China’s ‘Hidden Debt’ of Local Governments Threatens National Economy
China’s local government financing arms — and the real estate industry that supports them — have long been viewed as two important drivers for the nation’s economy. Now, after years of rapid growth, the property sector has hit the skids, triggering a liquidity crisis for municipal and provincial borrowers that poses risks to the country’s financial system.
More than 80% of local government financing vehicles, or LGFVs, do not have enough operating cash to cover interest payments on their debt, according to estimates by UBS. These entities are state-owned companies set up to finance infrastructure projects including highways and bridges.
Exacerbating the crisis is that trillions of dollars of local government borrowings consist of “hidden debt,” which the State Council defined in 2018 as separate from on-budget borrowings but carrying at least an implicit guarantee of repayment using fiscal funds or some illegal backing.
At a July meeting, the Communist Party’s Politburo emphasized the need to defuse local debt risks and proposed for the first time to formulate and implement a package of local government debt reduction programs. The pledge demonstrated the central government’s determination to reduce or restructure the overhang of hidden debt. The task will require reforming relations between the central and local governments, experts suggest.
No official data
Ministry of Finance data showed that governments across China had 37 trillion yuan ($5.1 trillion) in on-book debt outstanding at the end of April, but there is no publicly official data publicy available on the current scale of hidden debt. Many analysts including those at the International Monetary Fund estimate those borrowings could range from 30 trillion yuan to more than 70 trillion yuan.
Finance Minister Liu Kun disclosed at the end of 2022 that local government hidden debt has decreased by more than one-third in the last five years, but that progress has gone slower than expected.
A new round of combing through local government debt began this year. Caixin learned that the Ministry of Finance launched a comprehensive survey of local governments’ off-the-books borrowing early in 2023. The results of the survey are yet to be disclosed.
Local government debt pressure has long existed. The new urgency to address the problem comes as local governments, which rely on land sales to developers for revenue, face a sharp decline in revenue and increasing default risks of LGFV debt. Revenue from local land sales fell 20% in the first six months of 2023 from the first half of prior year, and dropped the same amount in all of 2022. The government revenue shortfall relative to budget plans exceeded 720 billion yuan from January to May, estimated by Wang Tao, head of Asia economics and chief China economist at UBS Investment Bank.
Some local governments are unable to pay their debt interest this year, according to a person at a large bank’s government business department. From the start of the pandemic, debt repayment has been erratic, and has deteriorated further in the second half of last year, especially among provinces in the Southwest and Northeast regions, the person said.
Many local governments have had to borrow to pay salaries of civil servants, while a few governments have delayed salary payments altogether, Caixin learned from multiple government employees.
As cash-strapped developers are reluctant to buy land amid sluggish home sales, state-owned enterprises, including LGFVs, are the main buyers of property. From February 2021 to the end of the 2022 third quarter, LGFVs purchased 1,300 parcels, representing 41% of all land sold at auction. After many of these transactions, the LGFVs never developed the properties, according to a report by China Real Estate Information Corp. (CRIC), a Shanghai-based provider of data and analysis. The land purchases – which are intended to stabilize auction prices – instead increase the debt risk of LGFVs by leaving capital and land unused, CRIC said in the report.
By the end of this year, about 2.6 trillion yuan of bonds will come due for 3,427 LGFVs, with about 559.4 billion yuan due in August and 527.7 billion yuan due in September, according to research by HuaAn Securities Co. Ltd. The five provinces with the most LGFV debt coming due are Jiangsu, Zhejiang, Shandong, Tianjin and Sichuan, according to the data.
A common practice for LGFVs is to issue new bonds to repay existing borrowings. Among 1,539 LGFVs that sold new bonds this year, 46% issued the debt to repay maturing bonds, according to an August report by HuaAn Securities. The proportion was 90% in Guizhou province.
Some LGFVs have turned to unscrupulous private fund managers, who carry out so-called structured issuances to help risky borrowers access funding. This involves low rating issuers buying a portion of their own bond offering or having an affiliated party do so, artificially inflating the size of the issuance in an attempt to attract more genuine buyers. Such issuances become particularly risky in regions where local authorities borrow beyond their means.
In the first half of 2023, local governments issued 196 targeted financing products, a type of structured issuance, an increase of 83% from the first six months of last year, according to data compiled by HuaAn Securities.
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 is not traded on the interbank market or stock exchanges such as trust loans, bank acceptance bills, and accounts receivable.
Extend, Swap, or Bankruptcy
In 2018, the Ministry of Finance specified six strategies for resolving local government hidden debt: arrange repayment through a fiscal fund; sell government equity and state-owned assets; use project carry-over funds and operating income for repayment; transfer borrowings into business debts; issue new debt to repay existing borrowings to extend current debt; and use of bankruptcy reorganization or liquidation.
With declining fiscal revenue, the room for the first approach is limited. The second strategy of selling assets to repay debt is only feasible for local governments that own large equity in high-quality state-owned assets, such as Guizhou, where the local government owns equity in liquor-maker Kweichow Moutai Co. Ltd. Considering the market impact, no city has turned to bankruptcy reorganization or liquidation to resolve hidden debts in the past two years.
The most common strategy among LGFVs is to push the problem to the future. One of the most high-profile examples is Zunyi Road and Bridge Construction (Group) Ltd., a financing vehicle in Guizhou province. In December, the LGFV announced a debt restructuring agreement with financial institutions.
The restructuring delayed 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 plan raised market concerns that it would become a model LGFVs across the country.
A person close to the central bank told Caixin that the Zunyi agreement was a special case and unlikely to be replicated. Regulators at the National Administration of Financial Regulation have since halted the second phase of the restructuring.
This extra-long debt extension model would damage the local business environment and financial ecology, a senior banker said.
Banks are the biggest creditors to LGFVs. After recent rounds of reduction of LGFV hidden debt, the four largest state-owned banks have reduced their exposure to the financing vehicles, but thousands of small to medium-sized commercial banks still hold significant amount of the debt.
About 37 trillion yuan of commercial banks’ on-book outstanding loans were lent to LGFVs, and they also lent another 3 trillion yuan of non-standard loans to these platforms, according to Wang Jian, chief analyst of Guosen Securities.
Yan Meizhi, head of Greater China Financials at UBS’s Research Division, estimated Chinese banks’ exposure to LGFVs amount to 49 trillion yuan. Other analysts have even higher estimates.
Guosen Securities’ Wang has relative optimistic view on the impact of LGFV debt restructuring on the bank system. In the worst case scenario, if only 10% of LGFV debt is restructured, their impact on commercial banks’ total profits are expected to be no more than 135 billion yuan, or 6% of their net income last year, he estimated.
Once a large amount of local government debt becomes bad debt, it will inevitably produce a chain reaction, constituting a typical systemic risk, which will limit the liquidity of the entire financial system, and in turn greatly reduce the credit available to the real economy, experts warned.
Another way to tackle the problem is to swap the hidden, short-term, high-interest debt for lower-cost, longer-term government bonds. Since 2014, China has carried out four rounds of such swaps.
Since July, provincial governments of Fujian, Guizhou, Yunnan, Jiangxi and Guangzhou have kicked off work for some municipal and county-level governments to apply for inclusion in a national pilot program to defuse local government debt risks. These swaps are expected to reach 1.5 trillion yuan, Caixin learned from sources.
Ideally, large-scale swap of LGFV debt should be accompanied by structural reform of the fiscal system, UBS’s Wang said. This includes clarifying the fiscal relationship between the central and local governments, as well as their roles in the economy; reducing the investment impulse of local governments and setting more reasonable and pragmatic targets for infrastructure investment; and strictly enforcing fiscal discipline, she said.
“Without the simultaneous push-through of these structural reforms, any large-scale LGFV debt swap is only a temporary solution, not a permanent solution,” UBS’s Wang said. Given the importance of LGFVs in filling the financing gap for infrastructure investment, it will be hard to avoid another rise in LGFVs’ hidden debt, she added.
Financial institutions have long believed that the central government will ultimately guarantee local government debt, which has encouraged lending to LGFVs, said Zhong Zhengsheng, chief economist of Ping An Securities.
To break the illusion of backstopping by the central government, China should speed up reforms of the relationship between central and local governments, Zhong said. That would provide local governments more fiscal power by increasing their revenue sharing in the value-added tax and consumption levies.
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