Detroit bankruptcy: There are many debt-ridden local bodies in China too

Problems in municipal debt markets are not limited to the US. On the contrary, they are worldwide and in one country, China, they are potentially much worse

On 19th July a major US city, Detroit in Michigan, defaulted on its bonds and declared bankruptcy. With liabilities of over $18 billion this is the largest bankruptcy of a local government in the US history. The bankruptcy was expected. Detroit had been declining for years. What is still very uncertain is the impact Detroit’s bankruptcy will have on other parts of the $3.7 trillion US municipal bond market. But there is more to it than that. Problems in municipal debt markets are not limited to the US. On the contrary they are worldwide and in one country, China, they are potentially much worse.


The reasons for Detroit’s demise are many and varied. The most obvious is the decline of the US auto industry. No doubt over the years the city’s woes were also due in large part to mismanagement and corruption. But the main problem has to do with pension liabilities and health care costs. Generous benefits have been doled out over the years by city politicians to insure the good will of politically powerful civil service unions. The pension plans were never adequately funded. As Detroit’s population declined from a high of nearly two million in 1950 to about 700,000 today, the shrinking tax base could no longer make up the difference.


It would be easy to dismiss Detroit as a unique event specific to the demise of the car industry, but the political incentives to promise generous benefits without finding the money to pay for them exists everywhere. American states estimate that their pension funds are only 73% funded and this is based on a discount rate that has been termed optimistic, but might be better referred to as simply irrational. A more accurate estimate might be closer to 48%. The total might be as high as $2.7 trillion or 17% of American GDP.


Many states are far more profligate than others. Illinois is the worst with an unfunded pension system equal to 241% of its annual tax revenue. It is hardly alone. Connecticut owes 190%. For Kentucky the number is 141% and New Jersey is 137%. Not all the states are in such bad shape. Some actually reformed their pension plans. Nebraska has an obligation of only 7% of its annual tax revenue. It is followed by Wisconsin, New York and Florida with 14%, 15% and 18% respectively.


As might be expected, the bankruptcy of Detroit will be exceptionally messy and take years of legal manoeuvring as various creditors including pensioners and bondholders face off for access to a shrinking pool of assets. The process will create important legal precedents, but it won’t be the last. In the state of Michigan where Detroit is located, there are five more towns in the same situation. There are many more municipalities just like them all across the country.


So far the municipal bond market in the US has hardly reacted to Detroit’s problems, but this may be a false sense of security. At issue in Detroit are general obligations bonds that are supposed to be supported by the tax payers. They are generally considered exceptionally safe because the politicians can make good just by raising the taxes. But this choice is becoming harder as pension liabilities grow. They now make up an average of 22% of state budgets, providing less money for roads and education. Eventually elected officials or their unhappy constituents will decide that their cities should not be held hostage to older promises or the bond market.


American is not the only country where local governments have cash flow problems. In fact on a relative basis it might be dwarfed by China. There are no municipal bonds in China. Chinese cities have been barred from issuing bonds since 1994, but that does not mean that they didn’t borrow money. Local governments got around the problem by establishing local government financing vehicles (LGFV). There are more than 10,000 of these things. They were established to fund construction of roads, sewage plants, subways, and other infrastructure projects commanded by Beijing to help stimulate the economy. LGFVs may hold as much as 20 trillion yuan in debt ($3.2 trillion). According to former Finance Minister Xiang Huaicheng this figure has doubled since 2011. It equals about 40% of nominal GDP, about twice the level of municipal debt in the US. But no one really knows what the real amount is.


Even the central government is unsure. Beijing began an urgent national audit to determine local governments’ true debt levels at the end of last month. This is not surprising. In 2012 alone growth of the debt in the shadow banking system including LGFVs increased by an explosive 55.3 %. Since many of these infrastructure projects have little or no income, they could easily default. The central bank Governor Zhou Xiaochuan said in March of this year that as much as 20% of the local debt is risky.


The bill is also about to come due. Some 127 billion yuan ($21 billion) of the LGFV notes will expire in the second half of this year, double the 62.7 billion that matured in the first six months. The market is also beginning to take notice. China bond data shows that the yield premium over top-rated notes for one-year AA debt, the most common rating for LGFVs, widened to 67 basis points at the end of July, the highest level since January 16th,. The comparable gap in India is 47.


Although bonds of Chinese companies have defaulted specifically Suntech, which went into bankruptcy earlier this year, there have not been any defaults of publically traded bonds since the central bank started to regulate the market in 1997. This may change. Next year, 208.8 billion yuan of LGFV debt comes due, up 10% from this year and 122% from 2012. Moody’s Investors Service, Chinese rating services and brokerages are beginning to warn that some of the LGFVs might go under. Haitong Securities Company, the second largest listed brokerage, recently forecast that a default could occur in the next six to twelve months. In the past the central government would bail out the locals, but the current administration is bent on reigning in excessive, inefficient and dangerous lending.  


The reason why the situation in the US and China are so similar is that the incentives and disincentives are similar. Local leaders in both countries were rewarded for lavish spending and borrowing. The Americans were re-elected year after year by mollifying public service unions and handing out patronage. They didn’t have to raise taxes because they could borrow the money. In China the leaders were rewarded for implementing Beijing’s demands for growth and infrastructure spending. Chinese leaders also didn’t have to rely on taxes. They simply borrowed from local state owned banks, which helped create the LGFVs. Both the Americans and Chinese could borrow at rock bottom prices because investors always assumed that an entity government would pay them back. In addition both countries have pursued ultra loose monetary policies which has exacerbated the problem and delayed the reckoning. The incentives that exist in China and the US are similar to those all over the world. In time there will be many places just like Detroit.


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)


“Stocks are a part of business; but we ignore that and get influenced by the price changes

Many of us are not hardwired to understand finance and thus give in to our emotional biases. Very few investors may have a clearly defined process for investing. In a Moneylife Foundation event titled ‘Buying stocks safely”, we described how one can develop a safe method for investing in stocks.

Many investors burn their fingers in the stock market because they blindly follow tips and advice freely available. They do not follow a process or have a discipline to cross-check the facts and invest directly. In the second exclusive workshop on ‘How to Invest Safely in Stocks’ conducted by Moneylife Foundation, Debashis Basu, editor, Moneylife, covered the main reasons why investors lose money in stocks, the myths and facts about stocks, how one can develop a process of investing and winning strategies one could adopt. Most investors usually have no clue about the financials of the company or how a company is expected to perform. Though a company may be fundamentally strong, it could be highly priced and thus price appreciation would be low. Even if an investor knows how and when to invest, exiting at the right time is also extremely crucial.


There is lot of free advice available all over the internet. Some may be good, while most of the other is just noise and these sources do not have adequate data to prove their stance. Thus, investors following the latter source may have false beliefs of the stock market, inflation and GDP is correlated to the stock market movement being one example. All these can be both right and wrong as certain rules work under certain conditions. As far as GDP growth versus stocks is concerned, there is little or no correlation. Before investing, one also needs to accept the fact that stocks are risky. “Stocks fetch higher returns in the long-term but can fall by 30%-70% in one year and may take years to recover. It takes years to understand this. You don’t need to focus on the price when you are analysing the business” said Mr Basu. If the business is good, prices will appreciate over the long-term. “Daily movement of price is pure noise,” he explained.


The two factors that essentially drive the market, said Mr Basu, are expected profit growth and valuation. Explaining these two factors he said, “Earnings growth determines the trajectory of the stock, whereas, valuation determines the profit or loss. If one can pick a stock with high earnings growth and which is under-valuated, you can almost never end up with a loss” Great businesses at low prices over a long period of time is what one should look for, he advised.


While giving the participants buying ideas, Mr Basu explained that one should look to buy good companies in market panic. He also mentioned which sectors can do well giving India’s consumption demand. “The maximum gains have come from the consumption sector”, he said. If one does not wish to try and time the market, one could invest is through a systematic investment plan.


As important as buying is, when to sell is a common predicament faced by investors. Mr Basu informed the audience on how to avoid making bad selling decisions. “If a stock has fallen 30%-40% in a fundamentally good company you should not sell unless you need the money, on the other hand you should invest more,” he said.


The session was followed by an interactive question and answer session where Moneylife Foundation members raised their queries.


This session was attended by savers across categories. If you would like to be informed of many more such events in future become a Moneylife Foundation member. Click here to register. (Join Moneylife Foundation)



Suiketu Shah

4 years ago

Wrong advise(most of it unsolicted by brokers aka relationship manager who are unemployable people out to loot you like hardcore criminals)in equities is worst than no advise.

Mastering shares is not difficult if you know who to learn from.

Sensex, Nifty may stage a rally if last week's low holds: Weekly closing report

A slight strength in rupee can spark a market rally. This very likely since dollar has been weakening over the last week.

The holiday shortened week too ended in the negative for the third consecutive time. Market moved down on the concerns of weakening rupee and on growing uncertainty over when the Federal Reserve will start to wind down its stimulus.


The Sensex lost 375 points (or 2%) to close the week at 18,789 and the Nifty settled at 5,566, down 112 points ( or 2%). The market has been down three weeks in a row.


On Monday, the indices rose marginally, bucking the seven-day continuous fall. The HSBC India Composite Output Index, which maps both services and manufacturing activity, fell to 48.4 in July from 50.9 in June, indicating an overall contraction. On Tuesday, the indices had the highest absolute fall since 20 June 2013. The indices were pulled down with the rupee hitting its record low. After market hours, news came in of the appointment of Raghuram Rajan, the country's chief economic advisor to the finance ministry, as the 23rd governor of RBI. On Wednesday too, the indices fell on the concern over the US economic data. Market participants expected the Fed to bring in its asset-purchase program by the end of the year. On Thursday, the indices closed in the positive after China reported much better than expected trade results for July, marking a sharp recovery from the previous month.


Among the indices on the NSE, India Volatility (up 1%) and Nifty Midcap 50 (up 1%) were among the top gainers this week, while CNX 100 (down 2%) and CNX 200 (down 2%) were among the losers.


Among the other indices, Metal (up 5%) and Realty (up 3%) were among the top gainers this week while Finance (down 3%) and Pharma (down 3%) were among the losers.


The top gainers on the Nifty this week were Ranbaxy Lab (up 32%); Jindal Steel & Power (up 11%); Reliance Infrastructure (up 11%); Tata Steel (up 8%) and DLF (up 8%). BHEL (down 22%); Asian Paints (down 13%); Lupin (down 10%); Sun Pharma (down 9%) and Tata Power (down 8%) were the top losers this week.


Out of the 27 main sectors tracked by Moneylife, the top five and the bottom five sectors were:



Top ML sectors


Worst ML sectors




Foods & Beverages


Non-ferrous metals


Consumer durables








Financial services




Consumer products



The first meeting of the sub-committee of Financial Stability and Development Council (FSDC), chaired by RBI Governor D Subbarao was held on Wednesday, where the participants discussed the “potential risk to stability of the domestic financial system”. The sub-panel also expressed concern on the deteriorating asset quality of public-sector banks and discussed corrective measures for this.


The second meeting, of the high-level committee on external commercial borrowings (ECBs), discussed measures to relax ECB norms to allow leveraged firms to tap foreign markets for funds, and to repay rupee loans from ECB proceeds.


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