Download Discussion of *The Great Wall of Debt: Real Estate, Political Risk

Discussion of “The Great Wall of Debt: Real Estate,
Political Risk, and Chinese Local Government Credit
Spreads”
Andrew Ang, Jennie Bai, and Hao Zhou
Jasper Hoek
Board of Governors of the Federal Reserve System
2016 Pacific Basin Research Conference
Center for Pacific Basin Studies, Federal Reserve Bank of San Francisco
November 18, 2016
Disclaimer: The views expressed in this presentation are those of the presenter and do not
necessarily represent those of the Board of Governors or the Federal Reserve System.
Background
• Lively policy debate on role local
governments play in China’s debt
expansion, but little research
• Problem: lousy data
• National Audit
• Local government financing vehicle
(LGFV) bonds
• Ang, Bai, and Zhou (ABZ) is one
of the first papers to make use of
LGFV bond data
This paper’s story
1.
2.
3.
4.
5.
6.
7.
Local government financing vehicles’ (LGFV) credit spreads are determined by the
creditworthiness of the local governments backing them.
Use of land-use rights as collateral for LGFV bonds links them to local real estate
markets.
Local governments have much control over local real estate markets via land sales,
which drives economic development.
In principle, depending on how astutely local governments exert this control, realestate-driven development may either increase or reduce their creditworthiness, and,
in turn, the creditworthiness of the LGFVs they implicitly guarantee. In practice, it
appears to increase local governments’ creditworthiness.
Local governments’ control over land-use rights also opens the door to rent-seeking
and hence political corruption.
In principle, corruption could facilitate more deal-making, thus promoting economic
development, but in practice it appears to hinder economic development and thus
impair local governments’ creditworthiness.
Moreover, corruption mitigates the beneficial impact of real-estate-driven
development on local governments’ creditworthiness.
The evidence
1. Despite the existence of implicit government guarantees, LGFV
credit spreads vary across provinces and over time.
2. Regression of LGFV excess bond yields on province-level real estate
and corruption proxies, and their interaction, shows that credit
spreads are:
• Negatively correlated with importance of real estate in a province
• Positively correlated with presence of political corruption
• Positively correlated with the interaction of corruption and real estate
development
The implicit guarantee
• One of the most interesting contributions of the paper is to add nuance to the notion of the
implicit guarantee in China.
• Common perception is that the implicit guarantee is very strong because bonds are rarely allowed
to default.
• But the fact that: (a) collateral is required at all, and (b) bond prices vary with the value of
collateral suggests that, contrary to popular perceptions, there is some market discipline on local
government finances.
1)
But doesn’t tell us how strong investors perceive the implicit guarantee to be. For that, we
need to know the counterfactual of yields on similar debt that doesn’t benefit from a
guarantee.
2)
The story ABZ tell is focused on the strength of the local governments ability or willingness to
back the debt. But there is still the question of why the central government guarantee of local
government debts doesn’t eliminate variation in spreads.
The real estate effect
1. Focus on explaining crosssectional variation in bond yields
exposes estimates to potentially
serious omitted variable bias.
o Example: Real estate GDP strongly
correlated with GDP per capita across
provinces, which presumably affects
credit risk but is not controlled for.
o Would be more convincing if
controlled for province fixed effects.
Unfortunately, not much withinprovince variation over time.
The real estate effect
2.
Reverse causality—low yields may drive investment in real estate, rather than vice
versa. Could use lags of real estate GDP but, again, not enough time variation in this
measure.
3.
Province-level real estate GDP is a pretty noisy measure of the local real estate market
conditions that may be affecting the credit risk of a given LGFV.
• Most LGFV debt is at the municipal and county level.
4.
The precise connection between real estate GDP and credit spreads is murky.
• ABZ’s “growth engine” story: real estate development -> stronger tax revenues -> stronger fiscal
position of backing local government -> implicit guarantee worth more -> lower credit spreads
• Alternative real estate-driven story: real estate market strong -> collateral worth more -> lower
credit spreads
The corruption effect
• Similar issues apply to the estimates of the effect of corruption. Ideally, would
control for province fixed effects, but corruption proxy does not vary over time
• Provinces that are poorer and have weaker institutions may be more susceptible
to corruption and also have higher credit risk. But this does not imply that
corruption is driving up credit spreads by “destroying value”.
• What to make of the fact that corruption appears to explain some cross-sectional
variation in credit spreads but credit spreads don’t generally rise after corruption
announcements?
• Taken at face value, suggests that graft probes don’t in and of themselves reveal any
information and/or affect the likelihood of default.
• Another interpretation is that corruption itself does not have much of an effect on credit
spreads, but is correlated with unobserved variables in the cross section.
Some suggestions
• Tie municipal LGFV credit spreads to real estate market conditions in that
municipality, e.g., property prices, sales, land sales? More time variation,
closer correspondence with LGFV risk
• Use non-LGFV SOEs and/or private firms in the same municipalities as
“control” groups?
• Still problematic, but could give more insight into strength of implicit guarantee on
LGFV debt.
• E.g., Compare LGFV and non-LGFV reaction to regulatory announcements cracking
down on implicit guarantee.
• Tie corruption probes more closely to specific municipalities or firms.
• Include LGFV-level controls in the analysis (e.g., leverage, profitability).
Policy implications
• Bond swap currently underway appears to be imposing a haircut on
holders of debt
-> Investors were right to price in credit risk
• But there appear to be few repercussions for local governments
• Highlights importance of the fiscal reform to address local government
incentives.
• Proving very hard to implement because local government have significant
financing needs and central government relies on local governments to
prop up growth.