Jason Lee / Reuters Chinese 100-yuan banknotes.

China's Big Debt Swap

How Beijing Is Handling Local Liabilities

Chinese Premier Li Kegiang did not spare words when he spoke to the National People’s Congress and the People’s Political Consultative Conference last week. “With downward pressure building and deep-seated problems in development surfacing,” he warned, “the difficulties we are to encounter in the year ahead may be even more formidable.”

China’s economy does face challenges. Last year, the country’s GDP expanded by just 7.4 percent, the smallest increase in 24 years. In response, Beijing lowered its GDP growth target to around seven percent for 2015. And, local debt is soaring, which is complicating China’s transition from economic growth fueled by investments and net exports to growth fueled by consumption and innovation.

Nevertheless, Li’s address heralded huge shifts in the ongoing efforts by the Chinese reformers to restrain the growth of local debt and thus pave the way for accelerated reforms. Only a few days after he spoke, Beijing launched an estimated $160 billion debt-swap deal, in which local governments’ risky liabilities will be replaced with low-interest municipal debt.

DEBT BUBBLE

Unlike the advanced economies, China’s national debt is not unsustainable. In 2014, gross government debt accounted for only 20 percent of GDP. In the European Union, it exceeded 90 percent; in the United States, 105 percent; and in Japan, it is close to 250 percent.

Local debt, however, is a different story. In China, local government comprises over 30 administrative divisions, including 22 provinces, a number of megacities, and autonomous regions. Their debt soared after 2008–09, when the global financial crisis spread to Asia. That’s when Beijing resorted to a four-trillion renminbi ($640 billion in today’s dollars) stimulus package.

Initially, the infusion of liquidity spurred confidence and contributed to the modernization of China’s national infrastructure. It even helped along the recovery in the West. As the profits of U.S., European, and Japanese multinationals plunged in the advanced economies, business thrived in China.

At the same time, though, excessive liquidity led to increased speculation in property markets, and substantial overcapacity in construction, which

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