China’s Debt Hangover

China’s debt problem is mainly a local one. The latest iteration of this product as of December 2022 contains both a “Default Risk Indicator” (the first map) and a “Debt Drag Indicator” (the second map).

Replacing the previous “Stress Indicator,” the new Default Risk Indicator aims to measure the extent to which each province is facing local government financing vehicles (LGFV) financial risk and ranks each province according to a risk score. The Debt Drag Indicator, updated with the latest data, continues to rank each province based on its existing debt’s drag on local GDP. For detailed explanations of this product and its data, see the Overview.

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The shift from a debt stress to a default risk indicator is the recognition of more urgency in addressing the debt problem. That urgency is borne out of a new dynamic: Beijing’s desire to consolidate control over local governments. That political logic dictates local governments to pay back what’s owed now rather than later so Beijing can centralize finances—the surest way to control localities. But the mounting pressure to deal with local debt is coming at a time when many provinces are incapable of meeting their debt obligations, raising the risk of defaults and financial instability.

Default Risk Indicator

 High Risk

 Medium Risk

 Low Risk

Debt Drag Indicator

 High Drag

 Medium Drag

 Low Drag

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.

A high level of debt drag is not necessarily correlated with default risk. Those above the line are generally fiscally stronger provinces that are more capable of servicing their debt, hence lower risk. Those below the line are fiscally weaker provinces, hence higher risk.

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.

Learn more about the Default Risk Indicator

This indicator is aimed at producing a ranking of provinces based on the size of their liabilities relative to the size of their assets. The value attached to each province, therefore, is not the probability of default but rather a 0-1 min-max adjusted ranking that proxies a province’s default risk. For example, a province with a maximum value of 1 means it has the highest risk of default relative to the others but does not mean that there is 100% probability of default.

The indicator is derived from examining 1) regional fiscal burden (liabilities) and 2) regional repayment capability (assets). Below we detail the composition of these two terms and how the final ranking is derived.

Regional Fiscal Burden

This term is a proxy for regional liabilities, composed of either 1) total outstanding LGFV bonds or 2) total regional bank equity, whichever is the larger figure.

These are the two most consequential types of debt on local government balance sheets. The virtue of looking at LGFV bonds is that any default on bonds will be highly public and lead to contagion, while LGFVs defaulting on bank loans might not come to light because they get dealt with privately.

In cases of where LGFVs have already been shut out of the bond market, as noted above, or where regional banks have already taken on LGFV debt, we look at the regional banks’ total equity. This is because local governments will have to rescue these banks through recapitalization, and we assume that the recapitalization amounts are equal to the banks’ total equity.

Repayment Capability

This term is a proxy for regional assets, determined by the sum of local tax revenue and number of A-share listed firms headquartered in the region. Because the two factors have scale and unit differences, we convert the value of each factor into a number between 0 to 1 using min-max normalization (e.g. the region with the most tax revenue or listed firms will receive a value of 1). These two adjusted values are then summed up as a proxy measure for capability, which ranges between 0 and 2.

We excluded land and state assets (e.g. SOEs) for several reasons. One, tax revenue is a more stable and accurate measurement of local fiscal capability; two, we believe land sale revenue is likely exaggerated; three, since land sales and tax revenue are highly correlated, cross-regional comparisons can be done easier by looking at tax revenue alone, which serves our purposes here.

In terms of local tax revenue, we only included city- and county-level tax revenue because the most vulnerable LGFVs and regional banks are owned by lower-tier governments. Provincial governments also cannot always be counted on to lend fiscal support to lower-tier governments until the risks become more obvious. In other words, we assume provincial governments will be behind the curve.

In terms of the inclusion of listed firms, that helps with determining a region’s ability to repay debt. A region with abundant listed firms should have more sustainable tax revenue compared to a region with a dearth of listed firms.

Regional fiscal burden/Repayment capability = Default Risk

We set the two terms above as a ratio to derive the final score of default risk for each province, which determines the ranking.

To reemphasize, the actual value of each term is irrelevant because they have been adjusted to reflect relative ranking based on the respective size of liabilities and assets. For example, if Guizhou hypothetically has $100 million of fiscal burden (liabilities) and Jiangxi has $150 million of liabilities, for the purposes of this index we only care that Jiangxi’s liabilities are larger than Guizhou’s and assign it a score accordingly.

Learn more about 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.

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. For those interested in financial risk, they should instead use the Default Risk Indicator.

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.