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China's Enormous Local Government Bailout

Flag of the People's Republic of China
Eriko Koga | The Image Bank | Getty Images
Flag of the People's Republic of China

If the Chinese economy is really so strong, why are Chinese regulators preparing a bailout of bad loans made to local governments that may amount to almost a half trillion dollars?

Reuters reports:

China's regulators plan to shift 2-3 trillion yuan ($308-463 billion) of debt off local governments, sources said, reducing the risk of a wave of defaults that would threaten the stability of the world's second-biggest economy.

As part of Beijing's overhaul of the finances of heavily-indebted local governments, the central government will pay off some of their loans and state banks including some of the "Big Four" will be forced to take some losses on the bad debt, said the sources, both of whom have direct knowledge of the plans.

Part of the debt will also be shifted to newly created companies, while private investors would be welcomed in projects previously off-limits to them, sources said.

Beijing will also lift a ban on provincial and municipal governments selling bonds, a step aimed at bolstering their finances with more transparent sources of funding.

Keep in mind that China’s official GDP is just short $5 trillion, which means that this bailout is almost 10 percent of the size of the entire economy. The total amount of local government debt is around 10 trillion yuan and could rise as high as 12 trillion by the end of year, Reuters reports.

Bulls on China are applauding the move along the usual ways—putting the liabilities into “strong hands” and all that.

But it also raises serious questions about whether China’s underlying economic performance is far weaker than it looks. According to Reuters, the loans were made by Chinese state banks as part of Beijing’s economic stimulus programs. Official restrictions on borrowing were undermined by the use of hybrid financing vehicles, allowing the local governments to pile up debt behind the scenes.

The fact that as much as $300 billion in loans have already defaulted raises serious questions about how it was used. Were these just slush funds? Were they handed out to finance construction projects such as China’s famous empty cities?

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