The Great Loan Transformation

August 23, 2011 3:30 PM

Have a troublesome loan problem? Just reclassify it!

Chinese local government investment platforms have come under increasing scrutiny this year and along with this scrutiny have come new restrictions by the China Banking Regulatory Commission (CBRC). To guard against potential losses on the 10.7 trillion rmb outstanding local government debt, the CBRC has ordered Chinese banks to curtail lending to platform companies and adhere to heightened precautionary capital requirements. These capital requirements can be as much as three times the requirement for normal corporate loans and thus have been a drag on the balance sheets of banks that would like to lend more.

There is, however, a significant loophole in CBRC regulations. If a project has sufficient cash flow to cover its operating costs, it may be reclassified as a corporate loan. Reclassification thus reduces the appearance of local debt and frees up capital for additional lending. According to China Securities, as much as 2.8 trillion rmb of local government financing platform loans are now undergoing this transformation.

Unfortunately, loan reclassification fixes few problems and may cause some new ones. Reclassification lowers capital constraints on banks, but it doesn't alter underlying quality of their loan portfolio. Many of the loans that are reclassified may go into default anyway and now banks will be less prepared for that eventuality.

Additionally, allegations are now emerging that local governments are helping financing platforms tinker with their books in an effort to get them classified as commercial loans. This may mean that some very poor quality loans will receive the improved classification and avoid scrutiny.

Finally, if all the good quality loans are siphoned off through reclassification, the remaining pool of local government debt will rightly be identified by investors as junk. This will make financing these debts even more expensive in the future.

Further complicating the local goverment debt picture, Economic Observer is now reporting that provinces may now start issuing their own bonds, with Guangdong and Zhejiang leading the way. It remains to be seen whether putting this power directly into the hands of local governments will increase or reduce local government debt transparency.

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