One of the most persistent among the economic and financial problems challenging the Chinese government is the high level of local government debt, particularly as China relies on an investment and debt-driven model to boost the economy and urbanization.
After reforms to the tax sharing system between central and local governments in 1994, which granted local authorities more fiscal and financial power, almost all local governments established urban investment companies and State-owned enterprises (SOE) to promote local urban construction and development.
Supported by State-owned financial institutions and favorable land policies provided by local authorities, urban investment companies experienced explosive growth, most through aggressive borrowing and leveraging strategies, especially after 2008, when China resorted to a massive stimulus in response to the global financial crisis. In the meantime, urban investment companies have become the largest debt bearers of local governments.
However, as China’s economic growth slowed, the model proved unsustainable as debt reached dangerous levels. In the past years, as China launched efforts to deleverage, a large number of urban investment companies have faced problems of capital outflow, and some are struggling to survive. Among the most prominent recent case is the Yunnan Metropolitan Construction Investment Group (YMCI).
Established in 2005 by the provincial government of Yunnan in Southwest China, YMCI expanded rapidly in the past decade, with total assets increasing from 10 billion yuan (US$144m) in 2008 to over 300 billion yuan (US$21b) by March 2019.
The company’s landmark project is the Kunming Dianchi International Convention and Exhibition Center, built in 2012. The project was launched as a part of provincial efforts to build capital Kunming into a regional trade hub linking China to South and Southeast Asia.
Dubbed by some as one of China’s many vanity projects, the exhibition center involves an investment of 30 billion yuan (US$2.1b) and covers an area of 5.4 million square meters, making it China’s third-largest exhibition center. To compensate for YMCI’s investment, Yunnan handed the company the land surrounding the exhibition center for real estate development. This model is common for urban investment companies throughout China. Under such a model, local governments need urban investment companies to support their infrastructure construction, and in return, these companies receive valuable land resources to develop real estate.
But the result is that many urban investment companies are focused on securing star projects to obtain more land, rather than on the management and profitability of these projects. This poses a long-term threat to their financial health.
In the case of YMCI, the once-glamorous exhibition center turned out to be a major financial burden. In the first quarter of 2019, for example, the center generated an operating income of 15 million yuan (US$2.2m), while recording a net loss of 194 million yuan (US$28m).
But with political support from the Yunnan government, a booming real estate market and plenty of land to use, YMCI’s primary focus was on capital operation and expansion rather than improving the management of the existing business.
In 2014, YMCI ventured beyond Yunnan when it decided to enter the real estate market in Beijing. Then in December 2015, it acquired a real estate company in Xi’an, capital of Shaanxi Province. In 2016, the company made high profile acquisitions, including eight real estate companies under the Intime Retail Group with a combined value of 4.4 billion yuan (US$634m). At the same time, it spent 11.8 billion yuan (US$1.7b) to acquire a 51 percent stake in Chengdu Metropolis, based in Sichuan Province.
Then in 2017, it attempted to acquire the entire equity with a transaction price of 23.6 billion yuan (US$3.4b). The deal was widely likened to a snake trying to swallow an elephant, as the market value of YMCI was only 5 billion yuan (US$721m) at the time. Eventually, as regulators stepped in, the acquisition failed.
YMCI’s failed attempt to expand even more appears to be the result of changes in policy. As the local debt problem started to present a major threat to the country’s financial stability, China’s central leadership rolled out policies to curb local governments’ addiction to borrowing. In 2017, local governments were estimated to have raised 4.36 trillion yuan (US$629b), almost 30 percent lower than in 2016.
Contrary to the change in national policies, YMCI continued to expand during the period, with total assets increasing from 45 billion yuan in 2015 to 292 billion yuan by the end of 2018. In the meantime, the company’s debt also surged to 236 billion yuan (US$34b) in the first quarter of 2019.
As China’s economic slowdown persists and the central government continues to roll out more plans to push deleveraging at the local level, the company is starting to feel the chill as it is becoming more difficult to access bank lending.
According to a senior executive involved in the decision-making process within YMCI, in the past years, given the booming real estate market and land resources held by the company, borrowing money was never a problem. “Back then, YMCI was quite picky when choosing which bank to borrow from,” said the executive, who asked for anonymity. But as the real estate market cooled, the company started facing a major liquidity problem.
Then in May 2019 the company suffered a major blow as authorities announced that Xu Lei, chairman and Party secretary of YMCI was “suspected of serious disciplinary violations” and that he had “turned himself in” to law enforcement agencies. Xu’s downfall is believed to be associated with that of Qin Guangrong, former governor and Party secretary of Yunnan Province, who had been put under investigation for corruption just two weeks earlier.
Both hailing from Hunan Province, Xu and Qin’s career paths in politics and business appeared similar. During Qin’s administration in Yunnan, he set a target that some local SOEs’ annual revenue should increase to 100 billion yuan (US$14.4b). YMCI was one of them. It is a typical example of how political considerations influenced the business decisions of China’s SOEs. For YMCI, it appears the only way to reach such a goal was resorting to aggressive financing and large-scale acquisitions.
“The problems with YMCI and other urban investment companies are that we are subject to the influence of local governments, which often focus on short-term performance while ignoring long-term risks,” the YMCI executive told NewsChina.
With the downfall of Xu and Qin, YMCI has steered away from its past strategy. With mounting debts, the company changed course and is selling its assets. In November, the company sold two major assets to Sunac China for 15.3 billion yuan (US$2.2b). The deal includes what many call “the world’s single largest building,” the New Century Global Mall in Chengdu, capital of Sichuan Province.
In the meantime, the company introduced China Poly Group, a mega SOE administered under the central government, as its strategic partner. In July 2019, the Yunnan government signed a cooperation agreement with Poly Group, saying that YMCI will work with Poly Group to push forward a “mixed ownership” reform, a policy launched by the central government in 2017 which aims to introduce more market mechanisms into local urban investment companies to deal with their debt problems.
In October, Yunnan authorities appointed Wei Biao, a former senior executive from Poly Group, as the new chairman and Party secretary of YMCI. Hu Hengsong, assistant president of Caida Securities, who has been studying the transformation of government investment for a long time, told NewsChina that the move may indicate that the cooperation between YMCI and Poly is an administrative decision, rather than a market-based one.
But Hu said that given the land resources held by YMCI, the cooperation between the two, whether an acquisition or a restructuring, may still provide a win-win result.
But so far, neither Poly nor YMCI have provided specifics on the future path of the company.
In a statement released on January 22, YMCI said it estimated the company would record a net loss of between 2.45 and 2.95 billion yuan (US$343-413m) in 2019. It is estimated that the company is liable to pay back 28.7 billion (US$4b) and 30.4 billion yuan (US$4.3b) in 2020 and 2021. Whatever Poly Group’s strategy, it will not be an easy task to salvage one of China’s largest local SOEs.
YMCI’s situation is not unique. According to the 2017 Annual Report on Development of Urban Investment in China, a study co-published by China’s National City Investment Association and Social Sciences Academic Press, more than half of all local investment companies have encountered major financial problems as the central government tightened supervision and regulation in response to the increasing problem of local government debt.
“Now, the question for many local city investment companies is how to survive in a tightened monetary environment,” Hu said.
According to Chen Yurong, a senior researcher with Redetac, a Beijing-based consulting firm, the problems with China’s urban investment companies lie in their fundamental management and personnel structure.
“As local SOEs, not only do these companies have to carry out the decisions of local governments, they depend on local governments for financial support and land resources, which means they lack competitiveness in terms of both profitability and efficiency,” Chen said.
Given the relationship between local governments and local urban investment companies, the financial difficulties faced by companies like YMCI are actually a reflection of the overall debt problem of local governments.
According to China’s Ministry of Finance, outstanding local government debt had reached 21.3 trillion yuan (US$3 trillion) by the end of 2019. To make things worse, China’s 2 trillion yuan (US$280b) tax cut package launched in 2019 as a means to boost the economy lowered the revenue growth of local governments to 3 percent in 2019.
As China’s economy is expected to slow further, the local debt problem will remain a major threat in 2020.