Opinion | China should let some local governments file for bankruptcy as part of the solution to country’s debt problem

About a decade ago, Chinese researchers had discussions over whether China should have a law to allow indebted local governments to file for bankruptcy. The debate flared up after Beijing’s massive stimulus in response to the 2008 global financial crisis. The move unleashed competitive local government borrowing, but it was clear the debt build-up was not sustainable.

However, the idea of providing an official mechanism for local governments to go bust never took off because it would have been a massive political and legal project to pull it off. After all, the different layers of local Chinese administration – namely provincial, municipal, county and township – are part of a centralised structure in which Beijing shoulders unlimited political guarantees.

Instead of exploring how local governments could declare bankruptcy like business entities do, China adopted a top-down approach to tighten its fiscal discipline. The bonds issued within quotas approved by China’s finance ministry were covered by explicit credit guarantees given by Beijing, while other forms of local government debt, including those incurred by local government financing vehicles, are, in theory, not.

This solution proved to be half-baked as it failed to arrest the expansion of local government borrowing. The absence of bankruptcy procedures for local governments has also made it hard to develop a functioning municipal bond market. There’s no point evaluating the credit worthiness of different local governments because they are essentially all the same – a local government financing vehicle (LGFV) backed by a coastal city government with robust fiscal income has to pay the same interest rate as vehicles backed by a poor inland municipality.

Further, there are no consequences for local government officials if they over borrow. As such, almost all local governments maximise their debt. The finance ministry’s discipline has only a limited effect in reining in the debt expansion. According to an estimate by the International Monetary Fund, total outstanding debt at China’s LGFVs amounted to 57 trillion yuan (US$8.3 trillion) by the end of 2022, or nearly half of the country’s GDP. But it should be noted that the real amount of debt carried by local governments could be even bigger.

China’s draconian Covid-19 controls over three years significantly worsened the balance sheet of local governments. On the one hand, fiscal revenues plummeted as factories suspended production and residents were constantly locked up; and on the other hand, local government spending surged amid endless quarantines and constant nucleic acid testing. Guizhou provincial government’s research unit publicly admitted that it would be extremely difficult for its cities to solve debt problems on their own.

Beijing, meanwhile, has made it clear it will not bail out every local government financing vehicle in a policy known as “every household should look after their own babies”. If local governments are unable to repay debts and Beijing is unlikely to help, it is inevitable that some local governments will go through some form of debt restructuring. In fact, many local governments have already gone through a de facto liquidation process to sell every saleable asset on their hands.