Demystifying the debt of Chinese local authorities
- The market is concerned about the rapid growth of Chinese local government debt, which is much larger than central government debt.
- Ironically, Beijing’s deleveraging efforts since 2017 have compounded concerns; they have led to the absence or delay in repayment of certain local authority financing vehicles (LGFV).
The first credit events involving government-backed borrowers
China’s first LGFV bond default occurred in August 2018, when an army affiliate in Xinjiang failed to pay interest on a RMB 5 million bond. The second partial default occurred in December 2019: the Hohhot Economic and Technology Development Zone Investment Development Group (HETDZ) failed to repay 40% of its RMB 1 billion private bond issued in 2016.
LGFVs – a large portion of China’s local government debt – are special purpose vehicles (SPVs) set up by local governments to avoid regulatory borrowing restrictions on raising capital for projects. infrastructure. The pace of LGFV debt accumulation has largely contributed to the increase in China’s overall debt level since the 2008-09 Global Financial Crisis (GFC).
How big is China’s local government debt burden?
LGD size estimates are everywhere as there is no official definition of debt and data records have been poor. In 2017, those estimates ranged from 16 trn RMB to 42 trn RMB, according to sources such as the Chinese Ministry of Finance, BIS, IMF, Chinese brokers and academics such as the Chinese Academy of Social Sciences.
Everyone agrees that there are two parts to the Chinese LGD:
- Explicit debt which corresponds to the share of the budgetary commitments of local authorities that the central government recognizes
- Implicit debt which includes LGFV debt and public-private partnership (PPP) debt which constitute off-budget loans not recognized by the central government.
- The LGD has grown much more than the central government debt and there are no proper and timely records for the implicit debt burden. The most recent official record for implied LGD was released by the National Audit Office in June 2013 at RMB17.9 trn. But it has risen sharply since then. The market estimated that in 2018, the explicit debt was between 16.5 trn RMB and 18.4 trn RMB, and the implicit debt between 11.5 trn RMB and 31.6 trn RMB (see Table 1 below). below).
Chart 1: Structure of China’s debt
How did Chinese local government debt get so big?
It is mainly due to the accumulation of implicit debt (LGFV + PPP). By law, local authorities are not allowed to borrow. But since the late 1990s, many local governments have started setting up SPVs to bypass regulatory restrictions and raise funds for infrastructure projects. The size of implicit debt jumped when Beijing injected RMB 4 trn into the system in 2009 to counter the impact of GFC as local governments with central government consent set up multiple LGFVs to borrow debt. funds from banks and the capital market to finance approved infrastructure investments. as part of the recovery plan.
To meet the central government’s growth targets, the local government continued to borrow to finance infrastructure projects even when Beijing began restricting local borrowing from 2011 to contain systemic risk. Beijing also introduced in 2014 the PPP program aimed at attracting private investors to finance infrastructure investments in order to reduce borrowing pressure from local governments. But most of the PPP projects have been abused by local governments by inviting bogus private investors to obtain borrowing authorizations. The borrowers and ultimate stakeholders remain the local government authorities, and the PPP platform effectively mirrors the LGFV loan transfer.
The risks this debt burden poses to the Chinese financial system
The soaring LGD creates a systemic risk of balance sheet asymmetry, which underlies the Asian financial crisis of 1997-98. Most of the LGD is short-term, with a maturity of less than three years, but the investments it finances are long-term, over 10 years. The LGD is therefore subject to high interest rate and rollover risks.
Beijing’s deleveraging efforts since 2017 have compounded LGD’s problem by tightening domestic credit conditions, eroding the debt-servicing capabilities of many infrastructure projects that were initially ill-advised investments. Importantly, bank loans represent the largest share of LGD financing]linking LGD risk to the banking system.
Bank loans accounted for more than half of the total LGD and almost 60% of implicit debt in 2018, according to market estimates. Other sources of finance include Special Construction Funds (SCF), Government Guided Infrastructure Funds (GGIF), Slum Reconstruction Loans (SRs), Trust Loans, Leasing, PPP Loans , LGFV bonds, construction and transfer loans (BoT), etc.
In addition, revenues from land sales, which constitute the bulk of local government tax revenues, have become volatile in recent years due to Beijing’s efforts to quell real estate bubbles in major cities. As a large part of the LGD has entered the real estate market, the deterioration of financial conditions in this sector has considerably weakened the debt service capacity of local authorities.
The debt risk remains manageable
The main concern with LGD is its durability. In my opinion, the situation is not as bad as the headlines suggest. First, the LGD risk remains localized. Local debt-to-GDP ratios are highest in Guizhou, Qinghai and Yunnan, followed by Inner Mongolia, Liaoning and Ningxia. This suggests that systemic risks are highest in the western and northern provinces, although Hainan in the far south is also at high risk.
Second, China’s total public debt ratio (central government + local government) is not excessive compared to many other countries (Figure 2). Importantly, its public debt is financed by domestic savings denominated in renminbi, thus ruling out a foreign debt crisis. With high domestic savings, Beijing should have no problem servicing the public debt.
Figure 2: Public debt / GDP ratios in selected countries (2017)
What matters most …
All of this is not to minimize LGD vulnerabilities. While it’s manageable today, that doesn’t mean it will be manageable tomorrow. In recent years, the adjusted budget deficit (i.e. government deficit plus total government borrowing) has grown at an annual rate of 10%. If Beijing cannot effectively contain the growth of LGD, the problem could eventually become unmanageable.
What matters most is the government’s attitude to debt risk. Beijing has so far taken a slow and gradual approach to reducing debt growth. This is quite different from countries in debt crises which took no action until it was too late for their debt bombs to be defused.
Since 2011, Beijing has put in place regulations and measures to reduce LGD by:
- Prohibit borrowing from LGFVs and curb shadow banking, which is a key source of financing for LGFVs
- Encourage local communities to set up early warning systems for their debt
- Implementation of a debt swap program (in 2015), which replaces LGFV debts with state and municipal bonds, thus improving LGFV credit risk and reducing the cost of debt service, because borrowing government bond market pays lower interest rates than shadow banks borrowing
- Implement PPP infrastructure investment programs to attract private sector funds. Although the program has been abused (see above), a redesign has been implemented since 2016 to review PPP project approvals.
- Include local government loans in the fiscal budget through a legal procedure. China amended the budget law in 2015, banning LGFV borrowing and requiring all local government borrowing to be included in the official budget and regulated by the local People’s Congress.
- Slowly withdraw from the implied warranty policy to allow LGFV and SOE bankruptcies and defaults to introduce market discipline to resolve the moral hazard problem.
China’s new policy mix is ââconducive to debt reduction
China is also changing the incentive for local government borrowing by reducing the focus on GDP growth targets, which is what drives LGD’s growth. President Xi Jinping changed the country’s political goal from maximizing growth to targeting several goals, including maintaining moderate GDP growth, reducing poverty, reducing systemic risks and reducing Environmental Protection. By replacing the old growth incentive driven by a complex set of priorities, it has created a policy environment conducive to debt reduction.
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