China's dirty little stimulus secret
Investors trying to gauge how much appetite China has for stimulus should ignore official targets and look at local government bond issues instead.
Premier Li Keqiang set a 2019 GDP growth target of 6 to 6.5% at the National People's Congress yesterday, down from "around 6.5%" in 2017 and 2018. While Beijing's targeted fiscal deficit of 2.8% is higher than last year's 2.6%, billions will be going to cuts in personal-income and value-added taxes instead of on infrastructure projects. Tax cuts work like ayurvedic medicine -- it may be years before real benefits are seen. Hardly thrilling, is it?
In reality, though, Beijing has found a new way to finance its spending -- off the books and under the radar for outside observers.
Special purpose bonds are the new fad. Just like debt issued by local-government financing vehicles, or LGFVs, these aren't included in the balance sheets of municipal authorities. The argument is simple: In theory, cash flow from underlying projects can cover interest and principal payments; therefore, the credit profile of these bonds is independent of a local government's fiscal situation, and should be excluded from its budget.
China tiptoed into these bonds in 2015, when Beijing was starting to phase out LGFVs. At first, they were used to roll over old debt incurred by the financing vehicles, but increasingly, they are being deployed to finance new infrastructure projects. By the end of 2018, China had amassed 7.4 trillion yuan (35.1 trillion baht) of such bonds, equivalent to about 8% of GDP. Last year, more than 80% of incremental infrastructure spending was funded by special purpose bonds.
Most of those were sold in the last few months of the year. Even local governments were in dormant mode in the first seven months as Beijing cracked down on excess corporate debt. But trade spats with the US and a heavy-handed deleveraging campaign started to weigh on the real economy. Right after July's Politburo meeting, during which China's 25 most senior leaders shifted back to prioritising growth, these issues spiked.
In August, the Ministry of Finance set off a frenzy for the bonds by "guiding" that they needed to pay coupons at least 40 basis points above sovereign issues of the same tenor. Banks and insurers rushed in, because under the current capital adequacy rules, municipals are considered as safe as sovereigns provided they offer a 36-basis-point spread.
The craze carried into 2019. In previous years, local governments would issue new bonds only after Beijing's budget report, released during the NPC's annual meeting in March. In the first two months of 2017 and 2018, for examples, new issues were nil.
This year is different. Sales were robust in January, according to the latest data available. In late December, the State Council said local governments could issue as much as 810 billion yuan of incremental new bonds in 2019, paving the way for sales to start before this week's congress. In general, it takes three to six months before bond proceeds can be deployed on infrastructure spending.
Using debt to build railways and highways seems to be Beijing's way out of recessions. After the 2008 global financial crisis, a 4-trillion-yuan stimulus saved the economy. In 2012, the country turned to infrastructure spending again, mainly with the help of LGFV borrowing.
That spending came at great cost. China has stacked up almost 30 trillion yuan of LGFV debt, according to HSBC Holdings Plc, or roughly 30% of GDP. Once LGFV debt and special purpose bonds are accounted for, Beijing year after year is racking up a fiscal deficit in the neighbourhood of 8% of GDP, more than twice the official figure, the bank estimates.
The time it takes for an infrastructure binge to spur a recovery is lengthening, though. In 2008, it took China's economy only three months to bounce back. In 2012, it was six months. The question is whether Beijing will be able to use its magic wand this time, and how long it will take.
The government may ignore that inconvenient truth. In its view, experience has shown that fiscal stimulus works. The theory goes that if this round of spending lifts the economy again, wage growth will reaccelerate and so will land sales -- the main source of local governments' income. By that logic, municipalities will be on a more solid financial footing and some extra debt won't be too dangerous.
So China will just stay calm and carry on. And ignore that little secret hidden off its books. - BLOOMBERG OPINION
Shuli Ren is a Bloomberg Opinion columnist covering Asian markets.
Bloomberg Opinion columnist
Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charter holder.