Explainer | Is China’s local government debt a concern and what role do LGFVs play in infrastructure spending?
- Local government bonds reached 28.6 trillion yuan (US$4.5 trillion) at the end of September, accounting for 23 per cent of the all the listed bonds in China by volume
- Local government hidden debts, mainly LGFV debts including loans and bonds, reached 45 trillion yuan (US$7 trillion) at the end of 2020, according to estimates
Local government debt in China is broken down into two parts, namely explicit and implicit debt.
What are LGFVs?
Bonds sold by local government financing vehicles, or LGFVs, are one of the ways provincial authorities raise money to increase spending without including it on their official balance sheets.
LGFVs flourished following the 2008 global financial crisis as a way of funding China’s infrastructure building spree, even if they did not generate returns.
The debt raised is kept off the balance sheets of local authorities, yet carries an implicit government guarantee of repayment.
Why is local government debt a concern in China?
Implicit local government debt, which the central government often refers as so-called hidden debt, is seen as the biggest concern as there is no official data on the total debt sold by LGFVs, making it difficult to monitor.
LGFV debt includes both listed and unlisted securities, as well as loans to banks.
LGFV financing platforms have increased rapidly since the global financial crisis in 2008, when Beijing rolled out a 4 trillion yuan (US$572 billion) infrastructure spending package to boost growth.
But transparency is often poor, which has led to the misuse of funds in projects that do not comply with government guidelines.
Local governments’ deteriorating ability to pay off debts has been a long-standing concern and the coronavirus pandemic only exacerbated their financial woes.
Over the past few years, a series of missed interest and principal payments have taken place at a number of LGFVs, which has already affected some local governments’ ability to raise funds due to their weak credit profile.
Since 2014, debt from public private partnership (PPP) – a joint venture between the local governments and the private sector – has also grown. They tend to invest in the same projects as LGFVs.
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However, the growth of PPP has also raised concerns over the potential misuse of funds because local governments fail to conduct return-on-investment evaluations and fiscal stress tests, which means projects may not generate any returns, adding to the growing debt risk.
Beijing’s deleveraging campaign to curb speculation in the real estate market and shadow banking activities has aggravated local government financial problems since it started in 2015 because most rely on land sales for income, and this is linked to the performance of the property market.
Banks are among the biggest lenders to LGFVs, particularly through informal lending channels such as shadow banking.
Financial institutions’ significant exposure to local government debt could pose a systemic risk in China’s state-dominated banking system, as there is a possibility of collective collapse caused by a bankruptcy of a LGFV.
What is the current level of local government debt in China?
Local governments have been able to sell debt in the open market in the form of bonds since 2015.
The balance of local government bonds reached 28.6 trillion yuan (US$4.5 trillion) at the end of September 2021, accounting for 23 per cent of the all the listed bonds in China by volume, according to Huatai Securities.
However, there is no official record of the debt sold by LGFVs.
Local government hidden debts, mainly LGFV debts including loans and bonds, reached 45 trillion yuan (US$7 trillion) at the end of 2020, equivalent to 44 per cent of China’s gross domestic product (GDP), according to Lu Ting, chief China economist at Nomura. The amount is more than four times compared to the end of 2010.
Local government debt in the form of PPP has also risen significantly, and since 2014, a total of 10,126 projects with an investment amount of 15.7 trillion yuan (US$2.5 trillion) is still owed, according to the Ministry of Finance.
How has Beijing tackled local governments’ hidden debt?
This means debt carries on rising, while the legislation to regulate local government debt and its related issues has not made significant progress since it was introduced in 2015.
Beijing introduced special purpose bonds in 2015 as a transparent way to fund infrastructure plans in an effort to replace off-balance sheet borrowing by China’s local governments.
But the annual quota set by Beijing is not enough to cover local governments’ total financing needs, leading to authorities to rely on LGFVs.
PPP was also supposed to channel private sector money to support long-term investments by local governments when it was introduced in 2014.
However, the Ministry of Finance tightened up its supervision over PPP projects in 2017 to prevent a misuse of funds.
But despite Beijing’s effort to encourage the private sector to invest in PPP projects, there are still only administrative regulations in place that are insufficient to protect private investors.
In August 2021, the Ministry of Finance said it would cooperate with the Ministry of Justice to push forward the long stalled legislation covering PPP “as soon as possible”.
What is the outlook for local government debt?
While there has not been a high LGFV profile default recently, especially those that are sold in the open market, analysts believe refinancing risks are high for local governments as a result of a potential prolonged slowdown in the property market, which is likely to hurt land sales and with it local government revenues.
Some local governments have already introduced restrictions on the scale of decline in home prices and have allowed local banks to slightly lower their mortgage rates and speed up mortgage approvals to avoid a hard landing in the real estate market, according to a report by Nomura in October 2021.
Land development remains important to the economic growth of most local governments, especially for smaller regions.
Land revenues account for around 6 per cent of total revenues for provinces, 42 per cent for cities and 39 per cent for districts and counties, according to US rating agency Standard & Poor’s.
The Institute of Advanced Research at the Shanghai University of Finance and Economics estimated in a report at the end of October 2021 that around 5.82 trillion yuan (US$908 billion) of LGFV debt will mature in 2021. This figure would be 5.6 trillion yuan on average in 2023 and 2024.
“At present, many local governments can only continue to roll over their debts by borrowing the new to repay the old, but this is just drinking poison to quench their thirst, it’s not a long-term solution,” said the report by the Institute of Advanced Research.
Standard & Poor’s believes the central government will be more selective in bailing out LGFVs and state firms going forward as Beijing is determined to curb the growth of hidden debt by local governments.
In a report at the start of October 2021, Standard & Poor’s said that the LGFV sector will see “further deepening of credit differentiation, and issuers with deficient financial management and government administration could face mounting refinancing pressure”.
“The policy role of an LGFV alone is not enough to guarantee support. LGFVs need to follow risk-control measures and their government owners must exhibit a capability to manage its corporate resources,” the S&P’s report said.
Additional reporting by Ji Siqi