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Beijing reins in local governments

…the emperor is far away

One of the first things I heard from old China hands when I began looking at the country twenty some odd years ago was, “The mountains are high and the emperor is far away.”  Whether this is a good translation of the old saying, the point remains the same.  It means: a traditionally weak central government in Beijing will be unable to control the actions of provincial authorities.

The local authority head may at times find himself facing decisions among conflicting interests.

On the one hand, as a state employee and a Communist party member he is evaluated and gets promoted based on his ability to create economic growth.  He also maintains his reputation among his constituents by providing jobs.  And, in some cases, he may receive “gifts” from real estate developers or construction companies if he provides them work.

On the other, he is a state employee and a party member.  So he’s supposed to do what Beijing tells him.  That’s ok during expansionary periods, but at times like this when fiscal stimulus is supposed to stop, it’s not so easy.  Historically, local areas have simply ignored, or partially ignored, Beijing’s mandates to slow things down.

the cat-and-mouse game

In the cat-and-mouse game of making rules (Beijing) and finding loopholes (the locals), several rounds have already been played, including a prohibition by Beijing of local governments’ guaranteeing the borrowings of private industry projects–like apartment blocks or factories.  This is more important than it sounds.  Since the bank managers are also state employees and possibly party members, if the mayor or governor–much higher-ranking in both organizations–come to the bank to plead the cause of a given firm, it’s very hard to say no.

Always creative, local Chinese governments have taken a page from the playbook of commercial banks across the world.  Facing lending actions barred to banks, those institutions have simply created non-bank subsidiaries to perform the outlawed lending.  Local Chinese governments have done the same.  They’ve created investment companies which either borrow directly to finance building or issue loan guarantees that are implicitly backed by the government.  This is also similar to the actions of the US federal government in fostering the over-leveraged and now effectively bankrupt mortgage-lending entities, Fannie Mae and Freddie Mac.

Beijing’s latest move

In the next turn of the wheel, according to Bloomberg Beijing has just announced that local government guarantees of lending through such investment vehicles are improper and won’t be honored.  China will also quickly legislate to make future activity of this type illegal.

Implications:

In the long term, they’re distinctly positive, since this move shows Beijing is making greater efforts to achieve a coordinated country-wide economic policy.   Also, we’re likely to see far fewer low value-added, highly polluting chemical plants and steel mills.  Probably, fewer new sports stadia and empty apartment blocks will dot the landscape.

In the near term, some of this non-economic activity will grind to a halt.  That in itself is a good thing,  And it will also aid Beijing in cooling down the overall pace of growth.  Eliminating some new export-oriented manufacturing plants will help the central government’s aim of promoting domestic consumer-oriented growth, as well.

Certainly, there will be some near-term problems.  Economically speaking, the money spent on make-work projects has already been lost.  But some banks will now be faced with an increase in non-performing loans.  According to Bloomberg, the biggest problems will emerge in more rural areas in the north and west of China, where local governments apparently have been creating “me-too” projects in the hope of repeating the success of their southern and eastern counterparts.

For publicly traded financial institutions, those listed in Hong Kong are unlikely to be affected, I think.  For domestic banks listed on mainland exchanges, however, the situation is less clear.

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