Unwinding China’s US$8 trillion local debt crisis a ‘monumental challenge’, but can Beijing find the cash?

Local governments need immediate liquidity to prevent public defaults, according to policy advisers and analysts, although there are doubts about bolder measures from Beijing to resolve the ongoing debt crisis.

Over the past few decades, China has largely relied on rapid economic growth to support its debt level.

But the deteriorating financial health of some indebted local governments has become a key concern for policymakers and investors amid China’s slower-than-expected recovery.

The People’s Bank of China said last month that there will be “coordinated” financial support to resolve local government debt risks, although there is rising fear that the central government’s response might be too slow.

“I don’t think the central government had properly considered the consequence [of curbing local governments borrowing],” Yao Yang, dean of Peking University’s National School of Development, said at a seminar last week.

“I would suggest allowing local governments to sell 2 trillion yuan (US$275 billion) to 3 trillion yuan of sovereign debt to survive … this is a crisis, it is an urgent thing to do.”

Over the past few years, the central government has clamped down on the use of off-budget borrowing by local governments.

US rating agency Standard & Poor’s estimated that local government financing vehicles (LGFVs) – created to aid off-budget financing, especially for infrastructure spending – collectively owe about 60 trillion (US$8.2 trillion) in debt.

“S&P Global Ratings believes that the liquidity soundness of the lower-tier entities is deteriorating quickly, with a build-up of short-term debt amid depleting cash,” the rating agency said last week.

“The sector is simply the most visible and obvious outcome of China’s reliance on debt-driven growth for local and regional development.

“Unwinding this debt will be a monumental challenge given its sheer size and local government financing vehicles’ modest commercial viability.”

LGFVs are hybrid entities that are both public and corporate, created to skirt restrictions on local government borrowing and have proliferated since the global financial crisis in 2008.

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Despite various attempts to transform LGFVs into pure commercial companies, many continue to invest in low return projects and the investments are often riddled with opacity and fraud.

Over the years, interest payments on LGFVs have grown exponentially as many regions have had to borrow in the capital markets, as well as informal shadow banking channels at higher than the average bank loan rates.

Between 2015 and 2018, China introduced a debt swap programme to replace local government liabilities with more transparent and lower interest bonds, but off-budget borrowing quickly piled up again.

But the chance of a banking crisis triggered by large scale local government debt defaults remains small, according to Zhang Ming, a senior fellow and the deputy director of Institute of Finance and Banking at the Chinese Academy of Social Sciences.

However, Zhang noted that there is no visibility over how such risks would be handled.

“But we still need to consider regional defaults – from defaults on the LGFVs to regional commercial banks and rural banks, [when] suddenly a series of defaults taking place in a particular province,” Zhang said at the Peking University seminar last week.

“What kind of response are we going to see? Is it going to come from the provincial authorities or is it going to come from the central government, or is it going to be a combination of the two?”

China’s largely state-owned financial system has significant exposure to local financial vehicle debt.

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The US-based Rhodium Group estimated that, as of July, LGFV loans made up 20 to 25 per cent of total bank loans in China, while LGFV bonds accounted for 51 per cent of all corporate bonds.

LGFV credit, meanwhile, covered about 13 per cent of system-wide financial assets, it said.

Yao, however, expressed pessimism over bolder changes in standardising how local government debt should be financed.

“Evidently, it’s not achievable,” he said at the seminar.

“Under [then] premier Zhu Rongji, the different financing channels had been curbed but gradually they made a return again.”

Zhu, China’s premier between 1998 and 2003, was known for carrying out financial reforms as well as expanding sovereign debt for infrastructure investment to drive economic growth.

“The point is that you can’t just keep rolling it over because the banks have deposits that they have to pay interests on and then they have assets that they receive interests on, and if the interest rates received aren’t enough to pay for the deposits, they’ll go bankrupt,” said Michael Pettis, a senior fellow at Carnegie China.

“Somebody is going to have to eat the cost. I think it’s going to be local governments – they’ll be forced to liquidate assets.”