Chinese debt concerns mount as Beijing shifts focus to hidden local government funding

Concerns are mounting over how local governments in China will repay so-called hidden debt incurred through self-issued bonds, especially as Beijing ramps up controls to prevent a collapse of its largely state-dominated financial system .

After years of poor infrastructure returns, Beijing has raised concerns about 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 local governments to expand their commercial exposures to generate cash flow.

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“The commercial activities of Chinese LGFVs can increase credit risk if they diversify into high-risk ventures such as mining or real estate development,” said Ivan Chung, associate managing director at Moody’s.

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Beijing has tightened oversight of LGFVs since the beginning of the year to control the flow of funds, raising concerns about whether local governments can provide enough money to repay their debts, which have risen over the years.

LGFVs flourished after the global financial crisis of 2008 as a way to finance infrastructure construction in China, even if they failed to generate returns.

Only part of the LFGV debt is accounted for because the bonds sold are listed, although transparency about the actual use of the funds is often weak. LGFVs have also gained access to funds through informal lending channels, such as shadow banking – banking activities that primarily focus on lending that occurs outside the traditional banking sector.

The Chinese government does not release data on the total debt issued by LGFVs, but some estimates indicate that debt – including debt not accounted for by official figures – has continued to rise over the years.

Lu Ting, chief economist China at Nomura, estimates that: hidden debts of the local government, including loans and bonds, reached 45 trillion yuan ($47 trillion) at the end of 2020, equivalent to 44 percent of China’s gross domestic product (GDP). This is more than four times the 9.6 trillion yuan at the end of 2010, which Lu estimates was about 23 percent of GDP.

Since 2014, Beijing has unsuccessfully made a series of attempts to better regulate LGFVs and manage potential systemic risk, including encouraging local governments to convert them into commercially viable companies without using implied guarantees and requesting government bond quotas to public services that are not always 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 construction-based.

Both China’s 14th Five-Year Plan and the long-term development goals for 2035 have: outlined plans for infrastructure investments, including increasing the total transportation network to 700,000 km (435,000 miles), including approximately 460,000 km of roads.

In another three-year action plan issued in March by the Ministry of Transport, China also plans to build another 3,000 km of railways and more than 30 new airports for commercial use.

Former Finance Ministry official Sun Xiaoxia told a Beijing forum in June that local government bond quotas were often insufficient to cover construction costs, leading them to rely on LGFVs to finance the shortfall.

“It’s hard to get rid of it [relying on LGFVs], and it’s very difficult to turn them into a market-oriented business entity,” Sun said, according to local media reports.

While there has been no default on a publicly traded LGFV bond, LGFVs have historically defaulted on loans from banks, insurers and trust products.

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The risk to the banking system is serious, Sun explains, as more than 80 percent of local government debt is held by commercial banks.

This year, the central government set a modest economic growth target of “above 6 percent” for 2021, but emphasized debt reduction as one of its top five tasks as it seeks to reduce excess housing stock and reduce excess capacity in certain sectors.

In April, the Council of State said LGVVs must: restructure or declare bankruptcy if they cannot repay debts. Then In July, the official Effects Times reported that Beijing had instructed banks and insurers not to provide new liquidity to platforms that benefit from implicit guarantees from local governments.

According to Zhong Ninghua, a professor at Tongji University’s economic and management school, the implicit guarantees from local governments have led to money flowing into LGFVs, although they do not generate good returns.

Zhong estimates that implicit guarantees have enabled local governments to fund infrastructure projects at a discount of up to 40 percent.

While researching local government debt, published in August, Zhong found that between 2017 and 2020, 40 percent of local government debt was related to investment in toll roads, the bulk of all infrastructure projects.

However, since 2014, toll road revenues across China have been insufficient to repay the initial loan and subsequent interest on LGFV debt, and the figures show that the deficit has widened.

Freight traffic on highways has also been steadily decreasing since 2017, meaning the average highway efficiency per kilometer has fallen, Zhong said.

“It is necessary to assess to what extent the new road will stimulate 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 stimulate the local economy. In fact, many roads have not been built to promote the development of local industries.”

Analysts believe that the government’s policy objective, at least for the rest of the year, is to focus on controlling LGFV leverage, and therefore it is unlikely to decline anytime soon.

Moody’s Chung says measures to manage LGFV debt risk may actually complicate the outlook for local government debt financing as regional officials seek new ways to fund the deficit to meet regulatory requirements.

“I think the central government is stepping up restrictions on money transfers between local governments and the LGFVs they control, but local governments can find other ways to [to skirt the restrictions],” he said.

“Ultimately, they still meet the needs to fund government policy-driven projects, but now the ways to do so may become more complex.”

This article originally appeared in the South China Morning Post (SCMP), the most authoritative voice reporting on China and Asia in over a century. For more SCMP stories, explore the SCMP App or visit the SCMPs facebook and Twitter pages. Copyright © 2021 South China Morning Post Publishers Ltd. All rights reserved.

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