China’s Debt Hangover

Overview

More than a decade after the global financial crisis, China is still reeling from the debt hangover that was largely caused by the explosion of local government financing vehicles (LGFVs). The expansion of off-budget borrowing through LGFVs was officially sanctioned because it was meant as an emergency stop-gap effort to stimulate the economy after 2009.

That lending was more regulated as late as 2014, when Beijing still formally kept a tight lid on borrowing and mandated local governments to run balanced budgets. But Beijing soon realized that the LGFV genie couldn’t be put back into the bottle. Indeed, the LGFV debt/GDP ratio has grown through 2021, up more than 40 percentage points since 2008.

Debt growth is not necessarily a problem in and of itself, so long as the borrower maintains the ability to service that debt. But returns on LGFV investment are on average below 2%, far lower than the cost of borrowing. That strongly implies LGFVs have engaged in numerous ill-advised investments and can no longer service their debt.

Yet that didn’t matter so long as Beijing was willing to kick the deleveraging can down the road, tolerating LGFVs’ poor returns in the process. The day of reckoning is arriving sooner rather than later, however. For political reasons, Beijing is much more determined to reckon with LGFV debt.

China is now in the process of reverting to a more fiscally centralized governance model after more than three decades of decentralization. To do so requires control of the purse strings and cutting off easy financing at the local level, such as debt financing through LGFVs. Instead, Beijing wants to replace LGFV debt with bonds that the central government issues. That is, by making local governments more financially dependent on Beijing, the central government can both assert more political control and, in its view, allocate capital better to contain debt.

This fiscal re-centralization is coming at a time when local fiscal health has further deteriorated since 2021, largely due to the double impact of Zero Covid and the property sector bust. As a result, local tax revenues declined by 9% and revenue from land sales fell by more than 25% in 2022.

So, Beijing’s newfound hawkishness on local debt is like rubbing salt in the wound. Provinces are being pressured to pay back their LGFV debt when they are holding on to large sums of nonperforming assets without the incoming revenue to match that liability. That liability totals more than $10 trillion, making any serious effort at deleveraging a huge challenge to regional financial stability and growth.

That’s because provinces’ debt repayment capabilities diverge significantly, and the risk of defaults in weaker provinces precipitating regional financial crises is growing. Although Beijing will likely erect a firewall to prevent regional volatility from going national, financial instability in certain regions may not be avoided. At a minimum, how provinces manage their deleveraging process will be one of the most important determinants of the fate of regional economies in coming years.

This is why we at MacroPolo sifted through 10 years of financial reports from more than 2,500 LGFVs and created both the Default Risk Indicator and the Debt Drag Indicator. The first and new indicator aims to measure and rank each region’s LGFV default risk. The second and updated indicator measures how much existing debt drags on the local economy.

Data source

The LGFV data is accessed through Wind, which contains the financial reports of all LGFVs that have ever issued a bond. Any bond-issuing LGFV that is the subsidiary of other bond-issuing LGFVs has been removed to avoid double counting.

LGFV Default Risk and Regional Bank Contagion

The inability of LGFVs to meet their debt obligations appears to be increasingly priced in by bond investors. More than ten Chinese provinces are already unable to fully rollover their LGFV bonds, which prevents them from issuing new bonds. The de facto exclusion of certain provinces from the domestic bond market reflects investors’ loss of confidence in local governments’ ability to repay their LGFV debt.

Consequently, LGFVs have to increasingly rely on regional banks for financing. Because of the nepotistic relationship between local governments and regional banks, these banks will continue to lend to even the most troubled LGFVs. In essence, this means some regional banks are taking on LGFV nonperforming loans, making them more financially vulnerable.

Both of these dynamics can lead to contagion. When bond investors lose faith in one LGFV, that tends to lead to large-scale bond selloffs of other similar LGFVs. A regional bank taking on too much LGFV leverage can make depositors and investors doubt the soundness of similarly positioned regional banks. As more provinces can no longer issue LGFV bonds, that should raise red flags of the debt risk spreading to regional banks as the second-order effect.

These risks ultimately amount to the loss of faith in the credibility of local governments as the guarantor of LGFVs and regional banks. If the “buck” no longer stops with local governments, that reverses long-held assumptions about how China maintains its financial stability.