China debt crisis: $6 trillion off-balance-sheet debt poses ‘titanic’ risk, S&P Global says

A
boat steers slowly through floating ice, and around icebergs, all
shed from the Greenland ice sheet, outside Ilulissat,
Greenland.
AP/Brennan
Linsley

• Off-balance-sheet debt in Chinese local governments has
  ballooned in recent years and could now be worth as much as 40
  trillion yuan ($6 trillion).
• According to analysts at S&P Global Ratings,
  this represents a “debt iceberg with titanic credit
  risks.”
• Rising debt levels in China are a major concern for the
  global economy, with fears that a wave of defaults could be
  imminent.

China may be sitting on a hidden debt pile of as much as 40
trillion yuan ($6 trillion), concealed off-balance-sheet by the
country’s local governments, according to research from S&P
Global Ratings.

Many local governments in China raise debt and hold it off
their balance sheet, in order to avoid lending limits imposed by
central authorities. S&P says that this is a growing problem
within the country, and that the amount of debt held this way has
likely ballooned in recent years.

“S&P Global Ratings believes the amount of debt that
local governments keep off their balance sheets may be multiples
of the publicly disclosed amount,” analysts Gloria Lu and Linda
Li wrote in a note on Tuesday.

“That’s a debt iceberg with titanic credit risks,” the
analysts said, adding that i
ncluding hidden debts,
the “ratio of government debt to GDP could have reached 60% in
2017, an alarming level.”

LGFVs have risen in popularity in recent years as a means of
financing spending on a local level, following a dictat from
Beijing limiting the amount that could be raised
in local government bonds issuances. By using
LGFVs, local governments are able to skirt round these rules and
spend on infrastructure projects.

Not only is the level of hidden debt held by local
governments in the world’s second largest economy rising, but so
too is the risk of those debts being defaulted on. Much of the
debt is held by so-called local government financing
vehicles (LGFVs), and S&P reports that central government may
be willing to let these vehicles file for bankruptcy in the
future.

“Default risk of LGFVs is on the rise. China has opened up the
possibility of insolvent LGFVs filing for bankruptcy, but
managing the default aftermath is a formidable task for top
leadership,” the report noted.

This bankruptcy risk has not gone unnoticed, with S&P cutting
its credit ratings on seven LGFVs about a month
ago. According
to Reuters, Moody’s Investors Service “downgraded five
non-financial corporate and infrastructure issuers owned by
governments in Tianjin, Jiangsu, Hunan and Hubei” at about the
same time.

China’s rising debt levels across all areas of its economy
are seen as a major risk to global growth, with some analysts
estimating that the next financial crisis could crystalize from
the world’s second largest economy.

The country’s total non-financial sector debt, which includes
household, corporate and government debt, will surge to almost
300% of GDP by 2022, up from 242% in 2016. Fears abound that if
this debt pile continues to grow, a spectacular blow up could be
imminent.

“Investor skepticism will return if policymakers take ‘one step
forward and two steps back’ when the contagion of LGFV defaults
emerges,” the report said, referencing
a major correction in the Chinese markets last time there
were major concerns around debt levels in China back in late 2015
and early 2016.

“Clearly, the LGFV sector is a significant component of the
Chinese corporate bond market and banking assets,” it continued.

“On top of that, many shadow banking products related to LGFVs
have been sold to retail investors. When financial and social
stability is high on the agenda of China’s top leadership, local
governments and LGFVs are walking a tightrope.”

Deeper fears stoked by deficit woes

Fears about Chinese debt are
exacerbated by worries over the country possibly running a budget
deficit for the first time in more than two decades this
year.

China’s current account balance is down significantly from
last year’s 1.3% and will likely turn into a small deficit in
2019. If so, that would be the first time in 24 years.

“The larger the stimulus used by China to offset
the 
trade
 
war
 impact,
the bigger will its deficit likely be,” UBS’s Tao Wang,
chief China economist, said in a report on Tuesday.

That may hurt confidence and hasten outflows, putting pressure on
the nation’s currency. 

“Although CNY depreciation can partially
offset trade war impact,
a large depreciation will likely hurt domestic confidence,
trigger panic outflows and risk financial stability,” UBS
said.