There’s No Vanishing Act for China’s Hidden Debt

China is — yet again — looking to deal with its mountain of hidden debt. An absurd solution has emerged: just make it go away. But much like a landfill, it won’t ever quite disappear.

Earlier this month, Zhao Quanhou, a top researcher at the Chinese Academy of Fiscal Sciences, which is affiliated with the finance ministry, proposed that Beijing should dissolve some of its off-balance sheet debt by converting it into legal, or statutory, debt. Zhao suggested issuing government bonds to refinance these borrowings and then eventually doing away with it altogether.

That may seem like a measured way to go about China’s enormous hidden debt problem. In practice, however, it’s almost impossible, or at least financially unviable, to turn this troublesome debt — involving infrastructure projects across the country — into the mainstream variety that can be sold on the bond market to earn some returns.

For one, the infrastructure projects that have incurred this debt were never set up to succeed commercially.

Construction financing is premised on a project’s ability to generate money. Because the borrowing is linked to a project — not a company — the debt can be moved off-balance sheet. The regular cash flows — from the dam or highway or whatever is being built — ensure the loan can be repaid. It’s carefully structured so that there’s adequate amounts of money flowing during the various stages of construction. Reserve funds are put in place to manage ups and downs. The borrowings come with stringent covenants to cut risks for investors. In fact, infrastructure debt can come with high returns, since it is long-term and not as liquid as other assets like stocks and bonds. 

China’s provincial governments took this model and adapted it to their needs. Burdened by other economic problems, they took on heaps of this off-the-books debt. It’s now estimated to be several times greater than provinces’ on-balance sheet borrowings. There are no official figures, but a local securities house recently estimated the total outstanding was at least 40 trillion yuan ($6.15 trillion). The provinces didn’t give the commercial viability part of the equation much thought. 

Here’s the thing, the conversion that Zhao suggested can only happen if a project successfully reaches completion and starts to generate cash. That’s when the debt can be refinanced, repaying existing lenders and bringing in a new set of investors on market-oriented terms. From the get-go, none of the problem buildouts — predominantly in weaker regions of China — really had great prospects of spitting out cash. There was always some sort of expectation that the projects would have government support no matter what. Indeed, financing models were not focused on revenue generation but on the value of the land on which the project was built. That proved to be unsustainable.

China’s finance ministry has tried time and again to manage the country’s burgeoning local government debt, endlessly rolling and refinancing loans. It has run trials that allow provinces to swap out off-balance sheet borrowings. Trillions of yuan of soured debts have been absorbed by banks. Debt gets swapped for more of the same but on different terms. From one of China’s most-indebted cities Zhenjiang in Jiangsu province to Shanxi and Hunan, several locality-specific plans have emerged too. Yet the burden persists. That’s because most don’t deal with the reality that the projects don’t make money and won’t make money. 

An infrastructure project going belly-up is akin to a corporate bankruptcy. If a company is dissolved, the debt doesn’t just disappear. Someone is on the hook. Lenders take a hit on their principal or sell it at a discount, hoping there’s some value left in the assets.

It’s like a landfill. It smells and looks bad. Ultimately it may just have to be capped and covered up with a few feet of soil, in the hope that, at the very least, the land can be reclaimed. Accepting that fate — and the cost of it — will be the first step in Beijing’s hunt for a solution.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Anjani Trivedi is a Bloomberg Opinion columnist covering industrial companies in Asia. She previously worked for the Wall Street Journal.

©2021 Bloomberg L.P.

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