Financial markets in the developed world are intently focused on the taper that the U.S. Federal Reserve began on Dec. 18. In January, the Fed will buy only $75 billion in Treasuries and mortgage-backed assets instead of $85 billion. And the likelihood is that by the end of 2014, the Fed will have reduced its monthly purchases to $0.
Higher yields on Treasuries are certain and higher interest rates across the yield curve are likely. If interest rates move high enough and fast enough, they could slow or even sink the U.S. economy. At least that's what worries the financial markets.
But there's another taper taking place now, too -- one that also has the power to slow a major world economy and disrupt global financial markets.
In China, the People's Bank is trying to reduce a flood of debt in, first, the unregulated shadow banking sector, and, second, among local governments. The danger here is that if the central bank stomps too hard on the brakes it will slow the Chinese economy below the government's target of 7.5% GDP growth for 2014, but that if the People's Bank doesn't move quickly enough the level of debt will continue to soar until it gets big enough so that it forces a major government bailout like the one Beijing conducted after the Asian financial crisis of 1997.
The National Audit Office posted the latest debt figures from the local government side of the ledgers on Sunday, Dec. 29. Local government debt (including debt guaranteed by local governments) rose to 17.9 trillion yuan (about $3 trillion dollars) in the first six months of 2013. That's a 13% increase in the first six months of the year. And it follows on a 48% increase in the last two years.
A 13% increase in the first half of 2013 isn't a slowdown and that's got to be worrying for the People's Bank, since this increasing level of debt is built on an eroding revenue base. China's local governments account for about 80% of government spending, according to the World Bank, but receive only 40% of taxes. Local governments have made up the difference from other sources such as land sales to developers and by borrowing through financing units set up to fund capital projects. (China's local governments are not permitted to issue bonds directly.)
The first of those revenue streams has been curtailed by a slump in real estate development in some areas and efforts by the central government to pay more attention to how local governments "acquire" the farmland that they sell with minimal compensation to local farmers. And the second of these revenue streams is under pressure from efforts by government regulators to reduce borrowing by these affiliated financial units and by markets that are increasingly skeptical that the revenue from these projects is anywhere near enough to cover the interest on this borrowing.
This creates a big problem for financial regulators and officials at the People's Bank. The only way that local governments can stay current on this debt is to raise more money from real estate sales or to borrow more in the shadow-banking sector. That means any effort to prevent China's real estate market from overheating quickly becomes a problem for debt burdened local governments. Any effort to let the markets set (higher) interest rates or to restrict the growth of the shadow banking sector that provides one market for the debt of local-government-affiliated financial units threatens the ability of local governments to roll over their debts.
This doesn't mean that the recently announced efforts to give the market a bigger role in setting interest rates are doomed to failure or that regulators won't have any success in reducing the size of the shadow banking sector. It does mean that local governments are likely to fight tooth and nail against that threatens their ability to fund this debt. And it does mean that China's central institutions, such as the People's Bank, are more likely to make a mistake as they try to apply enough force to overcome this local resistance.
The traditional Chinese observation "The mountains are high and the emperor is far away" comes to mind.
The likelihood is that Chinese taper will be a bigger source of market volatility in 2014 than that other taper from the Federal Reserve.