China’s local governments have a ballooning debt problem that cries out for urgent resolution, but analysts suggest that this would be a herculean task. If the problem worsens, it will affect banks, interest rates and GDP growth in China, as well as offshore bonds issued by government-owned companies.
One of the primary concerns is that local government financing vehicles (LGFVs) – some of which have already defaulted on shadow banking instruments – will start to default on their publicly traded bonds.
This, explained a report by published this month by US think tank, the Centre for Strategic and International Studies (CSIS), could create new credit risk in 40% of China’s RMB33 trillion ($4.8 trillion) corporate bond market and would also likely reduce a significant source of credit demand for smaller Chinese banks.
This would have significant repercussions local government infrastructure investment, which serves as a large a driver of investment growth within the property sector.
“Even now, one of the most pressing potential risks to China’s financial system is the possibility that LGFV bonds might start defaulting in large numbers, indicating the continued salience of local government debt risks” the report warned, adding that the government’s deleveraging campaign had made little progress.
Chinese local governments fund regional infrastructure through LGFVs and the debt raised by these entities accounts for approximately 30% of the market’s GDP, according to data provider, CEIC, in figures cited by Alicia Garcia-Herrero, chief economist for Asia Pacific at Natixis, in a presentation at the Hong Kong Foreign Correspondents’ Club (FCC) last month. Debt raised by LGFVs has nearly doubled to RMB66 trillion in 2023 from RB35 trillion in 2018, according to an IMF report in February.
“An inability to maintain financing access to these vehicles would effectively limit Beijing’s ability to use fiscal policy to drive additional investment and maintain growth,” the CSIS report said.
Some form of bailout for China’s localities will be necessary in the years ahead, most likely using fiscal resources or an expansion of funding from the central bank’s balance sheet, the CSIS report predicted.
“Beijing would prefer not to support LGFVs, but likely has no choice,” it detailed.
“The fiscal situation is worsening. Local government debt is a big thing for China to think through,” said Garcia-Herrero at the media discussion.
“Every local government is in deficit. This is unheard of.” She explained that local government revenue plummeted partly because of the Covid-19 pandemic, which resulted in negative fiscal flow for the Shanghai and Beijing municipal governments in 2022.
“Fiscal reform in China is well overdue. [But] I’ve not seen any signs,” she added.
Historical precedents suggest that the main constraint preventing fiscal reform in China is political, Michael Pettis, a professor at the Guanghua School of Management of Peking University and senior fellow of Washington DC-based think tank, the Carnegie Endowment for International Peace.
Nearly all the provincial governments have very high levels of debt, but while in some provinces – mainly the richer ones – they are manageable, in others, they simply cannot be serviced out of existing revenue, he explained.
“This constraint can be very severe,” he told FinanceAsia.
He explained that when local government debt is channelled into infrastructure project capex, it can be quite effective: “When this infrastructure was productive, the debt didn't matter because these projects drove up GDP at least as fast as they drove up the debt.”
“But once the investment was no longer productive, GDP was not able to rise as quickly.… When this happens, the debt burden must surge relative to the capacity to service it.”
Any problem with LGFVs will affect credit spreads in China, Garcia Herrero told FA.
Fitch analysts perceive China’s fiscal risks to be higher than official government debt metrics suggest, given that government-related entities carry implicit state support.
Market woes remain amplified following issuance of a record $39.5 billion in cross-border debt in 2022 amid higher global interest rates, wrote S&P Global Marketing Intelligence analyst, John Wu, in January.
As LGFVs struggle to replenish liquidity amid challenging macro conditions and a lack of better funding alternatives onshore, many of them are turning to offshore options in spite of unfavourable interest rates, explained a report he cited.
“The weaker LGFVs are forced to pay the highest prices, driving a further wedge in the sector’s credit quality,” added Yuehao Wu, S&P Global credit analyst, in the report commentary.
The fiscal revenue of local governments in China “has collapsed”, said Garcia-Herrero. “They need to increase taxes.”
“Interest rates are flat but the increase in debt service is humongous. This means debt is piling up,” she added.
Given that typically, LGFVs generate returns on assets of less than 2%, they can barely manage a 3% interest rate. But many of these firms are actually borrowing at shadow bank interest rates as high as 10%, explained the CSIS report.
“The intertwining of the financial health of local governments, firms, and banks via LGFVs means that tightening in financial conditions, worsening local government debt dynamics, and drags on economic activity can become self-reinforcing even without defaults. This sets up the potential for destabilising feedback loops,” noted an earlier IMF report.
As the largest creditor to LGFVs, Chinese banks are likely to see a large increase in nonperforming exposures from even a small amount of LGFV defaults, the report warned.
Even a small LGFV default rate of around 5% could be equivalent to a roughly 75% increase in nonperforming loans among Chinese banks, the body projected.
The key to resolving the LGFV debt problem would be to decide how the costs of extinguishing the debt are allocated to different sectors of the economy, Pettis advised.