China’s Effort to Move Mountain of ‘Hidden Debt’ Faces Uphill Climb
As China’s economic growth gets back on track after three years of pandemic, efforts to tackle the mountain of so-called “hidden debt” accumulated by local governments have re-emerged as a priority on the agendas of top policymakers.
Fresh concerns have mounted that weakening income growth and rising spending over the past few years may force local authorities to resort to new off-the-book borrowing, while limiting their ability to pay down the debt. These liabilities are estimated by some to be almost $10 trillion, roughly double the GDP of Japan, the world’s third-largest economy.
The urgency to ensure the sustainability of local finances has become more acute after the Covid-19 pandemic, which along with a prolonged property crisis, have squeezed local coffers. These funds are crucial to fueling the economy towards the target of around 5% GDP growth for this year.
Indicative of the challenge this poses, since late 2022, when China abandoned stringent Covid controls, top policymakers have repeatedly vowed to continue efforts to prevent and defuse local government debt risks.
The government’s concern is that any large-scale defaults could have a destabilizing impact on the banking sector and financial system.
In a key December meeting outlining this year’s financial policy agenda, President Xi Jinping pressed provincial governments to guard against risks of hidden debt and take resolute measures to “curb any increases in debt and mitigate existing debt.”
In recent speeches, finance minister Liu Kun has again called for further efforts to control hidden debt risks and transform local government financing vehicles (LGFVs) into market entities, rather than simply operating as borrowing platforms.
“From the debt restructuring tasks assigned at the provincial level, it is evident that more efforts will be needed this year than in previous years,” a person from an LGFV said. Several other LGFV sources told Caixin that any increase in new hidden debts will be “absolutely prohibited while disposal of existing debts must be accelerated.”
China’s State Council in 2018 defined hidden debt as any borrowing that is not part of on-budget government debt, but carries an explicit or implicit guarantee of repayment using fiscal funds from cities or provinces or is backed by illegal guarantees.
It mainly includes issuing bonds by LGFVs, with state-owned companies set up to finance local government investment such as infrastructure projects, which are key drivers of economic growth, including highways and bridges.
Debt is also hidden in public-private partnership projects, shady loan contracts, and other channels used by local governments to raise money.
Under pressure to meet growth and investment targets, local authorities use these channels to raise money to pay for infrastructure and public welfare projects that they can’t fund entirely through on-budget spending because of controls on their official debt.
The main holders of LGFV bonds include insurance companies and banks, who are also major lenders to the vehicles.
There is no publicly available official data on the current scale of hidden debt, but some estimates put the number at between 50 trillion yuan and 70 trillion yuan ($7.1 trillion – $9.9 trillion).
Explicit, on-the-books borrowing by local governments, including bonds, was 35 trillion yuan by the end of 2022, according to the International Monetary Fund’s (IMF) latest Article IV consultation report on China. But implicit debt likely amounted to double that figure at 70.4 trillion yuan, said the IMF.
Domestic ratings firm China Chengxin International Credit Rating Co. Ltd. estimates the hidden debt of local governments was in a range of 52 trillion yuan to 58 trillion yuan at the end of 2022, about 1.5 to 1.7 times the amount of explicit debt.
China has since 2018 launched a campaign to wipe out all local governments’ invisible liabilities. A central government policy document issued that year set out plans to dispose of all hidden local debt – as calculated at July 2017 – in five to 10 years.
However, progress has been slower than expected. Finance Minister Liu stated at the end of last year that after five years of crackdown, hidden debts had only been reduced by one third compared to the level in 2017.
People close to the ministry said the pace of debt disposal had greatly slowed in 2020 and 2021 due to the pandemic.
Dealing with the pandemic also vacuumed up government funds through spending on virus control measures, while slashing their tax incomes as businesses struggled. The cooling housing market, which dragged down government land sales, further squeezed local finances.
Some localities once again turned to LGFVs to plug financial shortfalls, several analysts specializing on local government debt told Caixin.
Hidden debts of local governments expanded at a faster pace during the pandemic amid monetary easing, reversing a slowdown during the previous years under tough regulations, said Yuan Haixia, deputy director of the research arm of China Chengxin. But recently the growth has slowed again, said Yuan.
Caixin learned that the Ministry of Finance early this year launched a comprehensive survey of local governments’ off-the-books borrowing. The results and purpose of the survey are still unclear.
Facing financial strain, local authorities are finding their options for disposing of risky debts increasingly limited. Most of them have relied on debt restructuring to extend maturity and reduce the interest burden to seek short-term relief, while others are attempting to cut funding costs by various means.
In its quarterly report, the National Institution for Finance & Development (NIFD) said the extent to which local governments have disposed of their debt varies significantly based on their financial status and the strength of the local economy.
Regions with weaker overall economic and financial capacity are likely to seek short-term remedies with long-term costs, said the NIFD.
A fundamental solution would be to transform the LGFVs into market entities that no longer have to shoulder government financing responsibilities, according to experts.
The 2018 policy document pledged that the central government would issue guidelines for LGFV reform. However, they are yet to materialize with the task of drafting them passed around among multiple ministries over the intervening years, sources with knowledge of the reform plan told Caixin.
The task is now led by the Finance Department under the ministry of the same name and is expected to be accelerated, they said.
Plugging the loopholes
Bond sales and access to bank loans have been the main targets for regulators seeking to rein in LGFVs’ borrowing over the past few years. This year, regulators have moved to plug regulatory loopholes and taken aim at more specific financing practices that has allowed these entities to bypass oversight.
In January and April, securities regulators strengthened rules on the practice of structured bond issuances by limiting the exposure of private funds to the debt instrument and enacting harsher penalties for violations.
For years, some private fund managers have facilitated this practice, wherein an issuer with a lower credit rating purchases a portion of its own bond offering or has a third party make the purchase, artificially inflating the size of the issuance in an attempt to attract more genuine buyers.
Many LGFVs that are financially weak have relied on structured bond sales to get financing, and the new regulations will significantly affect their access to the bond market, according to a bond manager who spoke to Caixin.
LGFV structured bond sales may have reached 2.1 trillion yuan as of January 31, according to estimates by Founder Securities. Less developed regions, including Qinghai, Heilongjiang, Guizhou, and Guangxi, may have over 25% of their LGFV bonds involved in such practices, according to Founder Securities.
In March, an urban investment company in Siping city, Jilin province, became the first LGFV to be punished by regulators for engaging in structured bond sales. Four financial institutions involved in the bond issuance also received warnings and rectification orders.
In April, China announced a plan to transfer the regulatory authority of enterprise bonds, which are primarily corporate bonds issued by state-owned companies, from the National Development and Reform Commission (NDRC) to the China Securities Regulatory Commission (CSRC) in six months.
This move represented a significant step towards consolidating the fragmented oversight of the country’s bond market, which currently is supervised by three different entities — the NDRC, the CSRC, and the People’s Bank of China.
The regulatory revamp will also put LGFVs’ bond financing under closer scrutiny, said Qin Han, an analyst at Guotai Junan Securities.
Observers were given a better idea of the pace of debt disposal by local governments when they published their annual budget reports earlier this year. These revealed that in 2022, Beijing and Guangdong had declared success in resolving all hidden debts, while Ningxia and Guangxi said they had cleared 50% of off-the-book liabilities by the end of the same year.
Despite the progress, local authorities have felt a growing pinch when dealing with risky debts since the pandemic, as the slowing economy slashed local revenue while spending continues to rise.
Although governments’ fiscal incomes have started to see a revival this year as the economy has reopened, the pace has been moderate, rising just 4% in the first four months. Meanwhile, land sales, the main revenue source for local governments, have continued to slide.
A recent survey of government officials and LGFV managers by Fitch Ratings Inc. found pessimism on the outlook for government finances this year was rife, said Sun Hao, a senior China-based executive of the firm.
There are less resources for authorities to tap to prevent immediate debt risks and the task will become increasingly challenging, according to a local debt expert who spoke to Caixin.
Debt disposals will still mainly rely on local governments using their own funds and seeking new financing, said Sun. Some regions with significant debt pressures may not be able to resolve their debts on schedule, and there is the possibility that the timeline for debt resolution may be further extended, he said.
No LGFV has failed to repay a bond so far, although there have been defaults on non-standard debt, which usually refers to debt that isn’t traded on the interbank market or stock exchanges such as trust loans, bank acceptance bills, and accounts receivable.
Small cities where government borrowing has exceeded their ability to repay them are particularly at risk. For instance, in Weifang city, eastern Shandong province, 12 defaults related to LGFVs’ non-standard debts have been flagged so far this year, according to Guosheng Securities.
As of May 5, Weifang had outstanding LGFV debts of 114.8 billion yuan and most will mature in the next two years, according to Guosheng.
“The proper handling of the recently maturing debts will be the key to resolving the debt risks in Weifang,” said the brokerage in a May research note .
The Weifang city government and provincial authorities has held meetings with investors and financial institutions in an attempt to defuse market fears, pledging efforts to ensure repayments.
While the meetings are important first steps to restore confidence, it is more important to make concrete moves to improve the fundamentals and repayment capabilities of the LGFVs, said Yang Yewei, senior analyst at Guosheng.
Some local authorities are exploring ways to extend maturity or reduce financing costs to temporarily relieve their debt pressures.
In one of the most high-profile cases, Zunyi Road and Bridge Construction (Group) Ltd., a financing vehicle in southwest Guizhou province, announced in December a debt restructuring agreement with financial institutions.
It involved delaying repayment on 15.6 billion yuan in borrowings by changing the term on all the loans to 20 years, and only paying interest on the loans for the next 10 years.
The eastern province of Jiangsu has required local financial regulators to guide financial institutions to restructure and swap LGFV debts with high costs and short maturity. Several cities in Jiangsu have actively responded to the order.
Nantong city in Jiangsu set a target in early 2022 to dispose of all hidden debts with high financing costs through debt restructuring and swaps by the end of the year and bring down the average interest rate of LGFV debts to below 5%.
As more localities have stepped up similar efforts, a Jiangsu official warned that reducing financing costs for debt relief is a complicated task requiring a series of supportive policies such as those to ensure liquidity. It should follow the market rules, rather than administrative orders, said the official.
Lowering the interest burdens is also a test of financial institutions’ willingness and capabilities.
According to China Chengxin, commercial banks are capable of absorbing less than 20% of the implicit debts while meeting current capital requirements. During the process, the institutions will also face a series of issues such as declining profits and deterioration of asset quality, such as capital adequacy and bad asset ratios.
Amid revived fears of debt risks, some experts have called on the central government to step in.
China should consider transferring parts of the liabilities to the central government through a sweeping debt restructuring program similar to the one in 1994 to help state-owned banks dispose of risky loans, said Li Daokui, a professor at the School of Economics and Management at Tsinghua University, at a forum in early May.
Under that program, four asset management companies were set up to take over the bad assets to help local governments ease their debt burden.
But top authorities have repeatedly made it clear that local governments are responsible for their own debts and that the central government won’t come to their rescue.
Fitch’s Sun said there is little chance that the central government will step in and instead some tailored policies to support risky regions can be expected.
To fundamentally eliminate the impulse of local governments to borrow, it is necessary to streamline the fiscal relationship between the central and local governments, and make local authorities responsible for working within the limits of their finance capabilities, said a person close to the finance ministry.
It is also important to transform the governments’ functions and the mode of economic development to reduce economic growth’s reliance on investment, said the person.
Experts have agreed that the more effective solution to defuse local hidden debt risks is through reform of LGFVs.
Sun said there are signs that such entities are accelerating the pace of their transformation. Urban investment companies, a main part of LGFVs, are diversifying in three directions: becoming urban service providers, real estate developers or industrial investors, depending on their business focus, said Sun.
Since late 2022, an increasing number of local governments’ urban investment vehicles have announced their decision to no longer undertake government financing functions. In the first two months this year, 56 such companies have made similar statements.
But whether these entities can truly sever their ties with the government remains to be seen, as many of them are still backed by state investors and doing business for local infrastructure projects, according to an NIFD report.
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