China’s economy needs swift action to avert local government debt disaster

Together with a forceful stimulus to revive growth, a smart approach to defuse China’s local government debt bomb could go a long way towards reducing systemic risks of the financial system, lessening the burden of the economy and restoring the confidence of investors

Aidan Yao

Published: 3:45pm, 11 Jul 2023

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Growing speculation around attempts to shore up local government finances suggests that Beijing is finally starting to tackle one of the chronic ills in the Chinese economy. Local government debt had swollen to almost 38 trillion yuan (US$4.8 trillion) at the end of May this year.

More worrying is the hidden debt amassed by a vast number of local government financing vehicles (LGFVs), which surged to a record 66 trillion yuan at the end of last year, according to the International Monetary Fund. That is equivalent to about half of China’s GDP. There are several aspects of this growing debt pile that pose challenges for China’s economic and financial stability.

The first aspect is the debt pile’s rapid growth. Before the 2008 global financial crisis, local governments tended to run conservative budgets and had little debt, but this changed as they and their LGFVs played an important role in the post-crisis economic recovery. In 2015, the Ministry of Finance carried out a debt swap that replaced local government liabilities with more transparent and lower interest bonds.

However, not only did the swap fail to halt the debt boom, it reinforced the central government’s backstop of LGFVs and allowed the surviving entities cleaner balance sheets to start racking up debt again. Between 2015 and last year, local government debt ballooned from 40 trillion yuan to 100 trillion, outpacing the growth of the overall economy.

Besides its rapid growth, the structure of China’s local government debt is also of concern. The average tenor of LGFV bonds is too short for financing infrastructure projects, which often take a longer time to yield any returns. This has created a significant maturity mismatch between assets and liabilities that exposes LGFVs to repayment risks.

In addition, the costs of these debts are excessively high. These punitive funding costs are untenable for most LGFVs as stand-alone commercial entities, considering the meagre returns they earn from operating public infrastructure outside major city hubs.

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Finally, the debt problem has become more pronounced because local governments’ own finances have deteriorated because of a weak economy and collapsing land sales. Some cash-strapped governments are reportedly struggling to pay their bills and service their own debt, let alone provide a credible payment guarantee for their LGFVs. While no publicly traded bonds have defaulted yet, anecdotal reports suggest some borrowers have already defaulted on shadow banking instruments and are actively seeking loan restructuring with banks.

This underscores the urgency and challenges in addressing China’s fiscal debt problem. However, given the complexity of the macro situation and the lessons learned from the 2015 debt swap, a careful redesign of the restructuring plan that considers the following principles is needed.

First, the structure of the existing debt needs to be reshaped to align with economic reality. This means the funding costs of the entire LGFV debt stock need to fall, in line with the general decline in interest rates, to reduce borrowers’ financing burden. In addition, the maturity of debt should be extended to better match cash flows of assets to reduce duration mismatches.

Local governments across China often rely on infrastructure projects to boost economic output, but this can create considerable debt. Photo: AFP

Last week’s report of state-owned banks looking to provide qualified LGFVs with ultra-long-term loans – with low interest rates and possibly temporary interest waivers – is a move in the right direction towards debt sustainability. However, these cosmetic changes cannot be the sole solution if debt is merely shifted to banks’ balance sheet. Ultimately, the ownership of debt needs to be clarified.

One way to achieve this is by breaking the implicit guarantee and reiterating the commercial nature of most LGFVs. Without the official backing, mass defaults would ensue, leading to substantial and immediate debt write-offs. The debilitating effect of this on the economy and financial system will make this nothing more than a theoretical possibility for the authorities.

A more practical option is to crystallise the official guarantee through another debt swap, this time involving the central government’s balance sheet. The central government’s lower debt level gives it the capacity to act as the lender of last resort. Also, by converting these risky debts into “risk-free” bonds, China’s government bond market can expand in both depth and maturity, enhancing its risk-pricing capability and making it more appealing, from a liquidity standpoint, to local and global investors.

Finally, successful debt restructuring cannot be achieved by considering only the liability side of the balance sheet. Instead, improving the cash-generating capability of assets has to be part of the solution. This means reviving the economy and stabilising the property market – with the goal of replenishing fiscal coffers – have to be a priority in the near term.

Triangular debt will hurt China’s growth if it is not addressed

In the medium term, Beijing needs to either rebalance fiscal revenue and spending responsibilities with local governments or create more income sources for them to offset the likely permanent decline in land sale revenue. Reports that the State Council is considering inheritance and gift taxes, as well as broadening the property tax, should be viewed in that context.

Furthermore, Chinese governments hold an array of assets that could be sold to pay down debt. This raises an interesting question: is Beijing’s recent advocacy for re-rating listed state-owned enterprises intended to pave the way for their eventual sales?

Overall, the precarious state of China’s economy calls for swift and decisive action. Together with a forceful stimulus to revive growth, a smart approach to defuse the local government debt bomb could go a long way towards reducing systemic risks of the financial system, lessening the burden of the economy and restoring the confidence of investors.

Aidan Yao is a macroeconomist with more than 15 years of experience in both public- and private-sector organisations