Peking Under the Hood: The Debt Behind Beijing’s Glitz

Everyone knows Beijing has an air pollution problem, but few know that the Chinese capital also has a debt problem. A massive city dotted with gleaming skyscrapers, major companies foreign and domestic, and top-notch infrastructure, Beijing exudes economic dynamism. Yet based on the findings in our new “Debt Drag Indicator,” Beijing is the second-worst when it comes to debt’s drag on the local economy, only marginally better than last place Guizhou.

Guizhou, of course, has long been known to be weighed down by debt, particularly as a result of bad investments from local government financing vehicles (LGFVs). Other provinces, such as Inner Mongolia and Liaoning, also have earned the reputation for accumulating sizable LGFV debt. How can Beijing, one of the wealthiest urban centers, be lumped at the bottom with those debt-laden provinces? And if the municipality’s LGFV debt level is so high, why are there no ghost towns in sight?

That’s because Beijing’s LGFV debt is hidden in plain sight. Surprisingly, the capital has long been a national champion in terms of the size of its LGFV debt—a title it has held for over a decade. As early as 2008, Beijing already led the country with an LGFV debt/GDP ratio of 61%, which has mushroomed to the current 140%. This is due to two main reasons. First, a large share of the LGFV debt is used to finance industrial policy and support local state firms. Second, LGFV debt is also used to fund Beijing’s infrastructure and subsidize their operations. In other words, the gleaming façade of the Chinese capital was brought to you by LGFV debt.

Funding public works with debt isn’t out of the ordinary—many governments do it in fact. The problem for Beijing’s LGFV is its poor performance, with return on assets (ROA) below 1% in recent years. On average, the difference between the LGFV’s ROA and cost of capital has been around 4% over the past decade, which means the LGFV cannot adequately service its own debt. This is in part because Beijing’s LGFV has to pay higher interest on its debt than the national average (see Figure 1), somewhat puzzling given the soundness of the local economy.

Figure 1. Beijing’s LGFV Pays More Interest than the National AverageSource: Wind; author calculations.

So what explains the LGFV’s high debt level, poor return, and high cost of capital? The answer lies in politics and perceptions.

Much of it has to do with Beijing’s special political status as the Chinese capital, which makes banks believe that Beijing’s LGFV is inherently safe. They are not wrong, since the probability that Beijing would let its own LGFV fail is miniscule. But such an expectation of being fully backstopped by the government also leads to the perverse outcome of the LGFV taking on too much debt. Without such political cover, LGFVs in Inner Mongolia or Liaoning have a higher bar to cross to convince creditors to lend to them and are under more scrutiny to meet a lower debt/GDP ratio.

The accumulation of debt eventually erodes the LGFV’s advantage of being owned by a wealthy local government such as Beijing, and it ends up having to pay a relatively higher interest. Had Beijing’s LGFV debt/GDP ratio declined to that of Inner Mongolia or Liaoning, the LGFV would have much higher returns and pay a lower interest rate.

This pattern is not limited to Beijing. In fact, many ostensibly dynamic provincial economies such as Jiangsu and Zhejiang also have high LGFV debt levels. When ranked by LGFV debt’s drag on the economy, it turns out many vibrant local economies actually come out worse than those provinces considered economically weak.