How is China's municipal debt problem different from that of the U.S.?
I heard that most of the local government debt is off-the-book. Is
this the case for the U.S. also, which also somewhat has a problem
with the debt the states are raking? And if it's different, why is
China trying to put the local debt from their local government
off-the-book and what advantages does it give? It's not like they
won't have to repay it, so why keep it off-the-book?
I can't speak much to the Chinese situation, although it is clearly corrupt and unsound compared to U.S. municipal bonds, but I am much more familiar with the U.S. side.
There isn't really a U.S. municipal debt problem at all.
The U.S. has a federal government debt problem, but it doesn't have a municipal debt problem.
Full disclosure: very early in my legal career I did municipal bond due diligence and prepared municipal bond prospectuses.
State and local government debt is highly regulated under state law. The federal government also supervises the municipal debt industry, primarily through IRS regulation of eligibility for one of several kinds of tax-exempt bonds.
Certainly, some U.S. municipalities are more sound fiscally than others, but in general, this is a low risk area and municipalities do not tend to be overextended with debt.
In many states, most municipal bonds have to be approved by voters on a regular basis and the process of presenting these bonds for approval also results in another layer of transparency and checks and balances. Absent strict requirement for voters and/or legislative approval for issuing new state and local debt, most state and local governments are required to have balanced budgets, so municipal debt rarely reaches the level of the U.S. government federal debt and deficit spending for things other than capital improvements is rare.
Local governments tend to have stable revenue streams like property taxes as a strong base to support their municipal debt. Private enterprise bonds for government owned businesses which aren't supported by taxes (like airports and convention centers and stadiums) usually have quite conservative financial projections about the ability to repay. State government revenue sources like income taxes, mineral revenue, sales taxes, and public college tuition, are more variable, but since they are typically from a mix of sources, somewhat balance out.
The bond rating agencies for municipal bonds in the U.S. are not corrupt (certainly they are much less corrupt than the agencies that rated mortgage based securities during the financial crisis).
The lawyers who do the due diligence for municipal bond issuances are an elite, cohesive, seasoned, and through bunch of professionals (in part, because municipal bond investors tends to be one of the most affluent group of bond investors and sue if municipal bonds default or if there is fraud).
Even an isolated default on a rural cemetery district or irrigation district bond, the smallest and lowest stakes kind of local government debt there is, makes headlines in the municipal finance community and tarnishes the reputations of the professionals involved if they weren't sounding the alarm early on.
Secret deals and accounting mischief in municipal debt in the U.S. is the very rare exception.
Municipal bond default rates in the U.S. are very low
Defaults on municipal bonds in the U.S. are exceeding rare, result in only modest losses to investors in most cases when they happen, and only quite rarely impose hardships on state and local governments when they occur.
Just 800 private business companies (less than 5%) have investment grade bonds out of 23,000 U.S. companies with revenues over $35 million whose credit was reviewed by bond rating agencies. But, only about 1,800 companies with non-investment grade credit ratings, however, have actually issued publicly traded bonds (aka "junk bonds" aka "high yield bonds"). So, about 30% of publicly traded bonds are investment grade, less than 1% of investment grade bonds are AAA, and only about 0.2% of publicly traded bonds are AAA rated. Companies with sales of less than $35 million per year are not eligible for an investment grade bond rating. An investment grade bond rating, in practice, roughly corresponds to a "large capitalization" stock, although in principle, bond ratings are not directly dependent upon market capitalization. The rating system at Standard and Poors and at Fitch ranks investment grade bonds as follows (Moody's equivalent rating):
Bonds with ratings below BBB- or Baa3 are called "junk bonds" or "non-investment grade" bonds in contrast to investment grade bonds.
Historical default rates vary greatly, but in the S&P system through 2007, averaged about 0.6% for AAA, 1.5% for AA, 2.9% for A, 10.3% for BBB (the lowest investment grade), and 29.9% for BB, 53.7% for B, and 69.2% for any kind of C rating (the junk bond ratings). This is measured over the life of the long term bond and is not an annual default rate.
Historical default rates on municipal bonds are much lower than default rates on corporate bonds with the same rating until 2010 when Moody's and Fitch abolished the separate system (S&P abolished the separate system in 2001). More recent municipal bond issues are rated on the same scale as corporate bonds. For example, in the old system, S&P BB rated municipal bonds have about the same default rate on average as S&P AA rated corporate bonds. Investment grade municipal bonds as rated by any major bond rating agencies under the old system have default rates lower than AAA rated corporate bonds.
Within municipal bonds, there are two main categories, general obligation bonds, supported by the taxing power of the government, and private activity bonds, supported only by a government owned enterprise like an airport or government owned utility.
The former almost never default. For example, there were just 3 defaults on general obligation municipal bonds in the entire United States, from about 35,000 municipal bond issuers, from 1970 to 2009. Even in those three cases, none of those defaults was a total loss or anything close to a total loss for municipal bond investors.
The latter default at rates comparable to investment grade publicly held companies. Municipal bankruptcies are rare. For example. there were just twelve Chapter 9 bankruptcies filed in the calendar year 2014, out of roughly 90,000 local government entities that could issue bonds and declare bankruptcy under Chapter 9 (many of which issue multiple classes of bonds outstanding but default because they become unable to pay only certain private activity bonds for a single activity). Also about 10-20% of private activity bonds are reinsured by municipal bond insurers such as National/MBIA, Radian, CIFG and Syncora/XLCA, FGIC, ACA, Berkshire (BHAC), Assured Guarantee (AGO), and Financial Security Assurance (FSA), effectively reducing the risk for investors in these bonds even further and typically bringing them at at least an A credit rating.
As of 2011, according to Slate:
[H]istorically, their rates of default come in around one-third of 1
percent, far lower than the rates for, say, corporate bonds. Thus,
investors around the world own about $2.8 trillion in American
municipal debt—an amount that has more than doubled in the last decade
and increased about 35 percent over the course of the recession. . . .
Municipalities issue two main classes of bonds. One comes with a
"general obligation" pledge, meaning that the government agrees to
raise taxes or take other measures to pay bondholders back. But they
also issue riskier "non-GO" bonds, or revenue bonds—often to fund the
construction of things like hospitals, universities, and housing
complexes. It's those bonds where the defaults happen, for the most
part. According to Moody's Investors Service, between 1970 and 2009,
municipalities have defaulted on Moody's-rated debt only 54 times, and
51 of those defaults came from bonds to finance things like housing
projects. . . .
[D]efaults on non-GO debt—for things like hospitals and housing
projects, debt already considered more risky—are happening at a slower
rate than in years past. The National League of Cities notes that
there have been at least 72 defaults this year, down from 204 in 2009
and 162 in 2008. Considering the thousands of bonds issued in the last
decade by the 50 states,19,000 cities, 4,000 counties, 15,000 school
districts, and tens of thousands of individual projects—that's not too
State governments and territories like Puerto Rico, are not allowed to file for bankruptcy and on rare occasions do default on their debts (nine states defaulted on their debts in the 1840s, for example). But this has grown most less common in the post-WWII era.
A brief period when California was issuing IOUs in the financial crisis was probably the most notable, but almost no bond investors or trade creditors of the state were impaired in the medium to long term, a few months delay in payment was pretty much a worst case scenario.
China's bond markets are corrupt
In contrast, in China, as of 2015, around 97% of existing yuan-denominated bonds hold ratings of double-A to triple-A—the best a company can get.
(The source for this is from Fiona Law at the Wall Street Journal, cited by Christopher Balding, and ultimately Alex Frangos via Marginal Revolution.)
Basically, the bond ratings of all publicly listed Chinese companies were wildly overrated. Meanwhile, a Chinese government agency, the China Securities Finance Corp (CSF), central bank-backed refinancing institution, was as of 2015 "among top 10 shareholders of many listed-firms" as Chinese regulators have stepped in to prop up a collapsing stock market. Effectively, this is turning what had until recently been a mostly theoretical communist basis of the Chinese economy into one in which state ownership of enterprise is again rapidly becoming the norm.
In China, the corruption in the big business corporate bond sector spills over into the municipal bond sector.
China's underlying municipality economic environment is more turbulent than the U.S.
China is a society in wild economic transition with huge cities popping up all over the place every new decade from seemingly nothing. Even basics like property rights are in flux there.
In contrast the economic situation of most U.S. state and local governments is much more stable and stagnant. Debt markets do better in stable economic times (comparatively). The relevant property rights and legal framework have changed only modestly since the late 19th century in the U.S., and when it has changed, has made municipal bond risks lower and made municipalities less overextended.
For example, most municipalities now outsource management of their defined benefit pensions to state government, removing a major potential source of financial management problems and default risks for smaller, less professionally run, local governments.