Overview of local government and infrastructure finance in China, includes macroeconomic and macrofiscal environment, financial market characteristics, individual project financing approaches and recommendations for improvements.

1. Overview of
Local
Government
&
Infrastructure
Finance
in China
1
November 2015

2. Contents
•Economic Overview
•Local Government Financing
•Infrastructure Financing
•Recommendations
2

3. ECONOMIC OVERVIEW
3

4. Infrastructure & Investment
•Investment is spending on fixed assets
•Fixed assets are assets that are used in the
production of other goods & services repeatedly
for a period of more than one year
•Investment is spending on assets that last more
than one year & can be used to produce goods
& services (BEA 2014)
•Investment enables production & leads to
production in the future
•Most investment results in infrastructure (with
the exception of intellectual property, etc.)
4

5. Investment-led Growth
• China is the most notable country in the world for
investment-led growth
• Total investment as %GDP above 30 percent since
1980 & above 40 percent since 2003
• Supported GDP growth above 7.0% since 1990
peaking at 14.2% in 2007
• High level of investment justified as China undergoes
transformation from rural to urban society & from
low to middle income country
• However, much investment driven by top-down
policies leading to oversupply
• E.g. housing vacancy rate of 22.4% in urban areas in
2013
5

6. Economic Boom 2000-2007
•Economic growth peaks at 14.2% in 2007
•Massive infrastructure build
•Additional investment in housing &
commercial real estate
•Low interest rates & cheap credit lead to
doubling of property values
•Large increase in local government debt
6

7. Economic Slowdown & the
“New Normal”
•GDP growth slows from 14% in 2007 to 7.3% in
2014
•2009 $586 billion stimulus program
• Local government debt increased from 6% of GDP in
2008 to 33% of GDP in 2013
• Central government at 64% of GDP
•Potential ‘new normal’ of lower economic
growth
• Need for new growth model: spreading growth more
evenly throughout China
• Investing more abroad
7

8. Total Investment in China
0
10
20
30
40
50
60
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
%ofGDP
Total Investment
GDP Growth
General Government Gross Debt8

9. LOCAL GOVERNMENT
FINANCING
9

10. 1994 Fiscal Reforms
•Subnational government revenue dropped from
80% to 40% of total government revenue
•Expenditure responsibilities remained the same
•Local government debt issuance prohibited
•LGFV developed as main source to bridge local
budget gap
•Long-term land leasing for one-time, upfront
payments became a major source of funding
10

11. Effect of 1994 Fiscal Reforms
11

12. Taxes & Expenditures by Level of
Government
Tiers
Largest Revenue Sources
(% total)
Largest Expenditures
(% total)*
Central • Shared VAT (37.6)
• Trade Related VAT & Consumption
Tax (27.9)
• Corp. Income Tax (20.6)
• National Defense (26.6)
• Reserves of Cereals & Oils (10.6)
• Financial Affairs (8.1)
Provincial • Corp. Income Tax (37.8)
• Pers. Income Tax (34.6)
• Business Tax (29.2)
• Reserves of Cereals & Oils (16.4)
• Social Safety Nets (13.7)
• Urban & Community Affairs (10.2)
Prefecture • Urban Maint & Dev Tax (44.5)
• Property Tax (39.7)
• Resource Tax (37)
• Education (36.4)
• Social Safety Nets (9.9)
• General Public Services (9.3)
County • Property Tax (39.7)
• Resource Tax (37)
• Urban Maint & Dev Tax (36.1)
• Education (23.4)
• Social Safety Nets (18.5)
• General Public Services (10.2)
Townships • Resource Tax (26.9)
• VAT (16.6)
• Urban Maint & Dev Tax (13.3)
• Urban/Rural Community Affairs (27.2)
• Education (18.4)
• Social Safety Nets (15.2)
*(Not including earthquake recovery costs)
12

13. Total Government Revenue
CNY 9,314 Billion
Source: Wang, X. and . R. Herd (2013), "The System of Revenue Sharing and Fiscal Transfers in China", OECD Economics
Department Working Papers, No. 1030, OECD Publishing, Paris
Central, 3878
Provincial ,
1220
Prefecture, 2063
District, 957
County, 383
County City, 403
Township, 410
13

14. Total Government Expenditure
10,017 Billion CNY
Central, 1814,
18%
Provincial , 1736,
17%
Prefecture, 2510,
25%
District, 1291,
13%
County, 710, 7%
County City, 1498,
15%
Township, 458,
5%
14

15. Long-term Land Lease Revenues
• Decline in local government revenue driven by
slowdown in land sales
• Local government receipts from land sales rose
from RMB1.0 trillion in 2008 to RMB3.9 trillion in
2013
• Share of land sales in local government revenue
rose from 25% in 2008 to 35% in 2013
• Budgetary revenue for local governments rose
by less than half the rate of land sale revenues
in the same period
• In 2014, land sales for property development fell
by more than 25 percent
15

16. Local Government Financing
Vehicles (LGFVs)
• Fiscal controls implemented in 1994 Tax Reform led to upsurge in LGFVs
• Central government delegating responsibilities to local governments for
public services & infrastructure with no accompanying funding
• Local governments prohibited from borrowing, so LGFV created to take
on debt
• LGFVs financed through land assets, user chargers, central & subnational
government monies & guarantees
• Faith in eternal property value increases encouraged governments to
issue large amounts of debt & finance it by seizing leasing land
• Short-term loans from banks & corporations at higher interest rates than
government levels (averaged around 7%)
• LGFV total debt outstanding now exceeds $800 billion
• Government bond swap program to refinance debt
16

17. 2015 Local Government Debt-
Bond Swap
• $580 billion authorized bonds for sale to address maturing
bonds & avoid default
• Local governments swap debt for loans from central bank
• Refinancing with government bonds at lower interest &
longer maturity for
• E.g. Jiangsu Province sold $8.4 billion in debt from bonds
ranging from 2.94% for 3-year bonds to 3.41% for 10-year
bonds to refinance maturing LGFV loans
• Some bond sales initially offset by low demand
• Mandate that state-owned lenders purchase bonds
• Government incentivized banks to purchase bonds by allowing
banks to use the bonds as collateral for loans from the central
bank at lower interest
17

18. Shadow Banking
• Prevalent in China due to constraints & regulatory restrictions on
official bank lending on a total & by sector basis
• Increased lending as local governments needed ongoing funds to
continue infrastructure projects begun under the 2009 stimulus
plan despite new laws constraining LGFVs at the end of 2014
• Estimated at 43% of GDP in 2013
• By comparison, the US stands at 150%, & 120% globally
• Estimates range from 30-80%, but still small in relation to advanced
economies
• Carried about mostly by banks, & so shadow loans may still harbor
their guarantees
• The government has the tools & reserves necessary to reduce its size
& instability
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19. INFRASTRUCTURE FINANCING
19

20. Infrastructure Project Delivery
•Special purpose vehicles are created to build &
maintain projects, though these SPVs are
completely or majority state-owned
•Financing drawn from government funds &
borrowing (through bonds or LGFVs)
• Alternative capital raised from direct investment,
public listings, user fees, & commercial bank loans
• Half of PPPs completed by SOEs as private party
• PPPs hindered by heavy government involvement, private
party rights, & low returns
• Majority of PPPS receive fiscal subsidies to enhance
revenue
20

21. Listed Chinese Developers
Developer Symbol
Mkt. Cap.
US$B
Price 52wk H 52wk L P/E
China Communications
Construction Co Ltd
HKG 1800 34.40 8.92 17 5.33 8.26
China Railway
Construction Corp
Limited
SHA: 601186 26.57 15.89 28.18 4.61 17.02
China Railway Group Ltd HKG: 0390 39.09 6.42 12.3 3.96 10.67
China State Const. Eng.
Corp Ltd
SHA: 601668 33.01 7.23 12.52 2.8 9.28
CITIC Ltd HKG: 0267 41.28 12.06 16.88 12.06 7.54
CRRC Corp Ltd SHA: 601766 65.22 16.04 39.47 4.6 40.19
PetroChina Company
Limited (ADR)
NYSE: PTR 210.60 102.86 150.8 101.64 15.21
SAIC Motor Corporation
Limited
SHA: 600104 38.81 22.98 29.18 15.27 8.90
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22. Bank Est.
2015 Assets
US$B
2015
Market Cap
US$B
Staff
Bad Loan
% (2014)
Bank of China
(BoC)
1912 2,458 199.1 308,128 1.18%
China Construction
Bank (CCB)
1954 2,698 212.9 372,321 1.19%
Agricultural Bank of
China (ABoC)
1951 2,545 189.9 493,583 1.65%
Industrial &
Commercial Bank of
China (ICBC)
1984 3,322 278.3 308,128 1.13%
Total - 11,052 880.2 1,482,160 -
Big 4 State-Owned Commercial Banks
The Big Four Banks commercialized their operations in 1995
22

23. Highway Project Financing
•Although China contains 70% of the worlds
toll roads by length, only 7% of its greenfield
financing came from the private sector.
•Typical highway construction financing are
broken down as:
•6-7% Central Government
•20-30% Local Government
•63-74% Commercial & Policy Bank Loans,
Foreign, & Private Capital
•Estimated costs of $15 million per kilometer
for expressways in 2013
23

24. Initial Public Offerings
•Jiangsu, Zhejiang, Anhui, Shenzhen, Huayu
and Sichuan Expressway companies are all
listed on the Hong Kong Stock exchange as H-
shares
•SOE typically retains more than 50% of
shares
24

25. High Speed Rail Project Financing
• Typical railway construction financing broken down as:
• 45% Central government
• 40% China Railway Corporation (Ministry of Railways) Bonds
• 15% Local Government
• Average cost of $17-21 million/km vs $25-39 million/km in
Europe
• Economies of scale, cheaper labor, lower land acquisition costs
• 2003-2015, 10,000 miles of HSR line built. Planned 5,000
mile expansion by 2020
• Prohibitive costs for high speed rail lines
• E.g. Beijing-Shanghai train costs 555 yuan ($86), or about 35%
of monthly disposable per capita income for urbanites.
25

26. Corporate Bond Market
•Between 2009 - 2014, corporate bonds rose
from 10 – 33% of the bond market, vs
government bonds
•90% of corporate bonds issued by SOEs
•Largest issuer are industrial companies,
accounting for 48% of the bond market,
followed by financials at 36%, & utilities at 13%
• China Railway & China National Petro. Corp. are the
biggest issuers in the industrial sector
• Local Government Finance Vehicles (LGFV) also
included in this market
26

27. Institutional Investors
• China’s institutional investors only hold $1.1 trillion in assets, as
compared to $6.8 trillion in Japan & $22.7 trillion in the US (2010)
• In 2010, China’s pension funds invested $168 billion in infrastructure
projects
• China’s National Social Security Fund, with assets greater than $198
billion, can directly invest in infrastructure projects & private enterprises
• Variety of infrastructure funds locally & abroad in domestic & foreign
currencies
• The July 2012 China Insurance Regulatory Commission (CIRC) decision to
allow insurance companies to invest up to 10 percent of their balance
sheets in both real estate and private equity,16 as well as expected
growth in infrastructure investments from other pension and equity
funds, means pricing for good operating assets is becoming increasingly
competitive.
27

28. Individual Investors
•Infrastructure, project-specific companies
can be publically listed to bring in capital to
fund projects
•Households in China hold a combined $6.5
trillion in assets, compared to $11.6 trillion in
Japan, & $27 trillion in the US (2010)
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29. Recent Developments
•New PPP law introduced
•BOT, BOOT, BTO contracts with a 30 year
maximum
•Project types expanded to include power,
transport, water, & environmental projects
•Financing similar to global PPP practice
• Long term loans, private equity, strategic investors,
syndicated loans, corporate & government bonds on
top of project revenues
• Potential for fiscal & interest subsidies
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30. RECOMMENDATIONS
30

31. Recommendations
•Need to address fiscal imbalance caused by
1994 fiscal reforms
•Implicit & explicit sovereign guarantees should
be removed from local government &
infrastructure project financing
•As investors become aware of the risks they
face, they will be more vigilant in assessing
those risks
•Local governments & projects that are forced to
pay premia for risks will plan & manage projects
more efficiently
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32. Thank You!
Brien Desilets
Managing Director
bdesilets@claretconsult.com | www.claretconsult.com
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