The corruption and purging of Bo Xilai is illustrative of the shortcomings of China’s unsustainable growth model.
After Bo Xilai was purged and as new people will be running the Chongqing government, a review of the debts outstanding for the government, including the local government financing vehicles, which are used in funding many of the infrastructure projects, is required.
Bank of America Merrill Lynch came out with a note yesterday which included a very nice summary to illustrate the point of how the fastest growing region in China was growing via unsustainable level of borrowing that funds the over-investment:
Chongqing is reviewing its local government debt levels
The new leadership of Chongqing local government has reportedly required CQ LGFVs and SOEs to report local government investment projects and BT (Build-Transfer) financing projects. There are increasing concerns with respect to the mounting debts of CQ government, esp. at county and district levels. The new government is reportedly considering correcting its growth model to be less aggressive and to focus more on steady growth.
Fast growth based on fiscal overdraft
Chongqing’s GDP growth topped in China at 16.4% YoY in 2011, and its GDP doubled in 3 years from RMB0.5tn in 2008 to RMB1.0tn. The rapid GDP growth was mainly driven by the infrastructure investment by LGFVs. FAI in CQ amounted to RMB760bn in 2011; majority of this can be attributed to the “8 major LGFVs”, which relied on land as collateral to borrow from banks and land appreciation for refinancing. Some data reported by various local media include:
– In 2009, infrastructure project investment (land, bridge, water, tourism, etc) initiated by the CQ local government exceeded 520bn, vs local government budgetary income of <120bn. The gap was largely filled by LGFV loans.
– In 2010, CQ planned to build 40mn sqm of low-rent housing, which required 100bn of investment, of which 70% is dependent on the market.
– In 2011, fiscal income of CQ government amounted to RMB291bn, vs fiscal expenditure of 396bn. Fiscal expenditure accounted for 40% of CQ’s GDP,vs. 23% at national average.
And last year, I mentioned a presentation put out by Standard Chartered on the financing of low cost housing, which incidentally mentioned Chongqing, and this was what I wrote about the math of the financing as presented by Standard Chartered:
The presentation cites that there are 21 public housing projects currently under development in Chongqing, providing a total of 40 million square meters of rental housing in the next 3 years. Of which, 90% of the area (36 million square meters) will be for residential use, while the remaining 10% (4 million square meter) will be for commercial use. The total investment in these project amounts to RMB100 billion.
Here’s the big problem: the government will only put up 30% of the RMB100 billion of equity, while the remaining 70% of the investment is financed by bank loans at 5% interest rate. While the government is confident about the financing, I am much less sanguine.
Here is the math: At 5% interest rate per year for RMB70 billion loans, the interest expense per year will be RMB3.5 billion, and the maintenance costs for the projects will be RMB500 million, so the recurring expenses will be RMB4 billion per year.
Assuming the rental rate will be RMB11 per square meter and all the apartments will be occupied, the annual income will amount to about RMB4.75 billion per year, more than enough to pay the recurring interest expenses and maintenance costs.
So how about the principal of RMB70 billion?
Well, the occupants will have options to buy the units they occupy in 5 years time at cost, implying a sales price of around RMB2,500 – 3,000 per square meter. If 30% of the saleable residential area are sold at the high-end estimate, the income will amount to around RMB32 billion. The remaining commercial area will be sold at RMB 10,000 per square meter, so the expected sales income for commercial area will be RMB40 billion. So within 5 years time, the government can receive RMB72 billion or more from the sales.
The issues here are not new. In fact, we have known that all along, and the case of Chongqing is likely to be a tip of the iceberg, and the consideration on the corruption issues simply add some new colour to the economics of China’s growth in the past years that was not discussed very often among economists. We can also see that the above mentioned optimistic scenario from last year is now looking improbable as the real estate market cools and building continues. As I have already said:
The “margin of safety”, if you will, is pretty narrow. If the occupancy rate is 84% or less, for instance, they won’t even have enough revenue to pay the interest expenses and maintenance costs. The sales assumptions are also aggressive, with the margin of safety of RMB2 billion only. So practically if any of their sales assumptions turned out to be false in 5 years time, they would be unable to get RMB70 billion to repay the loans. Also, the investment of RMB100 billion to build 40 million square meter of floor area implies a cost per square meter of RMB2,500, so the sales price assumption of RMB3,000 per square meter is probably not achievable if they are really meant to sell the residential area “at cost”.