The enormous debt accumulated by China’s local governments—primarily through opaque shadow banking channels—has become a major problem for the world’s second-largest economy as it grapples with deep economic uncertainty, and policymakers scramble for a “comprehensive solution.”
“The sums involved [in the local government’s debt pile] are substantial; almost double on-balance sheet local government debt as per estimates,” Robert Carnell, the Singapore-based head of research and chief economist Asia-Pacific for ING Bank, told The Epoch Times.
“The stock of debt remains and can be an impediment to growth since as local governments try to tackle their over-leverage, this rules out substantial infrastructure spending, which is the usual go-to policy response in a downturn.”
Mr. Carnell reckons the local government debt is around 59 trillion yuan (about $8 trillion). However, according to the International Monetary Fund’s estimates, China’s total local government debt—raised mainly through a funding mechanism called the local government financing vehicle (LGFV)—has swollen to a record 66 trillion yuan (about $9 trillion) this year.
Local Government Financing Vehicles
According to analysts, LGFVs would have a greater impact on social and economic stability.
In recent months, the speed and spread of the materialization of contingent liabilities have been exceeding analysts’ expectations. While this has added to the credit risks across a broad spectrum, the debt raised through the LGFVs is alarming, according to a Moody’s Investor Service report released in early August.
LGFVs are local financing platforms set up by local governments in China to raise funds for infrastructure and real estate development projects. They are not subject to the same regulatory oversight as traditional banks, yet they can borrow money from various sources, such as banks, bond markets, or individuals.
LGFVs are considered part of the shadow banking system since they operate outside of the conventional banking system and generate credit without being bound by capital or liquidity restrictions.
LGFVs are also often nonprofit and heavily leveraged. However, as state-owned companies that borrow money from banks and capital markets on behalf of local governments, they usually enjoy explicit or implicit government guarantees.
Yet they are not included in the official budget, which is why the mechanism poses potential risks to the financial stability of China. Many LGFVs are not profitable and must repay their loans through land sales or fiscal transfers.
“This debt [through LGFVs] usually offers a higher interest rate than on-balance sheet debt to attract investors and creates a large debt service issue now that local government revenues have been hit by the lack of land sale revenues,” says Mr. Carnell.
According to Moody’s, for example, while most provinces experienced a land sales contraction in 2022, Jilin, Tianjin, Qinghai, Heilongjiang, and Liaoning dropped by more than half last year.
Contractions in provinces such as Shandong, Fujian, Jiangsu, and Zhejiang—for which land sales historically composed a greater share of total revenue—were also sizable.
Patterns are likely to be similar in 2023. “While we expect the decline in land sales revenue will stabilize, longer-term demographic trends such as population outward migration will also weaken some provinces’ ability to grow future revenue from this source,” said Moody’s in its note.
Provinces with high population outflows and high LGFV loans relative to fiscal revenue, such as Tianjin, Yunnan, Jilin, and Gansu, according to Moody’s, may have a more difficult time adapting to much-decreased land sales revenues.
Other Challenges
The nation faces other challenges with local government debts.According to the World Bank, China needs to relax payback pressures on local governments and minimize default risks, while simultaneously increasing fiscal income and spending capacity and moving the economy away from a property- and local government-led development model.
Beijing needs to motivate local governments to build their economies without incurring debt, while simultaneously imposing realistic budgetary restraints on them.
This would require Beijing to recognize and respect local governments’ access to and control over the fruits of local growth, such as local fiscal resources.
Central authorities must also prevent the possible spillover effects of the local government debt crisis on the banking sector and the property market, both of which are critical to China’s economic stability and growth. This involves lending money, restructuring debt, and reining in the real estate sector.
Nonetheless, Moody’s believes that the LGFVs’ distinct qualities suggest a higher possibility of government backing.
“The rising liquidity challenges of some LGFVs have prompted comparisons to the property market downturn. While the two sectors share similarities, we believe that LGFVs have a higher likelihood of getting direct support from their regional and local government owners, provided that [they] have the available resources to do so,” Moody’s note said.
This public-private fund will, for up to six months, provide loans to LGFVs that are having trouble accessing funding in the capital market or through traditional lending institutions.
