Chinese currency.

Chinese Premier Li Kegiang did not spare words when he spoke to the National People’s Congress and the People’s Political Consultative Conference last week. “With downward pressure building and deep-seated problems in development surfacing,” he warned, “the difficulties we are to encounter in the year ahead may be even more formidable.”

China’s economy does face challenges. Last year, the country’s GDP expanded by just 7.4 percent, the smallest increase in 24 years. In response, Beijing lowered its GDP growth target to around seven percent for 2015. And, local debt is soaring, which is complicating China’s transition from economic growth fueled by investments and net exports to growth fueled by consumption and innovation.

Nevertheless, Li’s address heralded huge shifts in the ongoing efforts by the Chinese reformers to restrain the growth of local debt and thus pave the way for accelerated reforms. Only a few days after he spoke, Beijing launched an estimated $160 billion debtswap deal, in which local governments’ risky liabilities will be replaced with low-interest
municipal debt.

DEBT BUBBLE

Unlike the advanced economies, China’s national debt is not unsustainable. In 2014, gross government debt accounted for only 20 percent of GDP. In the European Union, it exceeded 90 percent; in the United States, 105 percent; and in Japan, it is close to 250 percent.

Local debt, however, is a different story. In China, local government comprises over 30 administrative divisions, including 22 provinces, a number of megacities, and autonomous regions. Their debt soared after 2008–09, when the global financial crisis
spread to Asia. That’s when Beijing resorted to a four-trillion renminbi ($640 billion in today’s dollars) stimulus package.

Initially, the infusion of liquidity spurred confidence and contributed to the modernization of China’s national infrastructure. It even helped along the recovery in the West. As the profits of U.S., European, and Japanese multinationals plunged in the advanced economies, business thrived in China.

At the same time, though, excessive liquidity led to increased speculation in property markets, and substantial overcapacity in construction, which was supported by banks and land sales. Local debt soared as local governments, developers, construction firms, and banks got stuck in a vicious cycle.

Between 2008 and 2013, local government debt as percentage of China’s GDP doubled to 36 percent. And there was more bad news: Last year, two out of three Chinese provinces failed to reach the national growth target of seven percent, which raised fears about local governments’ financial vulnerabilities. But it also suggested that, today, local governments are more realistic in their target-setting and are willing to implement painful reforms.

A further problem with the rapidly growing local debt is that the liabilities themselves are extraordinarily opaque. When local governments overleveraged in the mid-1990s, Beijing banned municipalities from selling bonds or borrowing directly from banks. To raise funds, the governments resorted to off-balance-sheet instruments, the so-called local government financing vehicles (LGFVs). These LGFVs have funded roads, airports, subways, housing, and other projects in the mainland. And local governments guaranteed the debt, indirectly.

To be sure, Chinese cities do not exhibit evidence of broad distress. Nor is debt uniform across the cities. Rather, as corporate debt has soared, risks have accumulated in certain sectors with excess capacity, particularly in large state-owned enterprises (SOEs). The problem is exemplified by Hebei, which used to manufacture as much steel products as the European Union, but which is now suffering from a severe slowdown thanks to the decline in steel prices.

FAIR TRADE

Ever since 2013, Li’s challenge has been to balance the volatile property markets with efforts to deleverage the local debt. On the one hand, Beijing has tried to avoid property development, which fuels overheated real estate markets and boosts the debt. On the other hand, the central government has sought not to deleverage too fast, because doing so would cause stagnation in the property markets.

After a decade of strong growth though volatile expansion, China’s real estate market is coping with excessive supply. In 2013, average prices in the Chinese property markets soared 27 percent. Over the next year, they took a 7.8 percent plunge. In 2015, optimists expect flat growth, whereas realists forecast a contraction of five percent. This trend is likely to continue for some time, as developers tackle oversupply and price correction.

What further complicates things is the uneven recovery across the mainland’s regional markets. The first to pull through are likely to be the first-tier municipal regions (from Shanghai and Beijing to Guangdong). But large inventories continue to burden lower-tier regions (Shanxi, Liaoning, and Gansu). Yet growth is more mature in the former regions, whereas the latter still have further potential for catch-up growth.

And that brings us to the debt-swap deal. In China, public debate about local debt intensified after January, when property developer Kaisa was almost swept by default on its dollar-denominated bonds. The case spooked money managers, especially since the State Council estimated that, in 2015, local governments would owe debt repayments of
over $300 billion.

Li and some central bank officials had already suggested a year ago that Beijing might allow some defaults to subdue the local debt. But, as the national growth rate fell below 7.5 percent, they took a different tack. The debt-swap deal, which could increase to some $480 billion over time, will involve the government trading local government’s risky and paque 2–3 year debts for the central government’s gold-plated, low-yield 7-year municipal debts.

The deal was designed to lessen debt pressures and reduce risk premiums until the late 2010s, while shining some daylight on the shadow financing economy. Indeed, the central government hopes that the debt swap will allow it to get a better view of the opaque liabilities, neutralize the shadow banks, and thus reform local governance.

Initially, markets reacted positively to the news and bank shares soared. The CSI 300 banking index climbed 6.6 percent to its highest level in 1.5 months. But the debt swap alone will not clean up the tangle between banks and the local government.

The outstanding bank loans to LGFVs account for less than 15 percent of total outstanding loans. Corporate loans account for almost 67 percent. Consequently, the swap deal is shifting the spotlight toward the long-anticipated reforms of the SOEs.

In 2015, global output is expected to grow by only 3.5 percent. Advanced economies continue to rely on unsustainable levels of debt. China is trying to keep growth steady while also addressing its local debt problems. Together with fiscal support and rate cuts, the great debt swap will help China along, but the country still has a long way to go.

However, the portion of China’s population that is urban is barely 55 percent (as in the United States’ in the early 1930s); China therefore has substantial urbanization potential for another decade or so. That is likely to drive property markets even after the correction is over.