Pros, Cons and Feasibility Analysis of the Possible Path of Hidden Debt-Transformed Debt: Looking at the Future from the Past Two Rounds of Bonding

First, the hidden debt "wildfire burns endlessly", the root cause is the performance appraisal mechanism and the almost unlimited responsibility of the government function, and the urbanization process is only a catalyst, let alone a tax-sharing system

After the single GDP assessment target and the multi-target assessment, the power and expenditure responsibilities of local governments continue to expand, and the demand for debt financing continues to rise. With the rapid process of economic development and urbanization, local governments have led the establishment of various financing platforms, and hidden debts have accumulated rapidly after the 2008 financial crisis.

However, after the next two rounds of debt, hidden debts have risen again in recent years, with the characteristics of diverse forms, high concealment, and disorderly expansion, rooted in the unrationalized relationship between the government and the market and between the central and local governments, the former means that the government has assumed more functions, the latter means that the local government has assumed more functions, and the problem of "a thousand lines above and a needle below" has intensified. With large-scale tax and fee cuts and the decline of macro tax burden, debt has climbed.

By the end of 2022, the balance of explicit debt of local governments in the mainland was 35.1 trillion yuan, and the scale of interest-bearing debt of urban investment platforms reached 55.0 trillion yuan, with a total scale of 90.1 trillion yuan. After considering the interest-bearing debt of urban investment platforms, the broad debt ratio and broad debt ratio of mainland local governments reached 320.4% and 74.4% respectively, which were at a high level. In terms of provinces, there are 18 provinces with broad debt ratios of more than 300%.

Second, the mainland has already experienced two rounds of hidden debt resolution

(1) Hidden debt resolution 1.0 - "bonds" replace "non-bonds"

From 2015 to 2019, local government bonds were issued nationwide to replace existing hidden debts. However, due to the fact that the soil generated by hidden debts has not fundamentally changed, a large number of local government hidden debts continued to breed during the replacement period from 2015 to 2018, laying the groundwork for the next round of high hidden debts.

Guo Fa [2014] No. 43 and Cai Wei [2014] No. 351 clearly screen the stock of local government debts, and each region can apply for the issuance of government bonds to replace the local government debt stock debts that are included in the budget management after screening. By the end of 2014, the balance of local government existing debt was 15.4 trillion yuan, of which 1.06 trillion yuan was in the form of bonds and 14.34 trillion yuan was in the form of non-bond existing debt, which needed to be replaced with government bonds in about three years. By the end of 2018, the stock of government debt in non-bond form was only 315.1 billion yuan.

(2) Hidden debt resolution 2.0 - The second round of hidden debt resolution work began at the end of 2018, with "strict control of increment and resolution of stock" as the main line and gradually tightened, and is expected to continue until 2028.

With the continuous advancement of hidden debt resolution, the central level has successively launched plans such as the pilot of hidden debt resolution in formed counties, special refinancing bonds, and the pilot of no hidden debts in the whole region. In 2019, some organized counties in six provinces, Hunan, Guizhou, Yunnan, Liaoning, Inner Mongolia and Gansu, were included in the pilot and replaced some hidden debts by issuing local bonds. At the end of 2020, the use of funds for some refinancing bonds changed from the previous "repayment of maturing government bonds" to "repayment of existing government debts", opening the starting point for "special refinancing bonds" to replace hidden debts; Guangdong, Beijing and Shanghai were included in the first batch of pilot provinces and cities in the country for "no hidden debts" and started the pilot work.

Based on the requirements of the central government to internalize debt within 5-10 years, all localities have formulated plans according to their own economic strength and debt status and local conditions to actively carry out hidden debt resolution work, mainly along two main lines:

Main line 1: Strictly control the increase of hidden debts and put an end to the situation of "turning old debts into new debts."

First, we should open the front door well, do a good job in "borrowing, using, managing and repaying" local government bonds, and give full play to the leverage role of local government bonds, especially special bond funds.

The second is to standardize the decision-making and project establishment of government investment projects, curb blind projects and paving the way at the root, and put an end to excessive borrowing. Hunan Province said that local governments will never be allowed to add new projects with hidden debts, government investment projects will not be approved without a source of funds, and construction will not be started without a budget, and explore the implementation of a higher-level fiscal approval system for government investment projects in high-risk areas.

The third is to standardize non-compliant financing methods, standardize the operation mechanism of PPPs and government investment funds, standardize the scope of implementation of government procurement services, and ensure that there is a budget before purchasing services.

Main line 2: Resolve existing hidden debts, including debt repayment, debt replacement, debt conversion, bankruptcy restructuring or liquidation, and auxiliary measures

First, debt repayment. Arrange for the repayment of fiscal funds, and transfer the equity rights, land use rights and operational state-owned assets held by the government to repay debts.

The second is debt replacement and restructuring. 1) Replace high-cost debt by issuing refinancing bonds. 2) Coordinate with financial institutions to support debt restructuring, extend interest rate cuts, and actively and orderly mitigate debt risks. For example, Guizhou City Investment Zunyi Road Bridge only pays interest but does not repay the principal in the first 10 years, and repays the principal in installments in the next 10 years. Earlier, Zhenjiang also replaced existing loans and non-standard loans through bank loans, while reducing high-cost existing debts, "financing cost peaking", and reducing interest expenses and financing costs.

The third is debt conversion. Most of the transformation plans for financing platform companies issued in Chongqing, Hunan, Shaanxi, Shandong, Gansu and other places propose to control the number of financing platforms, strengthen the governance of financing platforms, prevent local state-owned enterprises and institutions from becoming platform-oriented, promote the market-oriented transformation of financing platforms, divest non-compliant assets such as reserve land and public welfare assets, strip off government financing functions, and reduce fiscal dependence.

The fourth is bankruptcy, reorganization or liquidation. Fifth, auxiliary debt reduction measures. 1) Improve the emergency response mechanism, establish debt service reserves, emergency turnover "capital pools", relief funds, etc., and maintain the bottom line of no systemic risks. 2) Hold symposiums and discussions to improve investor confidence and optimize the financing environment. In recent years, Tianjin, Guizhou, Henan and other places have held bond investor discussions to maintain market confidence and financing environment. 3) Establish accountability and reward mechanisms.

According to the 2022 budget implementation report, Guangdong and Beijing have achieved zero hidden debt, eight provinces in Guangxi, Ningxia, Jiangsu, Tianjin, Shaanxi, Gansu, Henan and Qinghai have exceeded the 2022 annual debt plan, and Shanghai, Jiangsu, Qinghai, Inner Mongolia and other places have achieved partial zero.

Third, the next step of hidden debt resolution: analysis of the pros, cons and feasibility of market expectations and local practical debt paths

We have made a short-term and medium-term analysis in "Preventing and Resolving Debt Risks: The Current Situation and 14 Comprehensive Countermeasures", and now mainly analyzes the pros and cons of market expectations and 7 debt transformation paths in local practice.

The first is to arrange for the repayment of financial funds, but the space for local finances to maneuver is relatively limited. The repayment of fiscal funds is the most direct way to resolve hidden debts, but the overall situation of fiscal funds is "difficult to open source and limited savings". In the first half of 2023, the growth rate of general public budget revenue continued to rise under the effect of a low base, with an average growth rate of only 0.9% in the two years, and the income from the transfer of state-owned land use rights fell by 20.9% year-on-year from the base of more than 2 trillion yuan last year. What local governments can do more is to strictly save too tight a day and cut some non-essential expenditures such as training fees and conference fees, but the rigidity of people's livelihood expenditures such as social security employment, education, and health has increased, and the funds that can be "saved" are limited. At the same time, there is a paradox, regions that can be repaid through fiscal funds have strong financial resources, less overfinancing or even illegal borrowing, and lighter debt burdens. In regions with heavy debt burdens, the process of debt accumulation is often accompanied by a decline in local financial resources.

The second is to transfer the equity held by the government and transfer some of the more liquid state-owned assets to solve part of the existing debt. The most typical case is Guizhou's "Moutai bonds", but there may not be such high-quality assets everywhere. In December 2019, Moutai Group transferred 50.24 million shares and 4% of Kweichow Moutai shares to Guizhou State-owned Assets Operation Company without compensation, opening the road of "Moutai bonds", and then used low-interest bond issuance to acquire Guizhou Expressway and purchase urban investment bonds of governments at all levels in Guizhou to help Guizhou transform bonds. However, this method is difficult to replicate in other regions, not all places have such unique state-owned enterprise resources as "Kweichow Moutai", and the asset scale, asset quality and realizability cannot be compared with Kweichow Moutai, and it may even be a state-owned enterprise such as "Guizhou Expressway" that needs blood transfusion from local governments. At the same time, it also involves the loss of state-owned assets and the accountability mechanism at all levels.

Third, the use of the existing debt limit space for debt replacement can optimize the debt term structure and reduce the debt interest rate, which is the easiest to do in practice, but this practice does not reduce the total amount of debt, and the limit space is too small compared with the scale of hidden debt. At present, Guangdong and Beijing are promoting the resolution of hidden debts through special refinancing bonds, providing reference for other provinces, and many provinces are also actively striving to be included in the "Pilot of Hidden Debt Risk Resolution in Constituent Counties", hoping to issue local government refinancing bonds to replace some hidden debts. However, the use of previous year's balance does not fundamentally solve the hidden debt, and it is necessary to increase the debt limit and make inter-provincial transfers, mainly for the following reasons:

First, from the perspective of quota, as of the end of 2022, the balance of local government debt in the country is 35.06 trillion yuan, the limit is 37.65 trillion yuan, and the theoretical maximum space for bond issuance is 2.59 trillion yuan. However, it is far from the scale of interest-bearing debt of 55.0 trillion yuan of urban investment platforms, equivalent to only 4.7% of it.

Second, the distribution is uneven among regions, concentrated in provinces with less debt pressure, such as Shanghai, Jiangsu and Beijing. Judging from the gap between the debt limit and balance of each province at the end of 2022, Shanghai, Jiangsu and Beijing have more room to issue refinancing bonds to replace hidden debts, with 276.55 billion yuan, 190.01 billion yuan and 163.71 billion yuan respectively.

The fourth is to financialize debt, strengthen consultation and communication with financial institutions, and support debt restructuring and interest rate reduction. However, it should be noted that the essence of financialized bonds is to transfer local hidden debt risks to the financial system, and a large-scale rollover of interest rate cuts will lead to a decline in the profitability of banks, especially local urban commercial banks and rural commercial banks, and an increase in the ratio of non-performing assets, triggering the resonance of fiscal and financial risks. At the same time, as market-oriented entities, financial institutions are also facing the pressure of safety, liquidity and profitability. After Zunyi Daoqiao announced the extension of its debt, Guiyang Bank granted 7 billion yuan of credit to it, and the non-performing loan ratio increased rapidly. Since the underlying assets of Guiyang Bank are mainly local government platforms, China Merchants Bank believes that there is a risk of overall thunderstorms in the local area and there are systemic and regional risks, and has suspended its interbank credit business to Guiyang Bank. The largest shareholder of Guiyang Bank is the Department of Finance of Guizhou Province, and the local finance bears certain back-up or related responsibilities, and financial risks are eventually transmitted to financial risks, resulting in a vicious circle.

Fifth, asset management companies (AMCs) purchase urban investment bonds of local urban commercial banks and rural commercial banks, and strip financial institutions of their claims against local governments in a relatively market-oriented manner. However, AMC's participation in hidden debt resolution is relatively limited. On the one hand, compared with the huge local hidden debt, AMC is small and difficult to provide sufficient liquidity support. On the other hand, AMC, as an operating entity, has its own profitability requirements, and will not accept local hidden debts in full, but choose high-quality local debt risk mitigation projects.

Sixth, under the premise of making existing hidden debts explicit and market-oriented, do a good job in risk isolation, and write down debts through bankruptcy restructuring, liquidation and other means. However, bankruptcy restructuring or liquidation has a strong negative effect on investors, which may have a greater impact on the financial market and public opinion, and is the last choice.

Seventh, the market expects that the central government will increase the leverage and issue additional government bonds to replace local government debt, but we believe that it is necessary to solve the problem of systemic risk and moral hazard, otherwise it is easy to breed local flattening and discourage the enthusiasm of regions that are actively engaged in debt reduction. The central government generally adheres to the principle of "whose children are the ones who hold them", and at the same time sets the preconditions for bailouts, including the severity of debt risks and the externalities of assets formed by debt investment, as well as the simultaneous implementation of rescue and accountability to avoid moral hazard.

Risk warning: external shocks exceed expectations, and economic downward pressure exceeds expectations

(Luo Zhiheng is the chief economist and president of the research institute of Guangdong Securities)