China’s iceberg of hidden debt shows the biggest risks in provinces dominated by local authorities and state enterprises

In China’s financial system, the bigger the role of the state, the cheaper the funding costs. As a rule. But in one corner of the country’s US$13 trillion bond market, something different has happened.

The highest yields in the 7.5 trillion yuan (US$1.1 trillion) worth of debt sold by local government financing vehicles (LGFVs) are found on the securities sold in provinces where the public sector dominates the economy.

That analysis, conducted by Bloomberg on data as of April, showcases both the productivity gap between state-owned and private industries, and the increasing differentiation between weaker and stronger borrowers in Chinese bonds. As China’s economic growth slows, the pressure is set to grow for policymakers in Beijing to ensure against mass defaults.

“Places with the most noticeable debt risks, such as the northeast area, Tianjin, Guizhou, Yunnan and Chongqing, all have a bigger state-driven economy,” said Wan Qian, China economist at Bloomberg Economics in Hong Kong. “Such a state-led model is less sustainable, and the debt may damage economic growth in the future,” she said.

As it gets easier for global investors to access China’s bond market, the world’s third largest, LGFV securities are potentially appealing. They enjoy both higher yields and a record – up to now – of implicit official backing.