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China’s local debt crisis is intensifying. Standard & Poor’s estimated that the nation’s local government financing vehicles (LGFVs) collectively owe about 60 tn yuan ($8.3 tn) in debt. “The liquidity soundness of the lower-tier entities is deteriorating quickly, with a build-up of short-term debt amid depleting cash,” cautioned the rating agency.
The International Monetary Fund even estimated that China’s LGFV debt has already reached 66 tn yuan ($9 tn).
According to China’s Finance Ministry, at the end of 2022, the outstanding debt by the local governments and that from LGFVs stood at nearly 100 tn yuan. The amount represented almost 80% of China’s nominal GDP.
The huge outstanding LGFV loans are increasingly becoming a risk. As per President Xi Jinping, the issue is one of the “major economic and financial risks” that China is facing.
LGFVs developed rapidly after the 2008 global financial crisis instead of traditional municipal bonds, mainly because local governments in China weren’t allowed to borrow directly. Thus, this quasi-official vehicles were established to raise funds for cash-strapped local authorities.
Funds raised through LGFVs are mainly used to extensively finance property and infrastructure development.
According to Fidelity International, LGFVs have helped drive up China’s urbanisation ratio, from 36% at the turn of the century to 65% in 2023.
LGFV debt is usually considered a form of hidden debt as they are indirectly guaranteed by local governments and not explicitly reported in their official budgets.
What led to the ballooning debt crisis?
A report from April 2023 highlights the extent of the crisis, when the debt-ridden province of Guizhou made a strong plea to Beijing for help.
As LGFV debts do not appear on the accounting books, local governments have used them to finance projects that were unsustainable. This led to a ballooning debt crisis. LGFVs financed several public welfare projects which hardly generated adequate cash to allow the vehicles to repay their debts, thus compelling them to refinance at higher interest rates.
When the Chinese property market boomed, local governments were able to generate handsome revenue, and LGFVs flourished. However, post the Evergrande debacle, things went downhill.
The accumulated debt has added to the interest burden on local governments. Amid China’s slower-than-expected recovery, the deteriorating financial health of some indebted local governments has become a key concern for policymakers and investors.
In July, China’s politburo reiterated the need for “defusing local government debt risks with a package of plans.” Market watchers stated that the plan could lessen some liquidity pressure on the most non-performing LGFVs, however, it’s not a long-term solution.
Local governments require immediate liquidity
According to Rhodium Group, it is unlikely that any solution would emerge from the localities. The central government needs to act urgently to restructure local government debt with concrete steps and stabilise local finances.
Some experts are expecting Beijing to take drastic measures to resolve the ongoing debt crisis.
In August, China allowed provincial-level governments to raise about 1 tn yuan ($139 bn) through bond sales to repay the debt of LGFVs and other off-balance sheet issuers.
S&P expects bank refinancing to be the main means to refinance maturing LGFV debt and cover interest payments. “We view as remote the probability that a series of LGFV defaults will cause sector-wide contagion over the next 12 months,” opined the credit rating agency. “That said, we see at 1 tn yuan of short-term maturities for LGFVs in the cities showing acute liquidity strains for the entities.“
BNP Paribas considers the issue to be a threat to China’s financial stability. The asset manager cautioned, “Beijing could be at risk of a policy miscalculation, creating a Black Swan event. Also, it cannot – nor does it want to – save every hybrid LGFV. In short, there are likely to be more LGFV defaults in the coming years as China’s debt reduction and restructuring processes move ahead.”
