Category: General Finance

China’s Growing Local Government Debt Burden

1.27.16 Chinas Growing Local Government Debt BurdenHigh rates of debt growth by local governments are a cause for concern in any country. In China, where recent turmoil in the equity and foreign-exchange markets has put a spotlight on that country’s economy and growth prospects, increasing levels of borrowing by provincial and other lower levels of government has resulted in local indebtedness rising nearly fourfold since 2008, reaching about 40 percent of GDP.

Debt growth of that magnitude raises concerns about fiscal sustainability, debt affordability, transparency and accountability. Cautionary tales abound. From New York City in the ‘70s, emerging market countries in the ‘80s, Russia in the ‘90s, and Detroit, Greece and Puerto Rico more recently, there is a long list of governments that have experienced the painful economic repercussions of taking on debt they could not afford.

A new policy brief from the MIT Center for Finance and Policy by Xun Wu, a visiting scholar at the Center, suggests that while the massive debt buildup in China presents challenges, the situation is not as dire as a full-blown debt crisis. In fact, Chinese policymakers appear to be taking steps to mitigate the risks, including shutting down some of the more opaque financing channels and operations that facilitated the explosion of local debt in recent years.

Moreover, the central government of China is taking measures to restructure local debt—pointing to the possibility, and perhaps likelihood, of a larger bailout should debt levels become unmanageable. While further measures may be necessary, local debt levels also may stabilize if the pace of public infrastructure investment slows as China’s voracious appetite for public works is finally satiated.

However, a structural imbalance between local government spending and access to tax revenues remains a fundamental tension that has yet to be addressed. The central government ultimately has political and financial control over the entire public sector, and policies and regulations emanating from Beijing dominate borrowing and budgetary decisions. Currently local governments receive about 50 percent of taxes collected but are responsible for about 80 percent of expenditures. The resulting gap continues to be filled from other sources, primarily through borrowing and land sales.

As for differential impacts across the country, China’s more affluent eastern provinces have the greatest levels of debt in absolute terms, but as a share of local GDP their burden is manageable compared with the poorer western provinces.

China’s situation is complex as the country attempts to turn its government-dominated economic growth model into a market-oriented one. From that perspective, how it manages its local fiscal imbalances will be telling about the commitment to and speed of those larger changes.

The policy brief, which can be found here, is the first in a series of CFP Policy Briefs that will highlight innovative research conducted on issues residing at the intersection of finance and policy. The aim is to provide accessible, objective, quantitative, and non-partisan analyses that further public policy discourse and help inform decision-making in the public and private sectors.

Who pays when Greece defaults on the IMF?

Greece recently failed to pay $1.7 billion due to the IMF, thereby becoming the first developed country to default on an IMF loan. That missed payment represents only a portion of the approximately $23 billion in IMF credit outstanding to Greece, suggesting the ultimate losses to the Fund could be much bigger.

The good news is that the potential losses are small in comparison to the IMF’s $350 billion in pledged resources from its members. Barring massive contagion, there is no threat from Greece to the Fund’s solvency.

Nevertheless, the costs to the IMF are likely to be significant. And ultimately it is the taxpayers from the IMF’s 188 member countries that will bear them. The losses are distributed unevenly because membership shares across countries vary widely. The U.S. holds the largest stake, at 17.6 percent of the total. The next largest shares belong to Japan, Germany, France, the UK and China, at 6.6, 6.1, 4.5, 4.5 and 4.0 percent respectively.

The IMF’s opaque financial disclosures and the vagaries of member government accounting practices will allow those taxpayer losses to go largely unnoticed. Member exposures arise through their “quotas,” which are obligations to deposit funds with the IMF. The deposits are backed by the IMF’s substantial holdings of gold, its loans and other assets. The IMF offers a succinct description of its funding structure here.

Some contend that quota payments made to the IMF are investments and not a taxpayer expense. They argue that balances earn interest at the fund and can, at least in theory, be withdrawn if a participating country so chooses. However, when the price of an investment exceeds its value, the investors take an immediate loss. When the IMF offers financing at concessionary terms to distressed countries, it provides subsidies that are paid for by taxpayers. Those subsidies are much smaller than the total amounts paid in, but nevertheless significant.

Of course the benefits of the IMF’s support of the international monetary system and aid to troubled economies may greatly exceed the associated costs to member countries. The point here is that in the interest of transparency, it is worthwhile to quantify the costs (and benefits) more carefully than has typically been done. Work at the CFP has looked at the cost of related guarantees – such as our work to evaluate the cost of government credit support in the OECD context – but we have not yet studied the IMF deeply.

Apart from IMF loans feeling a bit like play money, another factor that may have muted the repercussions in financial markets of Greece’s default to the IMF is that the event didn’t trigger payments on Greek CDS contracts. This is a reminder that CDS contractual terms do not always align with one’s intuitive notion of what constitutes a default, and complicates the relation between CDS pricing and bond valuations.

Professor Deborah Lucas is the Sloan Distinguished Professor of Finance at MIT’s Sloan School of Management, and the Director of the MIT Center for Finance and Policy. Doug Criscitello is the Executive Director of  the MIT Center for Finance and Policy.

For more information, please visit the CFP website http://cfpweb.mit.edu.

How much do natural disasters really cost corporate America?

See the original article posted on Fortune here>>

Sales growth of supplier firms directly hit by a natural disaster drops by around five percentage points, according to a study.

As spring begins in New England after record-setting snowfall this winter, the economic consequences of natural disaster are a common topic of discussion. We know it will have a big impact on New England, but will it affect other parts of the country? If so, who will be affected and how much?

We hear these types of questions a lot following any type of disaster whether it is weather related or not. For instance, the fear of contagion was at the root of the decision of the U.S. government to bailout Chrysler and GM in 2008. Surprisingly, Ford’s CEO Allan Mullaly himself advocated the bailout of his two competitors in front of a U.S. Senate committee, as he recognized that “the collapse of one or both of our domestic competitors would threaten Ford because we have 80% overlap in supplier networks and nearly 25% of Ford’s top dealers also own GM and Chrysler franchises.”

So the key question is: When a shock — like a natural disaster or financial crisis — hits a supplier, what really happens to the firms in that network? Is there a spillover effects? To address this issues, we studied the transmission of shock caused by natural disasters in the past 30 years in the U.S. within the supply chain of publicly traded firms. We analyzed a sample of 2000 large corporations and 4000 of their suppliers.

You’d think that at a firm level, shocks could easily be absorbed in production networks. Even when they face disruptions, firms are supposedly flexible enough to change their production mix or switch to other suppliers. However, our study showed that shocks cause significant effects in production networks.

First, we found that the sales growth of supplier firms directly hit by a natural disaster drops by around five percentage points. The customers of these suppliers are also disrupted, as their sales growth drops on average by two percentage points when one of their suppliers is hit by a natural disaster. This is a strikingly large effect. We also found evidence that customers with lower inventories are the most exposed to disruption affecting their suppliers.

Then we investigated whether the drop in firms’ sales caused by supply disruptions translates into value losses. Our study shows that supply disruptions caused a 1% drop in customer firms’ equity value. This effect is almost twice as large when the disrupted supplier is a specific supplier, meaning a supplier producing differentiated goods, generating high R&D expenses, or holding patents.

Finally, we looked at whether the shock originating from one supplier propagates to other suppliers of the same firm, which were not directly affected by the natural disaster. You might expect that firms would continue to buy from other suppliers outside of the natural disaster zone, or that the other suppliers would find alternative buyers. However, our research shows large negative spillovers of the initial shock to other suppliers. We found that other suppliers of a main customer see a drop in sales growth by roughly three percentage points.

These findings highlight the presence of strong interdependencies in production networks. In other words, production networks matter. When one of your suppliers or customers is experiencing a negative event, there will be important implications for you.

This research likely applies to contexts beyond natural disasters, such as strikes and financial recessions. More generally, shocks that originate in one part of the economy can be amplified because of the strong interconnections between firms.

As for the economic impact of the weather in New England this winter, there is good reason to think that the effects will be propagated to other parts of the economy through relationships that Massachusetts firms have with customers all over the country. But who will be affected and how much? We’ll have to wait and see.

Jean-Noel Barrot is assistant professor of finance at the MIT Sloan School of Management. Julien Sauvagnat is a postdoctoral researcher at ENSAE-CREST and is expected to join Bocconi University in September 2015.