“Deleveraging” is a term normally used in conjunction with a company selling off assets to decrease debt. However, in terms of the Chinese economy, deleveraging problems have surfaced in the debts accrued by local government financing platforms.

To better understand and hopefully resolve this issue, we first need to conduct a thorough review of the relationship between local government finances and public finances. It is this conflation of the public and private sector that has resulted in huge resource misallocations and financial risk.

Banking has two main functions. The first involves discounting future returns on an investment over a fixed period, which allows a value to be assigned to an investment in the present. The second involves allocating currently available funds to places that may yield higher future returns, on the basis of supply and demand of capital.

The essence of public finance is different. Public finance is when the government invests in things that won’t necessarily yield a monetary return. Returns on government investments are normally indirect and don’t have the goal of maximizing profit. For this reason, governments often try to finance by issuing bonds not for specific projects, but things like economic development instead.

This kind of financing is calibrated to the government’s need to keep the rate of return low and the returns cycle long on their issued bonds. With relatively high-security government bonds like this, the interest rate paid is quite low.

However, a major problem currently facing China is that public and private finances have become tangled up with one another, and private finance has partially taken on the role of public financing.

China does not allow its local governments to independently issue government bonds, but of course local governments want to develop their economies by building up basic infrastructure and their provision of public services.

For this reason, local governments have established all sorts of state-owned finance companies, which are in charge of funding the local government’s many and varied projects. These financial vehicles create capital not only through regular company bonds, but also through loans from commercial banks and all kinds of shadow banks, and they have become intermediary institutions that mix both public and private finances. Unfortunately, the issues that arise from this can be extremely negative.

First, this type of financing fosters severe maturity mismatches in the private markets. Many short-term loans are used by the government’s financial vehicles to invest in projects with long returns cycles and low rates of return.

Second, the projects the government finances have high marginal interest rates. Interest rates on commercial bank loans are based on a reference rate. The price is comparatively low, and once the government has borrowed a lot, banks are no longer willing to continue giving the government more low-interest commercial bank loans.

Many financial vehicles thus turn to shadow banking. Generally speaking, the existence of shadow banks is not always a bad thing. In any country, when there is demand for financing that cannot be met on the commercial banking market, many people turn to shadow banking.

At such times, as long as the shadow banking market is competitive, then its interest rates will still reflect the expected return on investments. “Expected” implies that some high-risk projects may also be taken on by shadow banks, but the financer must pay high interest rates to make up for the potential risk. Shadow banks remain an effective allocator of resources.

However, a major problem with China’s shadow banks is that their loans yield low returns, high interest rates, and require rigid payments. Under normal circumstances, rigid payments should not exist on the financial markets, since risks like bankruptcy, breach of contract, and bad debt set the parameters for capital pricing.

As far as the shadow banks are concerned, there are implicit guarantees of repayment since the financer is the local government. They are therefore happy to continue throwing money into the government’s financial vehicles.

Of course, the shadow banks know fully well that government financing is used for long-cycle, low-return projects. They also know that local governments continue to take on more debt even while paying off old debts. Therefore, even though they believe government financing platforms to be secure, the interests rates the shadow banks charge are often much higher than commercial banks, since the risk of repayment is not zero. The costs of rigid payments can be exceptionally high as well, especially when the projects don’t yield high returns.

The final issue that has arisen because of this mixing of public and private financing is that private enterprises are finding it increasingly difficult to obtain financing. Commercial banks believe local governments and state-owned enterprises to be more secure institutions, so they send a lot of their capital there. The resulting shadow bank’s hike in interest rates — because of involvement of local governments — further squeezes out financing opportunities for private enterprises.

These three problems can be boiled down to a single issue: financial market interest rates don’t reflect investment returns, which means the financial markets have been severely distorted. As long as higher interest rates exist at shadow banks, credit resources from commercial banks will be funneled into them through many different channels.

The situation is dire. As local governments continue to finance themselves in this way, the interest rates they pay will continue diverging from their investment returns. As long as the market remains liquid, private enterprises will find it difficult to secure financing. However, if the economy slows down, things only get worse. Loans to private enterprises are considered more and more insecure. At such times, credit easing actually makes financing comparatively easier for local governments and state-owned enterprises.

At its root, the most critical issue facing the Chinese financial system is that the spheres of the fiscal and the financial have become conflated. The core mechanism by which this has occurred is the fact that local government financing platforms have simultaneously become involved in public and private finance, borrowing money from the financial markets and spending it on things the state should fund.

If we do not tackle this problem soon and completely separate the public and private finances, there will be essentially no solution to the currently severe distortions in the financial markets. Thus, the ability of the financial markets to make the price of capital reflect investment returns will not be corrected, and the severe misallocation of financial resources may persist in the long-term.

(A Chinese version of this article first appeared on Caijing.)

(Header image: A clerk at ICBC counts banknotes in Beijing, April 13, 2016. Kim Kyung-Hoon/Reuters)