenditure needs to be cut up to 8.3% (at the peak level) in order to cover the interest expenses. Under the high growth scenario, the magnitude of maximum cut is about 8%; meanwhile, under the low growth scenario, the magnitude would be close to 9%. Alternatively, if the regular on-budget expenditures are not to be cut, the local governments need to secure an equivalent amount of off-budget revenue.

The key question is whether local governments are able to secure that amount of revenue on a sustainable basis. We believe they can in view of the substantial amount of proceeds from land sales. The cumulative revenue from land sales accrued to the government - which is off budget - during 2004-09 amounted to Rmb5.7 trillion, which is over 25% of total local government on-budget expenditure during the same period of time.

Commercial Banks' Exposures: Transparency Is Key

By treating LGFP debt as part of government debt, we implicitly assume the government will guarantee all the debt incurred by the LGFPs. By illustrating that China's overall debt situation in general and government debt in particular are sustainable and does not pose systematic risks, we demonstrate that Chinese governments are able to guarantee the debt incurred by the LGFPs if they wish to, without jeopardizing fiscal sustainability.

However, in practice, to the extent that the government may not fully guarantee the LGFP debt, banks are exposed to credit risks of the LGFPs. Policy banks (e.g., China Development Bank, Agricultural Development Bank of China), which are wholly owned by the state, have been active in providing financial support to the LGFPs well before commercial banks become involved in 2009. We estimate that out of Rmb6.1 trillion loan borrowed by the LGFPs at end-2009, as much as one-third could be attributed to policy banks such that the total exposure of commercial banks as a whole to the LGFPs amounts to about Rmb4 trillion.

While it remains unclear at this stage how much each individual bank is exposed to the LGFPs, we believe that large state-controlled banks (e.g., ICBC, BOC, CCB and ABC) tend to have proportionately smaller exposure than medium and small ones (e.g., city commercial banks), whose lending decisions tend to be more heavily influenced by local governments. Moreover, large banks' exposure to LGFP debt is more likely guaranteed by the government, in our view. This is because only large banks have the capacity to finance large investment projects that involve higher level local governments and therefore more likely receive formal commitments.

However, lack of transparency in this regard has weighed on market sentiment, which explains in part the underperformance of the stocks of several publicly listed banks over recent months. While more relevant information will likely become available over time, we do not expect a quick resolution, because the still overall comfortable fiscal situation will likely ensure that it is an evolutionary instead of revolutionary process

What's Next?

The Chinese authorities are expected to issue policy guidance in the near term with the object of regulating the borrowing activity by the LGFPs in general and reining in the rapid expansion of LGFP debt in particular. The main purpose of this policy guidance will likely be to impart greater transparency and discipline to LGFP borrowing. Specifically, the LGFPs will likely be put in three broad categories according to the nature of their operations: a) of pure public service; b) commercially viable; and c) other. Category a) will be transferred from off-budget to on-budget operation. Category b) will be corporatized and/or privatized. Category c) will be unwound through a combination of privatization, securitization and forced exit through a workout procedure. It is likely that the policy guidance will be primarily aimed at regulating the new LGFPs and/or new LGFPs activities, while the existing LGFPs and their previous operations are grandfathered. These policy changes will likely help to achieve an orderly unwinding of LGFP debt, as should be warranted by the overall comfortable situation in China.

Venezuela
Venezuela: A Hard Currency Tipping Point?
March 31, 2010

By Giuliana Pardelli | Sao Paulo & Daniel Volberg | New York

Venezuela's ability to manage despite a worrisome and worsening business environment could face its greatest challenge as early as this year or next. For years now, Venezuela has managed to confound critics who assert that its macro mix is unsustainable in the long term. Thanks to the large cushion that its oil economy has provided, Venezuela has been able to muddle through despite the nationalizations, expropriations, price controls and other state interventions that have become frequent occurrences in recent years. At some point, however, the long term arrives. We are concerned that the long term may be here now as the risks rise that Venezuela is faced with a shortage of hard currency, forcing a break with the current policy mix. 

Demand for Dollars

Demand for dollars is showing no signs of abating in Venezuela; indeed, we are concerned that the drivers of dollar demand are likely to create a significant challenge for Venezuela's current policy mix even under the most optimistic scenarios for dollar supply. We would highlight two main drivers of hard currency demand in Venezuela.

First, Venezuela's deterioration in business environment has translated into declining domestic production and investment, making the economy increasingly reliant on imports as a substitute. From consumer durables, agricultural products and pharmaceuticals to capital goods, imports have replaced domestic production, given the continued deterioration in the business environment, threats of expropriation, high inflation and a reorientation of policy towards developing the energy industry. While imports accounted for near a quarter of the economy a decade ago, by 2007 and 2008 they represented near half of the economy. And while last year the import share declined to near 40% of GDP on the back of a severe hit to economic activity, Venezuela's imports to GDP share remains high by international standards. Indeed, should Venezuela's economy recover, we suspect that limited domestic supply would mean that much of the pick-up in demand would be met by soaring imports. And even at current levels, import demand implies a significant demand for hard currency.

Second, given the increasing uncertainty regarding property rights and macro sustainability, Venezuelans have turned to the dollar as a safe-haven, resulting in mounting capital outflows. In 2003, the authorities imposed capital controls in an attempt to cushion Venezuela's external position, but have been largely unsuccessful in preventing private sector capital outflows. Indeed, the private sector has been a key driver of mounting net capital outflows over the past decade - from near a balance in 1999 to -7.1% of GDP last year. While last year the overall net capital outflow was lower, at -4.8% of GDP, thanks to public sector repatriation of deposits held abroad and significant debt issuance, we suspect that this mitigating influence may prove temporary. We suspect that the authorities' increasing reliance on heterodox policies is a key factor behind Venezuela's continued dollar outflows. After all, we suspect that it is due to recent deterioration in the business environment in the oil sector - with expropriations of subcontractors, payment delays and continued deterioration in the incentive structure in the oil industry - that Venezuela, despite the vast opportunities in oil and gas, posted a large US$3.1 billion foreign direct investment (FDI) outflow during 2009, on top of a US$0.3 billion outflow in 2008. Last year's FDI outflow is the largest since the FDI statistics began to be compiled in their current form in 1997. 

Supply of Dollars

Faced with the rising demand for dollars, Venezuela's main source of dollar supply appears to be petroleum exports. Venezuela's export basket is dominated by oil: it has accounted on average for 84% of all exports during the past 13 years. Of course the overwhelming weight of oil among Venezuela's exports masks an even more concerning development: oil's share of exports has also been growing over time from 68.8% of total exports in 1998 to 94.1% last year. 

But while oil's share of exports has been on the rise, oil production has been in steady decline. Crude production has steadily fallen for the last 12 years, with total output declining from 3.7 million barrels a day in December 1997 to 2.2 million in December 2009. While OPEC target cuts may be partly responsible for some of the declines, we suspect that the main drivers of output decline are structural: the lack of investment by the state-run oil company to maintain and increase oil production, the natural decline in production of existing light crude oil wells, the failure to develop sufficient new wells, the rising number of stops in operation of the main refineries in the country, the nationalization of oil service companies and mounting labor issues.

While oil output has been in continued decline, Venezuela had avoided the full macroeconomic impact due to the sharp rise in oil prices during the past decade.  During 2003-08, rising oil prices were able to more than offset the negative effect of declining crude production on export revenues. Indeed, despite an average 2.2% annual decline in production, the value of oil exports actually climbed 18.5% per year on average in the same period. 

But Venezuela may be hard pressed to avoid its day of reckoning. Given the rapid rebound in oil prices and the still difficult global fundamentals, Venezuela is now faced with the risk that oil prices may not rise sufficiently to offset output declines.  Consequently, we see a rising risk of an inflection point marking the beginning of a trend decline in export revenues. Indeed, global commodity markets suggest that such a scenario may be at hand, given that the oil futures curve shows limited oil price upside over the next five years. With rising structural demand for dollars, risk of limited upside in oil prices and oil output in a trend decline, the data beg the question: is Venezuela about to run short of dollars?

Introducing the Dollar Balance

In order to assess Venezuela's macro vulnerability, we have constructed a dollar balance. Dollar demand is largely driven by a trend rise in net capital outflows and a trend rise in imports. Dollar supply is driven by oil exports, with the caveat that oil production has been in trend decline aided only by the dramatic increases the price of oil. An overall surplus of dollars can help mask the distortions driven by continued policy slippage. In contrast, a negative balance means the government has to dip into its external savings, tap capital markets or further intensify policy heterodoxy. The authorities do have some hard currency savings, with US$29.5 billion in international reserves (as of March 2010) and an estimated US$41.1 billion in other government hard currency assets. But while these savings could buy the authorities some time in the event of a dollar deficit on the back of a drop in oil export revenues, these resources are limited.

We have developed a dollar balance under two broad scenarios. In both scenarios, we use the trends in import growth, capital flight, oil output decline and rising domestic oil consumption (in part due to distorting fuel subsidies), and then, with the help of the current oil futures curve for WTI crude, construct projections of dollar demand and dollar supply. The key difference between the scenarios is which trend we use to make the forward projections. In the more benign scenario, we use the trend for the last 12 years; in the more severe scenario, we use the trend for the last three years, which shows a greater pace of deterioration. In addition, for each scenario we provide two paths, one with and one without the impact of new oil projects in the Orinoco belt, particularly the Carabobo fields. The contributions from Carabobo are two-fold: in the near term, the main impact is a capital inflow, while in the longer term the impact is extra oil production. In both the benign as well as the severe scenario, we use the government's estimates for the impact of the Orinoco belt projects. Altogether, the government estimates that the two projects auctioned in Carabobo and the four projects directly assigned in the Junin section of the Orinoco belt should bring in over US$80 billion in foreign direct investment (FDI) from 2010 to 2016 and increase production by close to 3 million bpd from 2012 to 2016. 

Even using the government's assumptions on the new FDI in oil fields, our work suggests that Venezuela may be faced with a severe dollar crunch as early as this year or, if not, by next year.  If we assume that dollar supply and demand dynamics continue to move in line with their three-year trend, even with the uptick in FDI as projected by the authorities for Carabobo, we estimate that Venezuela could face a deficit between up to US$7.9 billion in 2010 and up to US$11.7 billion in 2011. In the best of cases, using 12-year trends (benign scenario) and assuming new oil investment in line with the government's assumptions, the dollar balance is a US$7.7-19.6 billion surplus in 2010 and a US$10.8 billion deficit to US$5.9 billion surplus in 2011, but turns to a deficit in the range of US$7.7-80.1 billion by 2014. 

We calculate a range for each scenario based on two methodologies used - one based on supply and demand trends in US dollar terms and the other based on percentage of GDP terms - and hence our estimates of the dollar shortfalls widen in the coming years. However, despite the range of outcomes, our modeling work suggests that even if we assume that oil prices remain in the US$80-85 per barrel range, such a level is likely to be insufficient to offset the decline in oil production, mounting capital flight and trend rise in imports.

Issuance

In the short run the authorities may counter the slippage in the dollar balance that our modeling work suggests by issuing external debt. Debt issuance is only one of several options, but we suspect that, along with using savings, it is one of the more benign policy choices. If we assume that the authorities would like to maintain the dollar balance at the very least in balance, we could see anywhere up to US$19 billion in external debt financing needs this year and up to US$22 billion in financing needs in 2011. Of course, we suspect that, if faced with a dollar crunch, the authorities would rely in part on their hard currency savings, which total US$70.6 billion.

Bottom Line

Venezuela may be nearing a tipping point where the country's oil wealth is no longer sufficient to mask the policy-induced macroeconomic distortions. While there are many factors that may make the near term more manageable, including a dramatic uptick in oil prices or further weakness in import demand, we are concerned that, short of some break in Venezuela's current dynamic, the economy may be faced with a severe dollar crunch as early as this year. The dollar crunch, in turn, may prompt the authorities to attempt to buy time by drawing down their hard currency savings, issuing debt or significantly ratcheting up policy heterodoxy.