China’s Local Government Debt: Problem or Crisis?

China’s local government and local government financing vehicles (LGFVs) are facing challenges, but how big could the problem become? 

Market Implications: We do not see a Lehman style moment in either the LGFV, SOE or property developer’s debts, as China authorities have huge moral suasion in ensuring that creditors help an orderly restructuring of debt. Even so, the debt overhang does have an economic cost and this is one of the reason we see growth slowing to 3-4% in the second half of the decade (here) – though the cyclical boost from reopening can deliver 5.8% and 5.5% GDP growth in 2023 and 2024 (here). 

Figure 1: Volatile Local Government Revenue From Land Sales (%) 

Source: Datastream/Continuum Economics

Local Government and LGFV debt 

Local government debt was estimated to be 29% of GDP in 2022 and they face a revenue squeeze as one off taxes on land sales has fallen with the property developer’s crisis -- land sales tax is an important element of revenue (Figure 1) with the rest being local taxes or split of VAT/Income tax with central government. At least, the local governments have central government transfers and Beijing approval of special bonds as a buffer to ensure that any financing problems can be addressed. However, central government generosity will likely be less in 2023 than in recent years and the momentum will swing towards fiscal consolidation in 2024 given China’s overall low tax revenue/GDP ratio (here). However, weak local government finances mean that they are not in a position to help out LGFV vehicles. 

LGFV vehicles are a key part of China’s economy, both as they have traditionally been involved in local infrastructure investment and, in recent years, have played a wider role in countercyclical expenditure to support regional growth. Official data on LGFVs is not available, as China’s authorities focus on central government debt at 22% of GDP in 2022. Some estimates suggest over 9000 LGFVs exist, though the IMF data estimate is based on the public financial data from 2200 LGFVs – those that also tend to issue debt. Some are good, some are weak and some are financially stressed. IMF estimates that these additional LGFVs, that are possible to recognise, had an estimate debt of Yuan56.7trn or 47% of GDP in 2022 (Figure 2) and that this would rise to 66% of GDP by 2027. This debt is mainly loans, but includes an estimate Yuan13.5trn according to S&P Global ratings. Combined with local government debt, this would be a debt pile of 107% of GDP by 2027.

Figure 2: Local Government and Additional LGFV debt/GDP (%) 

Source: IMF Article IV 2022 (here)

Central government has been trying to curtail LGFV borrowing by removing local government requirements to bailout LGFVs in 2015; restrictions on local government guarantees for LGFVs in 2018 and tightening prudential regulations for new borrowing for the most heavily indebted LGFVs in 2021. However, China’s central government knows that they cannot be too strict and that moral suasion is required to allow existing loans and bonds to be rolled over. Additionally, LGFVs are closely interlinked to state owned enterprises (SOEs); local governments; banks and private companies throughout China. Severe debt problems for LGFVs are a debt problem for the rest of the financial system, but also for China’s economy, as restrained finances for LGFVs mean less local business and infrastructure investment and, hence, less growth momentum. Some weak and stressed LGFVs have been struggling to issue bonds in recent months and paying higher coupons, which can undermine long-term financial stability. 

China’s authorities do want to deal with the growing debt problem at this juncture, as was highlighted by outgoing PM Li Keqiang at the National Party Congress on March 5. A default by a major LGFV would probably send shockwaves through refinancing activities of LGFVs, which would spill over to the wider financial markets and the economy. However, a bond default has not occurred recently for a major LGFV and some are focused on a recent loan restructuring as a solution. Zunyi road and bridge construction extended loan repayments by 20 years with no principal repayment for 10 years in a recent agreement.

This extend and pretend approach could be a template for other LGFVs in acute distress. Li Keqiang indicated that the authorities must improve the mix of debt maturities, reduce the burden of interest payment and prevent a build-up of new debt. This sounds like more loan restructuring could be approved. Additionally, buying of new issuance by banks could also be officially encouraged. If a crisis were to occur, then the backstop could be a 2015 style debt swap when a huge amount of LGFV debt was swapped into government and local government bonds. However, this could undermine China’s sovereign debt rating if it is too large again. 

From a wider macro standpoint, it does seem as though the authorities want to navigate the LGFV problems in a balanced manner by avoiding default but also seeking to reduce the problem. Even so, multi-year it remains a concern that China is dependent on loans and debt to sustain growth. Reasonable M2 loan growth is no long sufficient to keep cyclical growth pushing above 5%, as credit efficiency is reduced with weak borrowers being sustained rather than resolved (Figure 3).

Figure 3: China M2 and Real GDP Growth (%) 

Source: Datastream/Continuum Economics

China’s total non-financial debt/GDP at 291% of GDP is much higher than other large EM countries. Household debt at 62% is high and corporate debt excluding additional LGFV is 119% of GDP. However, a lot of the corporate debt is loans and bonds with SOEs that, in the worst case, would likely be bailed out by the government or government sponsored vehicles. The remaining 113% is central/local government/additional LGFV and other off balance sheet government vehicles, e.g. special construction funds. We do not see a Lehman style moment in either the LGFV, SOE or property developer’s debts, as China authorities have huge moral suasion in ensuring that creditors help to help orderly restructuring of debt. Even so, the debt pile is a headwind on structural growth.