China's Reform Blueprint Bodes Well For Taming Local Government Debt

Primary Credit Analyst: KimEng Tan, Singapore (65) 6239-6350; kimeng.tan@standardandpoors.com Secondary Contact: Liang Zhong, Beijing (86) 10-6569-2938; liang.zhong@standardandpoors.com

Table Of Contents
Greater Accountability Will Reduce Borrowing Appetites Transparency Should Improve Debt Management Rationalized Intergovernment Arrangements Success Will Hinge On Market-Oriented Reforms Related Criteria Related Research

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 20, 2013 1

1219106 | 301447691

China's Reform Blueprint Bodes Well For Taming Local Government Debt
China's new leadership appears to be taking decisive steps to tackle soaring debt levels at local and regional governments (LRGs). The recent plenum of the Communist Party culminated in a reform blueprint that Standard & Poor's Ratings Services believes could lower the financial, economic, and fiscal risks to sovereign creditworthiness if it's implemented effectively. That's partly because the reforms may significantly reduce the incentives and need for LRGs to aggressively borrow. The plan aims to achieve strong breakthroughs in key reforms by 2020. But we anticipate much earlier progress in some of these areas. In our view, the central government's emphasis on controlling risks associated with the rapid increase in LRG debt in recent years could help to speed up implementation. Overview The ruling Communist Party has outlined a series of reforms to tackle China's sizable debt levels at local and regional governments. The steps are aimed at improving accountability among local officials and increasing fiscal transparency. We believe the reforms could reduce the risks to the sovereign credit rating over the next three to five years. But taming LRG debt depends on how well market forces determine the allocation of resources and support the central government's economic growth targets.

Local government debt has spiraled alarmingly since the onset of the global financial crisis. Standard & Poor's estimates that broad LRG debt reached Chinese renminbi (RMB) 14 trillion (about US$2.3 trillion) by the end of 2012. However, the National Audit Office (NAO) may reveal an even higher figure when it announces its most recent findings. In 2009 alone, broad LRG debt increased more than 60%, according to the NAO. Financing arms of local governments raised much of the debt, which included increasingly risky types of borrowings--i.e., those with high costs and short maturities. We believe the risk to the sovereign credit rating on China (AA-/Stable/A-1+; cnAAA/cnA-1+) arising from these debt burdens is likely to moderate over the next three to five years as the reform initiatives kick in. However, much hinges on the central government's ability to reduce the dependence of economic growth on LRG investments. Additional factors would include the local authorities' commitment to beefing up their transparency and accountability over debt levels, which includes providing stronger justification for new borrowings.

Greater Accountability Will Reduce Borrowing Appetites

We expect the heads of LRGs to become more cautious toward borrowing. One reason for that is the central government's plan to partly assess officials' performances on how much debt their authorities have incurred. The current performance appraisal scheme strongly emphasizes economic development, with little regard to how it was

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 20, 2013 2

1219106 | 301447691

China's Reform Blueprint Bodes Well For Taming Local Government Debt

financed. This sometimes meant aggressive spending on urban infrastructure and facilities--such as roads, subways, and parks--mostly funded through debt. Few officials, if any, were held personally responsible for the heavy debt burdens, which successive leaders then inherited. The effectiveness of this new measure in combating excess debt levels will depend on how much weight it contributes to overall performance assessments. An earlier attempt to include social welfare and environmental indicators into local officials' appraisals didn't seem to achieve a significant change in behavior. That's partly because of the continued dominance of economic and employment measures in overall assessments.

The focus is now on repaying the principal, not just interest

The proposed introduction of multiple-year budgeting could also help moderate LRG borrowings, in our view. Anecdotal evidence suggests that some local officials care only about interest payments and not about the need to repay the principal at a later date. Many LRGs choose to delay the inevitable by rolling over a large proportion of their debts on maturity. Consequently, some governments have borrowed much more than they can comfortably support. The blueprint proposals imply that local officials must take into account principal repayments in coming years when they decide to borrow. Under the medium-term budgetary framework, officials will need to prove that debt-financed investments could generate fair economic returns or future government revenue. Such a requirement should discourage aggressive borrowings or borrowings for uneconomic projects.

Transparency Should Improve Debt Management

Comprehensive budgeting and fiscal transparency among LRGs would help the central government meet its interconnected targets of guarding against aggressive LRG borrowing and better directing the allocation of funds. The blueprint suggests that the governments should more frequently tap the bond markets to finance urban infrastructure projects. These moves would likely strengthen internal and market discipline over LRG borrowings. The lack of fiscal transparency has led to unproductive spending or overspending among some LRGs because of weak financial management or corruption. Under the new reforms, governments with weak credit profiles or intending to undertake relatively unproductive projects will likely face higher funding costs and reduced access to borrowing channels than their peers. This should scale back their borrowing capacity.

Public financial accounting will aid investment decisions

The central government's aim for LRGs to report comprehensive financial statements would alleviate a long-standing headache for investors struggling to gauge LRGs' financial health. Weak debt disclosure sometimes stems from concern among local officials that the financial strength of their LRGs could be misread. If these LRGs disclose only their debts, some investors may conclude they are over-indebted. This could have negative implications for the governments' image and borrowing capacity. Under a comprehensive financial reporting system that consolidates LRGs' various assets--such as net investments in state-owned enterprises--many governments would likely be more comfortable with enhancing their fiscal transparency, in our view.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 20, 2013 3

1219106 | 301447691

China's Reform Blueprint Bodes Well For Taming Local Government Debt

Rationalized Intergovernment Arrangements

The central government's aim to cut "unfunded mandates" would reduce the LRG's funding shortfall and the related excuses for LRGs to borrow heavily, in our view. Under unfunded mandates, the central government asks local authorities to carry out some policy initiatives, but doesn't provide them with sufficient funds to do so. In 2008, for example, LRGs were pushed to provide a large proportion of the funds needed for the RMB4 trillion stimulus package that the central government introduced in response to the global financial crisis. At that time, LRGs grabbed the opportunity to borrow for their own projects, contributing to the hike in LRG debt in 2009.

Success Will Hinge On Market-Oriented Reforms

Many other measures and initiatives under the blueprint suggest LRG debt could be reined back in the coming years. For example, a new alert system will warn central and respective local governments when LRG indebtedness crosses a certain risk measure. But over the next three to five years, it's still possible that the central government will allow LRGs to borrow heavily to make large-scale investments. That scenario may materialize if market-oriented reforms proceed too slowly to achieve the central government's GDP growth target through the vibrancy of the private sector and by keeping state-owned enterprises at arm's length from LRGs. Robust growth remains a top priority for China's new leadership at a time when the economy has started to lose steam after a blistering decade. Overall, the taming of LRG debt will pivot around the success of market-oriented reforms.

Related Criteria
Sovereign Government Rating Methodology And Assumptions, June 24, 2013

Related Research
Credit Quality Varies Widely Among China's LRGs; Information Gap Complicates Assessments, Feb. 15, 2012 Strengthening Public Finance Institutions Will Likely Help China Manage Its Rising Local Government Debt, Sept. 28, 2011

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 20, 2013 4

1219106 | 301447691

Copyright 2013 by Standard & Poor's Financial Services LLC. All rights reserved. No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor's Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an "as is" basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT'S FUNCTIONING WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages. Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P's opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof. S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process. S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription) and www.spcapitaliq.com (subscription) and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 20, 2013 5

1219106 | 301447691