China’s Debt Hangover

China’s debt problem is mainly a local one. This map shows the extent to which local government financing vehicle (LGFV) debt has put a drag on regional GDP. All 31 regions and provinces are ranked based on LGFV debt’s drag on the economy. Click to see a breakdown of LGFV performance and how each province stacks up nationally. For detailed explanation of this product and its data, see the Overview below.

 High Drag

 Medium Drag

 Low Drag

Debt Drag Indicator

Local Government Debt Chart A bar chart showing information about Chinese provincial debt Guizhou 12.82% Beijing 7.58% Tianjin 5.69% Yunnan 5.54% Jilin 5.40% Jiangsu 4.85% Hubei 4.81% Zhejiang 4.79% Liaoning 4.53% Shaanxi 4.49% Qinghai 4.48% Chongqing 4.41% Hunan 4.24% Jiangxi 4.15% Xinjiang 3.92% Sichuan 3.90% Guangxi 3.83% Gansu 3.78% Hainan 3.71% Anhui 3.69% Heilongjiang 3.56% Henan 3.45% Inner Mongolia 3.36% Tibet 3.34% Shanxi 2.83% Hebei 2.31% Fujian 2.23% Shandong 1.94% Ningxia 1.76% Shanghai 1.74% Guangdong 0.97%

Debt Drag Indicator

Local Government Debt Chart A bar chart showing information about Chinese provincial debt Guizhou 12.82% Beijing 7.58% Tianjin 5.69% Yunnan 5.54% Jilin 5.40% Jiangsu 4.85% Hubei 4.81% Zhejiang 4.79% Liaoning 4.53% Shaanxi 4.49% Qinghai 4.48% Chongqing 4.41% Hunan 4.24% Jiangxi 4.15% Xinjiang 3.92% Sichuan 3.90% Guangxi 3.83% Gansu 3.78% Hainan 3.71% Anhui 3.69% Heilongjiang 3.56% Henan 3.45% Inner Mongolia 3.36% Tibet 3.34% Shanxi 2.83% Hebei 2.31% Fujian 2.23% Shandong 1.94% Ningxia 1.76% Shanghai 1.74% Guangdong 0.97%

Overview

A decade after the global financial crisis, China is still dealing with the debt hangover that can largely be attributed to the explosion of local government financing vehicles (LGFVs). The expansion of off-budget borrowing through the LGFVs was officially tolerated because it was meant as an emergency stop-gap effort to stimulate the economy after 2009. That wasn’t always the case. As late as 2014, Beijing still formally kept a tight lid on borrowing that mandated local governments to run balanced budgets.

But Beijing soon realized that the LGFV genie couldn’t be put back into the bottle. Despite repeated efforts to contain LGFV debt since 2010, that debt has grown through 2018, with the LGFV debt/GDP ratio up more than 30 percentage points since 2008.

A rising debt-to-GDP ratio is not necessarily a problem in and of itself. Debt’s impact on the economy depends much on how it is invested and how it is financed. On the investment front, the picture is bleak. LGFV debt has not been invested wisely, leading to waste and returns of below 2% that are far lower than the cost of borrowing.

Poor returns would, in theory, compound the LGFV debt accumulation problem. But this is where Beijing’s tolerance for moral hazard comes into play, because supporting LGFVs is fundamentally a political decision, not an economic one. So long as LGFVs can roll over their debt, which has been the case so far, their poor returns won’t lead to defaults or bankruptcy. In this sense, the LGFVs are almost a “safe haven” because the state won’t let them fail, which means the risk of a systemic crisis remains low as long as this condition holds.

Still, the low probability of a systemic crisis does not mean LGFVs’ performance has no impact on the broader economy. Servicing the debt from years of wasteful investment will take time and will have a long-term drag on provincial economies. In fact, LGFV debt’s drag on the real economy can be measured. This is why we at MacroPolo sifted through 10 years of financial reports from nearly 1,900 LGFVs and created the “Debt Drag Indicator.” The indicator measures the extent to which LGFV debt is affecting real economic output across all provinces/regions.

What Is the Debt Drag Indicator?

The indicator is calculated by multiplying (1) the difference between LGFV return and LGFV cost of capital and (2) LGFV debt (percentage of GDP), as represented by this equation:

(LGFVc  – LGFVr) x LGFV debt (percentage of GDP) = Debt Drag Indicator

The result for each province/region can be interpreted as the annual financial loss (as a percentage of local GDP) from LGFV debt. For example, a 0.01 score means the region suffered an annual loss equal to 1% of GDP. In some provinces and municipalities, such as Guizhou and Beijing, the loss may not fall entirely on the local economy since much of the lending is from national state banks.

This indicator can also be used as a measure for deleveraging. Successful LGFV deleveraging requires the Debt Drag Indicator to decline to zero, which can be achieved through either reducing total LGFV debt or by improving LGFV performance so its return becomes higher than the cost of capital.

Based on this indicator, we ranked China’s 31 provinces and regions and grouped them into three categories: high drag, medium drag, and low drag.

This indicator is not a measure of the overall financial vulnerability of a province. That’s because LGFV fundamentals have little to do with whether a province is exposed to financial risk. As explained above, LGFV’s survival and perpetuation is largely politically determined by Beijing. For this reason, we decided it would be more useful to examine risks associated with LGFV performance and potential defaults through future research notes and analysis.

What’s Different about This Product?

While other analyses of LGFV debt exist, we took a more refined approach to correct for bias and account for regional variation. We aim to present as realistic and accurate a picture of regional LGFV debt’s impact on the real economy as possible. Such province-by-province adjustments and extensive data imputations are important in ensuring the accuracy of the results and avoiding large errors due to bias in the data.

Our sample includes 1,880 LGFVs, which accounts for 80% of total LGFV debt. The sample does not include every single LGFV, particularly some of the smaller and weaker LGFVs. What is more, in economically weaker regions, few LGFVs are qualified to issue bonds.

Some analysis simply assumes such under-representation of small and non-bond issuing LGFVs is evenly distributed across the country, when in fact strong evidence suggests that regional variation is substantial. For regions like Inner Mongolia or Liaoning, for example, bond-issuing LGFVs likely only account for less than 40% of total LGFV debt. In other municipalities like Beijing or Shanghai, bond-issuing LGFVs account for nearly all local LGFV debt. As a result, it is important to account for such variation and adjust regional LGFV debt accordingly.

For more details on data sources and adjustments, please contact Houze Song (hsong@paulsoninstitute.org).

Methodology

Data source

The LGFV data is accessed from Wind, which contains the financial reports of all LGFVs that have ever issued a bond. Our sample contains 1,880 LGFVs with data covering 2009 to 2018. Any bond-issuing LGFV that is the subsidiary of other bond-issuing LGFVs has been removed to avoid double counting. All provincial data can be accessed by clicking on the link immediately under the map.

GDP adjustment

When computing the LGFV debt/GDP ratio, GDP figures are adjusted for provinces/regions that have been publicly revealed to overstate their GDP. As such, the GDP of Liaoning, Inner Mongolia, and Tianjin have been adjusted accordingly.

LGFV return

LGFV return is calculated by dividing net cash from operating activities by total assets. This is because, compared to profit, net cash from operating activities is less prone to manipulation and represents a more accurate picture of LGFV performance.

LGFV cost of capital

LGFV cost of capital is calculated by dividing annual interest payment (based on cash flow statements) by the total amount of interest-bearing debt.