China’s Long, Hard Struggle To Reform Local Govt Financing

China, Company Strategy, Economics, Fibre Intermediates

PTAChina29April2015

By John Richardson

A story that moves financial markets doesn’t have to be true. All that matters is that the narrative convinces enough people for a sufficient period of time to move markets either up or down, thus allowing speculators to make money.

And these days, because of high-frequency computer-driven trading, the credibility of any particular story, no matter how baseless it finally proves to be, only has to endure for a fraction of a second for people to make money.

This even applies to polyolefins markets in China, thanks to the big role that the Dalian Commodity Exchange’s linear low-density polyethylene and polypropylene futures contracts now play in setting physical prices. On the Dalian, too, a story can be completely groundless, but if it retains credibility long enough to move prices it will have served its purpose.

This is the context in which every serious chemicals industry planner must view claims earlier this week that China was about to launch a quantitative (QE) easing programme, similar to what the Fed and the European Central Bank have already carried out. In other words, this was nice story while it lasted, but it was never based on economy reality.

Here, in brief, is what happened:

  1. In 2014, Beijing forced local governments to make their debts fully transparent for the first time. Previously, many of these debts were hidden inside opaque Local Government Financing Vehicles, or LGVs (see my description of how LGVs have worked later in this post).
  2. The next step was to force local authorities to borrow money transparently, via a new local government bond market.
  3. But last week a bond offering launched by the Jiangsu provincial government failed.
  4. This led to the rumours that the People’s Bank of China (PBOC) was going to step in and buy huge amounts of local government debt. Like QE in the West, it was claimed that this would release lots of new liquidity into the financial system, enabling a return to the kind of investment-led growth that China enjoyed in 2009-2013.

But adding one and two together to make three was wrong because if the PBOC does end up buying local government debt, this would be purely a defensive measure. Any central government purchases of local government bonds would, as a result, be in the same category as recent cuts in interest rates and the bank reserve requirement ratio.

“From the details we know it’s probably wrong to characterise this as QE. It’s tempting to think that China would join everyone else, but the reality is that the Chinese central bank seems to be concerned about bank’s reluctance  to buy local government bonds,”  Frederick Neumann, chief Asia economist for HSBC, told the Financial Times.

It is hardly surprising that banks are reluctant to buy local government debt in China, given that it now totals $2.89 trillion compared with $1.7 trillion in 2010.

How did this come about? During the 2009-2013 economic stimulus programme, local authorities were told by Beijing to “spend, spend and spend” in order to shore-up growth.

They paid for this lending by acquiring ever-greater quantities of land from farmers at knockdown prices, which the authorities then sold-on to real estate and industrial developers. This has left China with a legacy of huge oversupply in both real estate and industrial capacity.

“You can see this in purified terephthalic acid (PTA). Just about every province in China decided to sell land to a PTA developer, with no real analysis of supply and demand balances,” said an Indian-based polyester industry observer.

Hence, you have ended up with the chronic oversupply detailed in the chart at the beginning of this post.

And it got even worse: As the “spend, spend and spend” frenzy gathered momentum, local governments used the land that they acquired as collateral to borrow money via the LGVs. These LGVS now hold debts worth many times the value of their collateral.

The root cause of this problem, as I highlighted back in October 2013, is that local governments have never received enough money from the central government to cover their liabilities.

This became a major problem during the 2009-2013 stimulus programme because local authorities were set huge very-high targets by Beijing. These targets could only be met by lots more land sales.

Corruption has been another side effect of this system, as the New York Times pointed out in October 2013 when it wrote: “By building a large dam or giant housing project, an official can boost GDP and create jobs while also creating a large pot of money he can dip into for himself or spread around his friends and family.”

So where do we go from here?

As I again pointed out in October 2013, Beijing has to entirely dismantle and re-assemble the funding system for local governments.

As this multi-year process takes place, there can be no Western-style QE programme, as this would make real estate and industrial oversupply even worse whilst also adding to China’s overall debt crisis.

Chemicals company planners everywhere must therefore assume that whilst this re-assembly process takes place, GDP growth in many of China’s provinces has to be lower because of the lost momentum from reduced construction of new homes and new factories.

And the planners must also accept that that chemicals plants in oversupplied sectors in China are unlikely to be shut down.

I think it is much more likely that China will run its new capacity at very high operating rates in order to maintain local jobs.

In the case of a product such as PTA, you also have to consider that many of the recent capacity additions in China have been “state of the art” – i.e. very modern, worldscale plants. It thus makes more sense to run these facilities as hard as possible in order to try and force older plants overseas to shut down.

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