- The market is concerned about the rapid growth of China’s local government debt, which is much larger than central government debt.
- Ironically, Beijing’s deleveraging efforts since 2017 have aggravated concerns; they have led to some local government financing vehicles (LGFVs) missing or delaying their repayments.
The first credit events involving state-backed borrowers
The first LGFV bond default in China occured in August 2018 when a military-affiliated company in Xinjiang failed to pay interest on a RMB5 mn bond. The second partial default was in December 2019: the Hohhot Economic and Technology Development Zone Investment Development Group (HETDZ) failed to repay 40% of its RMB1 bn private bond issued in 2016.
LGFVs - a large part of China's local government debt - are special purpose vehicles (SPVs) set up by local governments to eschew regulatory borrowing restrictions on raising capital for infrastructure projects. The pace of LGFVs’ debt accumulation has contributed substantially to the increase in China’s overall debt level since the global financial crisis (GFC) of 2008-09.
How big is China's local government debt burden?
Estimates of the size of the LGD are all over the place because there is no official definition of the debt and data records have been poor. In 2017, these estimates ranged between RMB16 trn and RMB42 trn, according to sources including China’s Ministry of Finance, the BIS, the IMF, Chinese brokers and academics such as the Chinese Academy of Social Sciences.
All agree that there are two parts to China’s LGD:
- Explicit debt which is the part of local government on-budget liabilities that the central government recognises
- Implicit debt which includes the LGFV debt and the public-private-partnership (PPP) debt that constitute off-budget borrowing not recognised by the central government.
- LGD has grown much larger than the central government debt and there are no proper and timely records for the implicit debt load. The most recent official record for the implicit LGD was released by the National Audit Office in June 2013 at RMB17.9 trn. But it has grown sharply since. The market estimated that in 2018, the explicit debt amounted to between RMB16.5 trn and RMB18.4 trn, and the implicit debt to between RMB11.5 trn and RMB31.6 trn (see Exhibit 1 below).
Exhibit 1: China's debt structure
How did China's local government debt become so large?
It is mainly due to the accumulation of implicit (LGFV + PPP) debt. By law, local governments are not allowed to borrow. But since the late 1990s, many local governments started setting up SPVs to circumvent the regulatory restrictions to raise funds for infrastructure projects. The size of implicit debt jumped when Beijing injected RMB4 trn into the system in 2009 to counteract the impact of the GFC as local governments with the central government’s acquiescence set up numerous LGFVs to borrow funds from banks and the capital market to fund the infrastructure investments approved under the stimulus package.
To meet the central government’s growth targets, local government kept on borrowing to fund infrastructure projects even when Beijing started to clamp down on local borrowing from 2011 to rein in systemic risk. Beijing also introduced in 2014 the PPP programme to bring in private investors to fund infrastructure investment to reduce local government borrowing pressure. But most of the PPP projects have been abused by the local governments by inviting fake private investors to get approvals for borrowing. The ultimate borrowers and stakeholders are still the local government authorities, and the PPP platform effectively reflects mutated LGFV borrowing.
The risks this debt burden poses for China's financial system
Ballooning LGD is creating a systemic balance-sheet mismatch risk, which underlay the 1997-98 Asian financial crisis. Most of the LGD is short-term, maturing in less than three years, but the investments it funds are long-term, over 10 years. So the LGD is subject to high interest-rate and roll-over risks.
Beijing’s deleveraging efforts since 2017 has aggravated the LGD problem by tightening domestic credit conditions, eroding the debt-service capabilities of many of the infrastructure projects which were unsound investments to start with. Crucially, bank loans account for the biggest funding share of the LGD], linking the LGD risk to the banking system.
Bank loans accounted for over half of the total LGD and almost 60% of the implicit debt in 2018, according to market estimates. Other funding sources include special construction funds (SCFs), government guided infrastructure funds (GGIFs), shantytown reconstruction (SR) loans, trust loans, leasing, PPP borrowing, LGFV bonds, build and transfer (BoT) loans and so on.
Furthermore, land sale revenues, which constitute the bulk of local government fiscal revenues, have become unstable in recent years due to Beijing’s efforts to clamp down on housing bubbles in the large cities. Since a lot of the LGD has gone into the property market, deteriorating financial conditions in this sector has significantly weakened the local governments’ debt-servicing ability.
Debt risk is still manageable
The prime concern about the LGD is its sustainability. In my opinion, the situation is not as bad as the news headlines would have it. Firstly, LGD risk remains localised. Local debt-to-GDP ratios are the highest in Guizhou, Qinghai and Yunnan, followed by Inner Mongolia, Liaoning and Ningxia. This suggests that systemic risks are the highest in the western and northern provinces, though Hainan in the far south is also high-risk.
Secondly, China’s total (central + local government) public debt-to-GDP ratio is not excessive compared to many other countries (Exhibit 2). Crucially, its public debt is funded by domestic savings denominated in renminbi, thus ruling out a foreign debt-currency crisis. With high domestic savings, Beijing should have no problems in servicing the public debt.
Exhibit 2: Public debt-to-GDP ratios in selected countries (2017)
What matters most...
All this is not to downplay the LGD vulnerabilities. While it is manageable today does not mean that it will remain manageable tomorrow. In recent years, the adjusted fiscal deficit (i.e. official deficit plus total government borrowing) has grown at an annual rate of 10%. If Beijing cannot effectively contain the growth of the LGD, the problem could eventually become unmanageable.
What matters most is the government’s attitude towards the debt risk. Beijing has so far taken a slow and gradual approach to cutting debt growth. This is quite different from the debt crisis countries which took no measures until it was too late for their debt bombs to be diffused.
Since 2011, Beijing has implemented regulations and measures to cut the LGD by:
- Prohibiting LGFV borrowing and reining in shadow banking, which is a key funding source for the LGFVs
- Urging local governments to set up early-warning systems for their debt
- Implementing a debt-swap programme (in 2015), which replaces LGFV debts by government and municipal bonds, thus improving the LGFV credit risk and reducing their debt-servicing cost as borrowing through the government bond market pays lower interest rates than borrowing from the shadow banks
- Implementing PPP infrastructure investment programmes to bring in private-sector funds. Though the programme has been abused (see above), an overhaul has been implemented since 2016 to scrutinise PPP project approvals
- Including local government borrowing in the fiscal budget via legal process. China amended the Budget Law in 2015, prohibiting LGFV borrowing and requiring all local government borrowing to be included in the official budget and regulated by the local People’s Congress
- Retreating slowly from the implicit guarantee policy to allow LGFV and SOE bankruptcies and defaults to bring in market discipline to address the moral hazard problem.
China's new policy mix is conducive to debt reduction
China is also changing the incentive behind local government borrowing by de-emphasising the GDP growth targets, which is the root cause for the growth in LGD. President Xi Jinping has changed the country’s policy objective from maximising growth to targeting multiple goals, including sustaining moderate GDP growth, reducing poverty, reducing systemic risk and protecting the environment. By replacing the old single-minded growth incentive with a set of complex priorities, he has created a political environment that is conducive to debt reduction.
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