China Continues to Borrow Despite Heavy Debt

Two recent events indicate that the Chinese government has helped open the way for foreign investment. First, Xinhua News Agency, Beijing's mouthpiece, reported on Sept. 28 that the State Council, China's cabinet, has approved the bond issuance in Chinese Yuan by International Finance Corporation (IFC); and secondly, Union Bank of Switzerland (UBS) has taken the management control of Beijing Securities, a brokerage house in Beijing, in a deal worth 1.7 billion yuan (US$210.5 million). Encouraged by the news, overseas fund managers claimed they will work harder to get into China's financial market in all services. Their enthusiasm is no less than when, a few years back, several foreign banks just obtained the right from Beijing to clean up China's bad accounts.

Right now Beijing still bars its local governments from raising funds by issuing bonds of various sorts; and yet why would it so graciously grant IFC the "privilege" of issuing bonds? A reason not to be revealed to foreign investors is: Beijing has milked its two cash cows—the stock market and bond market—long enough and is no longer able to squeeze anything from them. It is therefore now ready to throw them to overseas investors to be taken care of. Inevitably, the leftovers would not taste any better than the bad debts that foreign banks took over years ago.

The Bond Issuance Has Become an Over-Milked Cash Cow

Why has the domestic bond become the target for analysis? The national debt is known as the "bond laced with the gold" in China's financial markets. However, the "bond laced with the gold" has long since passed its prime. On Sept. 13, China's one-year state bonds were sold at 98.87 yuan, with a yield of only 1.1585%, a record low and a contrast to the bank's capital cost, and only 16 basic points away from the market's last psychological defense line—the large deposit bank rate of 0.99 percent.

In another development, Commerce Bank of China, with its large amount of idling funds, continues to be the major buyer of the country's one-year bonds, having purchased a total worth 21.3 billion yuan (approx. US$2.6 billion), or 64.21 percent of all China's one-year bond issuances. Nonetheless, the purchases from the four major state-owned commercial banks have declined noticeably, with a total of 8.73 billion yuan (approx. US$1.09 billion) leading to a drop to 26.31 percent of the total debt or a 10 percentage points lower than last year's purchase. Meanwhile, many publicly held commercial banks with less funds and few investment opportunities, have been on course to become principle buyers of China's national debt.

The reason that the four largest state-owned banks do not want more state-issued bonds is simple: at present the capital cost of large commercial banks stands at 1.25 percent, with that of the small and medium commercial banks even higher. However, even with underwriting fees, the yield for one-year state bonds is only 1.2085 percent, well below the banks' capital costs. The inversion of bond yields with bank capital costs shows that the issuance of national debts has turned into a tasteless hot potato. So it can be concluded that the few state-owned banks that have the advantage of monopolizing China's financial sector, bought national debts only to fulfill a task from the central government and lead a public show.

The 2003 Bond Issuance Plight

As a matter of fact, Beijing began to consider introducing foreign capital into its domestic bond market as early as 2003 when its efforts to issue government bonds were badly frustrated.

Started in 1981, China's Treasury bond sale had been small until 1997, with individual citizens as the main buyers. Later, as the debt increased and the public was unable to absorb such a huge sum, the country's state banks were called in and became the major purchasers. This, in essence, is tantamount to China's own banks issuing more generalized currency. Thus, the "the gold" of the national debts began to fade slowly. In early 2003, China encountered unprecedented difficulty in bond issuance. On Sept. 15, the eighth issuance of national bonds of that year started on the bond market with an invitation for bids from underwriters. The government had planned to raise 24 billion yuan (approx. U.S. $3 billion), but ended up with 16.38 billion yuan (approx. U.S. $2 billion), with its selling price set at the lowest end of the price range for the issuance—98 yuan (approx. U.S. $1.2), 7.62 billion yuan (approx. U.S. $950 million) below the target or a 31.73 percent shortage. In the end the Ministry of Finance had to retarget the bonds to 16.38 billion yuan (approx. U.S. $2 billion), the amount that was actually purchased, and call an immediate halt to its invitation for bids for the ninth bond issue scheduled for Sept. 18. So that the 194.9 billion yuan (approx. U.S. $24.3 billion) worth of bonds for the entire year could be issued within the remaining three months, the Finance Ministry was compelled to call an urgent meeting of Category A underwriters of national debt and adjust its issuance methods. The Ministry designated the inter-bank bond market as the target market and four out of five registered bond issues were made on the inter-bank bond market. In addition, issuance occurred before payment, a virtually mandatory allocation that barely ensured the fulfillment of that year's task of bond issuance.

According to international practice, the issuance of national debts serves as a bridge between a nation's fiscal policy and its monetary policy. In China, however, the buyers stand no chance to gain since the bond issuance has become an allocation by the government. Thereafter, Beijing began to consider luring foreign capital into its bond market. China, with its Finance Ministry obligated to pay back the eighteenth issuance of national debts due in 2005, has entered a five-year peak debt repayment period. Data shows that, between 2005 and 2009 the Finance Ministry's annual repayment of debt will amount to about 350-400 billion yuan (approx. U.S. $43-50 billion). China is reforming its four major state banks, looking to have them listed overseas. To do so, one of the methods employed is to inject funds into these banks to reduce their bad debt ratio. Ways of injecting funds come from the following: issuing corporate bonds or national debts. But the funds these banks need are so huge because of their numerous bad debts that a considerable amount of the bonds will have to be borne by the Finance Ministry. Under the circumstances, China has no choice but to quicken its steps in introducing foreign capital into its bond market. International financial institutions are nothing but a big fish rushing into the fishing net set by the Chinese government.

The Defense for Raising National Debts: High Debt Drives High Economic Growth

It is necessary to explain here why the Chinese government raises its indebtedness so high.

Since the mid and late 90s, Beijing has been adopting a more aggressive fiscal policy, raising a large amount of debts for public investments and, with it, driving its economic growth. There have always been different opinions over the measure. A couple of years ago when it was possible to talk more freely about this inside China, the topic was hotly debated.

Scholars who champion raising debts came up with three reasons: first, since there is a 1:4 ratio between national debt and bank loans, investment in debt will result in a four fold increase in loans, easing capital shortage in construction; secondly, since the funds raised through national debts are used in public works, raising national debts have played a significant role in China's economic growth. Since 1998, projects funded by national debts have added 1.5-2 percentage points per year to China's GDP. And thirdly, the European Union has set a limit on debt burden of no more than 60% of GDP, and China is far below that level, therefore China can still go a lot further into debt with peace of mind.

There are even those who believe that raising national debts is one of the most important policy tools. To make raising national debts an important tool in macro management of the economy, it is necessary that national debts go up slowly and the share of their balance in financial assets rise to 20 percent from its current level of 5 percent. According to sources close to the situation, China's debt balance in 2005 will reach 2.2 trillion yuan (approx. US$270 billion), or 16.8 percent of its GDP; by 2010 that figure will be 4.1 trillion yuan (approx. US$510 billion), or 22.4 percent of its GDP; and by 2020 it will top 15.2 trillion yuan (approx. US$2000 billion), or 40 percent of its GDP. The ratio of debt assets to financial assets will reach approximately 20 percent.

Table 1.

Opposing opinion: The Sum of the debt is too big; Debt Dependency Ratio (DDR) and Debt Service Ratio (DSR) are too high.

The reasons brought out by the opposing view are much more concrete. In order to judge the fiscal situation of a country and whether there is a fiscal crisis or not, normally one needs to adopt a series of indices related to government debt. Most common indices used to explain China's fiscal condition are Debt Dependency Ratio (DDR) and Debt Service Ratio (DSR). The reasons are:

First, National Debt to GDP ratio does not include potential factors such as contingent liability or implicit liability. These factors include, the national debt that the central government loans to local governments for infrastructure construction; special national debt used to replenish state banks; about $60 billion borrowed from the World Bank, Asian Development Bank, and foreign government under the name of the Central Government but not included in the national budget; losses from the state owned banks' bad debts; government grain trade loss, and a fund shortage in the social security system. If all the government's explicit and direct liabilities are included, the Chinese government's total fiscal debt is around 55 percent of China's GDP. But, according to an estimate by The World Bank, The Chinese government's total liability (including explicit and implicit liability) has already reached 100 percent of its GDP.

Second, China's Debt Dependency Ratio (DDR) is too high. The so-called "Debt Dependency Ratio" refers to the ratio of the amount of national debt issued to the fiscal expenditure of the same year. Currently, the formula used in China to calculate DDR is: DDR = amount of national debt issued / (central government fiscal expenditure + Interest repayment). This index directly gauges the government's debt burden from a financial point of view. Until now, only the central government could issue national debts, local governments are not allowed to issue municipal bonds. So DDR is an economic index that is only applicable to the central government (the debt crisis for local government needs to be addressed in a separate article). Currently, the international standard alarm zone for DDR is around 25 to 35 percent. In recent years, China's DDR has increased very rapidly. Calculating based on the central government's fiscal expenditure only, the DDR was 71.12 percent in 1998, and 69.7 percent in 1999. Since 2000, the national debt issuance scale increases, and so is the DDR. In the mid 1990s, the average DDR for western developed countries was 12 percent, much lower than the figure in China. Chinese government's fiscal expenditure depends so much on the proceeds from national debt, which not only brings more and more interest repayment pressure for the fiscal operation, but also creates dangers in securing the necessary fiscal expenditure when there is difficulty in issuing national debt caused by the changes in the social and economic environment. The fiscal risk caused by national debt could very possibly lead to a political risk.

Third, China's Debt Service Ratio (DSR) is also too high. DSR refers to the ratio of debt repayments to the fiscal income of the same year. It is an indication of the government's debt repayment capability. By international standards, the safety zone is between 8 and 10 percent. In China, the government fiscal income to GDP ratio, especially the Central government fiscal income to GDP ratio, is too low. Hence, DSR increases year after year, as shown in table 2:

Table 2.

Before domestic bond issuance reached a crisis in September 2003, the opponents could still be heard in the Chinese media. After the crisis took place, one could only hear the government's side. It does not mean the Chinese government's fiscal crisis disappeared. The discussions were simply restricted by the authorities.

"The Drain Effect" in National Debt Funded Projects

The usage efficiency of the funds raised by national debt it is also a topic worth talking about. Since 2000, the fund went mostly to transportation and communication infrastructure, at around 33 to 40 percent of the total fund. Second to those areas are municipal infrastructure and reconstruction. The third is environmental and public welfare projects. But the government being in charge of the projects invested and financed by the national debt, inevitably, creates several serious problems.

First, the yield of projects the national debt invests in is very low

According to China's National Audit Office annual audit report in 2002, after auditing 37 environmental projects funded by national debt in 9 provinces, the total fund used by these projects is 1.995 billion yuan. However, only 9 projects finished according to its plan and met the quality requirement, accounting for only 24 percent of the total projects. The conclusion drawn by Professor Song Yongming at the Renmin University of China, based on his quantitative study, was more shocking, "After the economic reform, national debts were mostly used in consumption, and not in construction expenditure as most people expected."

Second, corrupted officials have already converted projects funded by national debt into a huge bribery generator.

In these years, there is an implicit common understanding inside the transportation construction industries in China—bridge and road construction projects are "treasure baskets." The treasure inside the "basket" refers to the continuous money supply from the national debt funds. The problematic investment and financial system inevitably converts national debt fund into corrupted officials' sumptuous banquets. In recent years, over a dozen provincial transportation directors left office because of corruption, almost every case would reveal a big group of corrupt subordinates of those officials.

There are several methods that corrupt officials use to turn national debt funded projects into bribery generators. The first one is to propose a project (including ghost projects) in order to get funding from the central government. The second is to transform the fund to their own with their authority over the use of the funds. There are inherent shortcomings in China's large fund managing system. In construction projects, a government official would be administrator, business leader, the constructor, and the project manager, all at the same time. From survey, design, bidding, construction, to supervision and auditing, many links lack mutual supervision and restrictions. The gate of corruption opens from here. Analysing cases of corruption in the traffic construction departments, one would find one thing in common. Corrupted provincial transportation officials would assign most projects to companies owned by their relatives and friends (including their mistresses), to fill their pockets. This tactic is commonly used because the officials take advantage of the shortcoming of the government's playing four roles in one entity.

From the above analysis, it is not difficult to see that the so called "prosperity" in China is completely built upon raising a large volume of national debt. "Borrow new debt to repay the old one" is one of its basic tactics to maintain economic operations. The tactic could be used for a while, but definitely not for the long term. Any conscientious scholar who understands China's fiscal system would not be optimistic about the economic situation of China.

Ms.He Qinglian is perhaps the most famous Chinese economic commentator. She is the author of China's Pitfall (and edited version was published in Beijing as Modernization's Pitfall). The book was an immediate success, selling 200,000 legal copies and vastly more pirated ones. Her more recent writings have more blatantly found fault with the government, and have led to her exile to the United States.