A note from Citi today is worth quoting:
- Little conviction of a sustainable rebound at the local level – Last week we visited Changsha (central China), Chengdu (southwest China), and Wuxi (east China), and met with local government officials, financial regulators, and representatives of the financial institutions and property companies. We left with the impression that investment is losing momentum due to local government debt overhang and higher cost of capital, and financial risks have yet to be fully exposed.
- FAI growth appears to have slowed due to a high base – Changsha and Chengdu experienced rapid GDP growth (averaging 14-15% annually) in the past five years, benefiting from fiscal stimulus after the global financial crisis. Wuxi’s growth declined from more than 15% per year during 2003-07 to just below 12% in the past five years, as major investments are being completed and more recently the city has been dealing with excess capacity in the solar panel industry and the collapse of the steel trade. Fixed-asset investment (FAI) growth in these three cities has been lower than the national average so far this year. Local governments are trying to identify new sources of growth, but acknowledge that sustaining the growth enjoyed in the past few years will be challenging. Investment momentum in the central and west China may slow further, following what has already happened in east China.
- Credit is expensive – The cost of funding appears to have increased following the liquidity crunch in June.. As a result, banks are transferring part of the cost to the end borrowers. For example, banks no longer provide mortgage loans to first home buyers at a discount to the benchmark rate. For Local Government Financing Vehicles (LGFVs), the cost of funding from trust companies exceeds 10%.
- Financial risks have not been fully exposed – The reported NPL ratios are very low, but mainly because of ever greening. The amount of special mention loans has increased rapidly, and a large part of those loans are believed to be non-performing. NPL ratio may reach 3-5% if robust classification is used. In the case of Wuxi, the bankruptcy of the Suntech Power and the collapse of the steel trade may have exposed most of the NPLs, but problems appear less exposed in other cities.
- Governments rely on land sales to repay debt – The audit of the local government debt is ongoing and the results may be disclosed in October. The second comprehensive audit may show a much higher debt level than did the first audit (Rmb10.7tn as of end-2010). Land sale revenue appears to be the main source of repayment. For now, rollover appears inevitable, but the governments are starting to worry about the rising cost of financing, especially when bank lending and bond financing are being contained.
