China could face a “debt iceberg” and “titanic” credit risks, ratings agency S&P Global has warned. He estimates that off-balance sheet debts of Chinese municipalities could reach 30–40 trillion yuan ($4.5–6 trillion) due to their investments in infrastructure projects.

For many years, Chinese municipalities were not allowed to independently enter the debt markets; for this they created special financial organizations. Money was needed to finance infrastructure projects needed to achieve target GDP growth rates. These organizations have become the main source of project financing and a key driver of economic growth.

But by the end of 2017, the debt of such companies reached 60% of China's GDP. And its further growth will lead to their default, warns S&P. “Some cities already have hundreds of these financial institutions,” says S&P analyst Richard Langberg. In his opinion, the default of small organizations can be allowed: “But if they allow large ones to collapse, it is not known what this will lead to.”

This year, China allowed municipalities to issue bonds to address their off-balance sheet borrowing problem. The government is also trying to implement strict banking reforms that will reduce access to off-balance sheet borrowing.

But these financial institutions continued to actively borrow money. It is difficult to estimate such debts of municipalities, notes S&P: most of their loans are hidden behind the balance sheet. The actual size of the debt may be many times higher than official estimates.

Moody's estimates that municipal financial institutions' debt exceeded $8.5 trillion at the end of August. "This is just an estimate of the hidden debt burden of Chinese municipalities," said Moody's analyst Amanda Du.

Complicating the situation is that the creditors of these financial institutions are mainly small and medium-sized regional banks. “For many years we treated this debt as a government debt, but that was a mistake,” said Kevin Lai, chief economist at Daiwa Capital Markets. “It’s too big for the government to help without turning on the printing press.”

Some municipal financial institutions are already in a difficult situation. Xinjiang Production Construction 6th Shi, owned by one of the municipalities, defaulted on short-term debt securities worth 500 million yuan ($73 million) in August. This has raised doubts about whether the government will support other such organizations. “Much of the debt of such organizations will come due this year, and the government’s struggle with debt has led to rising borrowing costs for them,” said Diana Choileva of Enodo Economics. “It appears that the Xinjiang incident did not happen by accident.”

Fighting such financing could slow China's economic growth. According to the consensus forecast of analysts surveyed by Reuters, the country's GDP growth rate in the third quarter will be 6.6%. Official data will be published on Friday. However, even without this, the growth rate of the Chinese economy is expected to decline in the coming years. Another factor in the economic slowdown is the trade war with the United States, which will negatively affect the economy.

Translated by Alexey Nevelsky

China is threatened by a “debt iceberg”