In 2009, when the large stimulus package was announced in China, LGs used it as an opportunity to aggressively borrow from banks. Some of those loans have short-maturities of three years and are used to pay for long-dated infrastructure projects. As a result thus far, two LG financing vehicles have announced their inability to pay back principal on short-term loans.

Local debt will continue to rise, resulting in continued fiscal stress as the Government has chosen this method of funding for its infrastructure investments. But, as long as economic growth slows only gradually – which is what we expect – the level of stress should be contained.

Despite those two instances of loan repayment trouble, it is highly unlikely that the central government will allow local governments to default or fail.

From conversations with policy makers in Beijing, it is clear that the various LGs have been pushing back against the central government given their liquidity tightness in the face of their spending obligations. In response to the liquidity problems at the LG level, several initiatives have been undertaken.

1. The central government has already issued bonds that are specifically earmarked for social housing and with proceeds that will be transferred to the local governments. The central government has also studied alternatives to help local government funding, including potential bond issuance for high-priority local government projects.

2. The China Banking Regulatory Commission (CBRC) has been involved in talks with the banks and LGs to restructure the LG debt as repayment issues are more a matter of liquidity than solvency. This might be done by extending the maturity of the loans such that LGs will not be forced to repay principal this year. It is also likely that after a clampdown on bank lending, Chinese banks soon will be allowed to extend loans again to local governments, which should ease their liquidity situation.

Chinese bank shares have been sold off due to concerns over the previously mentioned loan restructuring negotiations. There is a perception that banks will be forced to perform “national service”; however, asset quality remains strong in the banking sector. Based on the premise that China will not experience a hard landing, a non-performing loan blow-out is unlikely. Also, the CBRC has been extremely prudent recently in terms of the capital adequacy of banks and the regulator is asking banks to bring the loans to local governments back onto the balance sheets for general disclosure in order to provide further clarity on the issues at hand.