“We are different from some Western countries,” he explained. “We have a single administration system – a centralised system … this kind of system, in a way, deepens the reliance of local governments on central government finances.”

And when local governments fail to receive sufficient state help, basic services begin falling by the wayside.

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Hu Hengsong, deputy general manager of Caida Securities, estimated that Chinese banks had roughly 30 to 40 per cent of their assets invested in LGFV bonds.

“I don’t think [bankruptcy] is a viable option for China’s financial sector,” Hu said at the same seminar. “Chinese banks will also have to go bankrupt … the implicit guarantee must be held.”

The nation’s property market crisis has exacerbated the financial problems of many LGFVs, which rely on land sales for the bulk of their revenue.

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But in the past few years, that policy has taken a heavy toll.

Local governments’ “growth models that rely on land cannot be sustained”, warned Zhang Ming, deputy director of the Institute of Finance at the Chinese Academy of Social Sciences (CASS), also at the seminar.

LGFVs were actually a cornerstone of Chinese development over the last few decades. In the mid-1990s the central government implemented budget laws to stop local authorities from accumulating large piles of debt. In response, regional governments crafted LGFVs as a workaround. There are now thousands of such vehicles in China, driving investments in bridges, roads, homes and industrial parks, and boosting the country’s gross domestic product (GDP).

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China targets to boost gross domestic product by ‘around 5%’ in 2023

China targets to boost gross domestic product by ‘around 5%’ in 2023

Li Xunlei, chief economist and head of research at Zhongtai Securities, estimated that the aforementioned Guizhou – one of China’s poorest and most indebted provinces – had built a total of 8,331km of highways by the end of 2022. In comparison, Japan’s expressways span about 7,800km, while Guizhou’s GDP is less than one-fifteenth of Japan’s.

The International Monetary Fund estimated that the total debt amassed by China’s LGFVs had swollen to a record 66 trillion yuan (US$9.23 trillion) this year – more than doubling since 2017, when the total was 30.7 trillion yuan.

Nicholas Borst, director of China research at Seafarer Capital Partners, contends that the central government is reluctant to change the fiscal structure because it gives Beijing significant financial control over the provinces.

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“I think Beijing is likely to muddle through the problem,” Borst said, adding that options to resolve the problem could include the central government using its own balance sheet, or possibly selling off state assets. “However, I do not currently see momentum toward a solution that would grant local governments a sustainable long-term fiscal situation.

“The policy direction under Xi Jinping is towards greater centralisation and reinforcement of state control over key parts of the economy. Fiscal reform would likely cut against both of those tendencies.”

There has not yet been a default among LGFVs traded in the exchanges, but Guangfa Securities estimated that there were a total of 73 defaults in LGFVs sold in private transactions in the first quarter this year – a record high since the brokerage started collecting such data in 2018. These were mostly vehicles in Guizhou and Shandong provinces.

Fitch Ratings said in a note on July 17 that Chinese banks are likely to face growing pressure on asset quality and profitability from their exposure to LGFV debt in the next year or two, leading to more loan restructurings.

Yet, many LGFVs have to pay around 6 to 8 per cent in annual interest on such investments, while some may have to even pay more, according to CASS’s Zhang. China’s central government, meanwhile, borrows at much lower rates in the capital market.

“All they can do is to rely on other means … Inevitably, this has led to significant debt growth, especially hidden debt,” Zhang said.

How is China defusing its debt bubble, and what’s the outlook?

There are no official figures on China’s so-called hidden debt, often stemming from informal channels of borrowing that involve LGFVs. It has been estimated that China’s local governments have around 30 trillion to 50 trillion yuan worth of hidden debts outstanding. Interest on these debts is much higher, with repayment terms shorter, than those in the bond market.

Li at Zhongtai Securities said that Beijing’s drive to become self-sufficient in producing semiconductors and alternative energy could once again lead to excess capacity. Local governments are being asked to invest huge amounts of money in advanced technology without much supervision or independent assessments of these projects’ efficiency, he warned.

“Local government debt is a long-standing problem,” Li said at the Renmin University seminar. “It’s a process. We can’t say, ‘Let’s just decouple [from local government guarantees]’. We need to respect their history and face reality.”

But Sun Xiaoxia, a former director general in the Ministry of Finance’s Finance Department, said it remains hard for the government to determine an “optimal debt scale”, and it is even more difficult to “maintain the debt at a certain scale”.

“In theory, there should be a discussion about the optimal debt scale, in the belief that there is an optimal debt ratio that can maximise economic growth. But the reality is often more complicated,” Sun said at the same seminar. “While achieving the goal of stable growth, we are also facing the problem of rapid expansion of local debt levels and rising debt pressure.

“Debt risk has become an issue of increasing concern. Debt risk and debt-sustainable development are two sides of the same coin.”