Concerns are mounting over how local governments in China will pay back so-called hidden debts raised through self-issued bonds, especially as Beijing is increasing controls to prevent a meltdown in its largely state-dominated financial system.
After years of poor infrastructure returns, Beijing has flagged concerns over local government financing vehicles (LGFVs), which are typically entities set up by authorities to fund infrastructure projects.
US rating agency Moody’s Investors Service said in a report last week that China’s tightening of LGFV debt will drive many local governments to expand their commercial exposures to generate cash flow.
“Chinese LGFVs’ commercial activities could increase credit risk if they diversify into high-risk ventures such as mining or property development,” said Ivan Chung, associate managing director at Moody’s.
Beijing has tightened its supervision over LGFVs since the start of the year to control the flow of funding, increasing concerns whether local governments can provide sufficient funds to repay their debts, which have been rising over the years.
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.
Only some LFGV debt is accounted for because the bonds sold are listed on stock exchanges, although transparency about how the funds are actually used is often weak. LGFVs have also gained access to funds through informal borrowing channels, such as shadow banking – banking activities that mainly focus on lending that takes place outside the traditional banking sector.
The Chinese government does not publish data on the total debt issued by LGFVs, but some estimates indicate that the debt – including debt that has not been accounted for by official figures – has continued to rise over the years.
Lu Ting, chief China economist at Nomura, estimates that local government hidden debts, including loans and bonds, hit 45 trillion yuan (US47 trillion) at the end of 2020, equivalent to 44 per cent of China’s gross domestic product (GDP). This is more than four times the 9.6 trillion yuan at the end of 2010, which was around 23 per cent of GDP, according to Lu’s estimates.
Since 2014, Beijing has unsuccessfully made a series of attempts to better regulate LGFVs and control the potential systemic risk, including encouraging local governments to convert them into commercially viable businesses away from using implicit guarantees and applying for government bond quotas to fund public services that are not always readily profitable.
Former officials and academics have attributed the lack of progress in making LGFVs efficient as financial platforms to China’s economic growth model, which is largely based on construction.
Both China’s 14th five-year plan and long-term development goals for 2035 have outlined plans for infrastructure investment, including increasing the total transport network to 700,000km (435,000 miles), which includes around 460,000km of roads.
It is difficult to get rid of [relying on LGFVs], and it is very difficult to transform them into a market-oriented business entity
In another three-year action plan issued in March by the Ministry of Transport, China also plans to build another 3,000km of railways and more than 30 new airports for commercial use.
Former Ministry of Finance official Sun Xiaoxia told a forum in Beijing in June that local government bond quotas were often insufficient to cover construction costs, leading to the reliance on LGFVs to fund the shortfall.
The risk of default of a LGFV is also high, Sun added, because many investments do not always produce a return, meaning local governments are not always able to support the LGFVs due to a fall in its own revenue.
“It is difficult to get rid of [relying on LGFVs], and it is very difficult to transform them into a market-oriented business entity,” Sun said, according to local media reports.
Even though there has not been a default on a publicly listed LGFV bond, LGFVs have in the past defaulted on loans from banks, insurers and trust products.
The risk to the banking system is serious, explained Sun, because more than 80 per cent of local government debt is held by commercial banks.
This year, the central government set a modest economic growth target of “above 6 per cent” for 2021, but highlighted debt reduction as one of five major tasks as it seeks to cut excess housing inventory and reduce overcapacity in certain sectors.
In April, the State Council said that LGFVs should restructure or declare bankruptcy if they are unable to pay back debts. Then In July, the official Securities Times reported that Beijing had ordered banks and insurers to refrain from providing fresh liquidity to platforms that enjoy implicit guarantees from local governments.
The implicit guarantees provided by local governments have spurred money flowing into LGFVs even though they do not produce good returns, according to Zhong Ninghua, a professor with Tongji University’s school of economics and management.
Zhong estimates that local governments have been able to fund infrastructure projects at up to a 40 per cent discount due to the implicit guarantees.
Many have said that infrastructure has helped to stimulate the local economy. In fact, many roads have not been built to promote the development of local industries
While conducting research on local government debt, which was published in August, Zhong found that between 2017 and 2020, 40 per cent of local government debt was tied to investment in toll roads, the highest portion of all infrastructure projects.
However, since 2014, income from toll roads across China has been insufficient to repay the initial loan and subsequent interest on the LGFV debt, with the figures showing that the deficit has been widening.
Highway freight traffic has also been steadily declining since 2017, meaning the average efficiency of motorways per kilometre has gone down, according to Zhong.
“It is necessary to assess to what extent the new road will boost the local economy and whether it is necessary to build it,” Zhong told the Southern Weekly at the end of August.
“Many have said that infrastructure has helped to stimulate the local economy. In fact, many roads have not been built to promote the development of local industries.”
I think the central government is increasing the restrictions in fund transfer between local governments and the LGFVs they control, but local governments can find other ways [to skirt the restrictions]
Analysts believe the government policy objective, at least for the rest of the year, is to focus on controlling LGFV leverage, and therefore, is not likely to ease any time soon.
Measures to control LGFV debt risk may actually add some complexities to the outlook for local government debt funding as regional officials seek new ways to finance the shortfall to meet regulatory requirements, according to Chung from Moody’s.
“I think the central government is increasing the restrictions in fund transfer between local governments and the LGFVs they control, but local governments can find other ways [to skirt the restrictions],” he said.
“In the end, they are still fulfilling the needs to fund public policy driven projects, but now the ways to do it may become more complex.”