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Beijing is taking a proactive approach to address the debts accumulated by local governments, signaling growing concerns over financial stability amidst a faltering Chinese economy.
China’s State Council is dispatching teams of officials to over 10 financially vulnerable provinces to investigate their debts, including those of off-balance sheet entities, and find solutions to reduce their liabilities. Working groups from the central bank, finance ministry, and securities regulator are collaborating on this debt resolution effort and reporting to Premier Li Qiang, according to insiders.
The massive debts accumulated by China’s provinces have become a pressing issue as policymakers seek to transition away from debt-fueled infrastructure investments to sustain economic growth. Goldman Sachs estimates that the total local government debt amounts to Rmb94tn ($13tn), including liabilities from local government financing vehicles (LGFVs), which are off-balance sheet entities.
A comprehensive resolution of the debt issue would reshape regional investment and financing, but it would also impact the pricing of locally-raised bonds and potentially affect the shares of regional banks heavily involved in lending to LGFVs.
The current plans being developed aim to review and categorize the hidden debt of LGFVs, which is not reflected on local government balance sheets and is often raised through non-public channels. The initiative proposes swapping some of this debt for official local government debt, while the rest would undergo restructuring. In addition, low-interest special purpose and other bonds could be used by local authorities to repay high-interest LGFV debt. The working groups will also encourage policy and commercial banks to extend loan maturities to LGFVs and reduce interest rates.
A major point of contention between central and local governments is who should bear the clean-up costs. Beijing expects provinces to sell assets to repay debt, but local officials argue that many of these assets are illiquid and that the central government should provide more assistance for rescues. The working groups may continue to push local authorities to sell assets for debt repayment and adhere to the principle of no direct central government bailouts to avoid moral hazard.
The plans to tackle local government debt were formulated by China’s politburo, chaired by President Xi Jinping, which pledged in July to develop and implement a set of measures to mitigate risks associated with this issue. While China has made previous attempts to curtail debt issuance by LGFVs since 2015, the current effort is one of the most focused initiatives to date.
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The spending model of local governments has become increasingly unsustainable, especially after the COVID-19 pandemic raised their costs significantly. The collapse of land sales, which many relied on for revenue, has further deteriorated the financial health of China’s regions.
However, concerns persist regarding the resolution of this trillion-dollar debt problem amid a slowdown in China’s economic growth. The target growth rate for this year, 5%, is the lowest in decades. Additionally, the world’s second-largest economy faces deflationary risks, as consumer prices fell in July for the first time since early 2021. Data from the central bank indicates a sharp decline in new bank lending, with new loans dropping to the lowest level since late 2009.
According to a source close to the finance ministry, debt swap programs are not a comprehensive solution as highly leveraged local governments may still struggle to repay their debts in the future. Slower economic growth will undermine fiscal revenue, which is a significant source of debt repayment. Ivan Chung, managing director of Moody’s Investors Services, describes the situation as a “chicken and egg issue,” questioning how debt can be repaid without sufficient growth.
No comments were received from the State Council, the People’s Bank of China, the Ministry of Finance, or the China Securities Regulatory Commission. Additional reporting by Ryan McMorrow in Beijing.
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