CHINA´S TEETERING LOCAL DEBT MOUNTAIN, IN SIX CHARTS / THE WALL STREET JOURNAL

China’s Teetering Local Debt Mountain, in Six Charts

Beijing might have no choice but to bail out cities and provinces—and soon

By Nathaniel Taplin

A high-speed road is under construction in Anyang, central China. PHOTO: CFOTO/NUTPHOTO/ZUMA PRESS

After a decade of kicking the can down the road, China’s local government debt problem has become impossible to ignore. 

How adroitly Beijing acts to address it could make or break China’s financial system over the next several years—and the economy’s trajectory as a whole.

China’s city governments have long been burdened with heavy debt—a consequence, in part, of a fiscal system that allocates most tax revenue to Beijing but leaves the bulk of expenditures, outside of defense, to cities and provinces.

But recently the debt pains of local governments have gotten noticeably more acute.

In May, the finance bureau of Guiyang, the capital of the far western province of Guizhou, admitted that it had “basically exhausted” measures to defuse debt risks itself. 

In September, Inner Mongolia announced that it would issue 66 billion yuan, equivalent to about $9 billion, of “special refinancing bonds” to help repay higher-interest debt issued before 2018.

The International Monetary Fund projected in February that China’s local government debt burden, as a percentage of gross domestic product, will rise 9 percentage points this year. 

In 2022, that rise was just 5 points. 

In 2021, it was 2. 

Much of that debt has been issued off official balance sheets, at high interest rates, through “local government financing vehicles,” or LGFVs: corporate fundraising platforms controlled by local authorities.

But banks and households—the latter through purchases of retail wealth-management products backed by LGFV bonds—are key creditors. 

That creates clear financial and political risks if too much debt goes bad.

Why has the long-festering problem finally come to a head now?

One reason is that two important sources of local government revenue—taxes and land sales for property development—took a big hit in 2022, even as expenditures to fight the Covid-19 pandemic were rising sharply.

Property and land sales—the latter about a quarter of local government revenue—look unlikely to fully recover soon. 

That could leave city governments with a permanent hole in their budgets.

China’s problems are also, ironically, in part a consequence of the previous crackdown on “shadow banking” in 2018, which starved financially stressed LGFVs of another funding source besides banks and the bond market.

Since 2018, yields on many higher-rated LGFV bonds have trended downward. 

But lower-rated debt has remained very expensive to issue, as doubts have grown about LGFV creditworthiness and alternative funding sources such as shadow banking have dried up.

At the same time, investment returns on many local government projects have fallen sharply, thanks to years of overbuilding. 

Return on assets in the power and heat supply sector, for example, fell from around 4% in 2015 to just 1.5% in 2022, figures from data provider CEIC show.

Falling returns, high legacy interest costs and deeply depressed land sales add up to a toxic mix for local governments. 

But there are some reasons for optimism too.

For one, while the debt problem is widespread and worsening, acute financial distress still appears to be concentrated in less-wealthy inland provinces, which typically have lower debt burdens in absolute terms. 

A list of the top 10 most financially distressed Chinese cities compiled by consulting firm Rhodium Group in mid-2023 was, with a few exceptions such as the megacity of Tianjin, dominated by cities in China’s north and west such as Lanzhou and Kunming.

There are also some tried-and-true strategies the central government can employ to tackle the problem.

Beijing can green-light local governments to swap much more of their off-balance-sheet, high-interest LGFV debt into official provincial debt—which is lower-interest because investors assume that provincial debt is ultimately backed by Beijing.

A similar program kicked off in 2015 helped local authorities refinance trillions of yuan of high-interest debt. 

Many more debt-swap announcements such as Inner Mongolia’s are likely soon: On Monday, the provinces of Liaoning, Yunnan and Guangxi, as well as the province-level city Chongqing, announced debt-swap plans totaling nearly 190 billion yuan.

Local authorities can also lean on local banks to refinance high-interest LGFV bond debt as low-interest bank debt—or roll over existing loans.

Both options have downsides. LGFV debt adds up to at least 11% of Chinese banks’ loan books, according to consulting firm Gavekal Dragonomics. 

Writing off or rolling over a significant chunk of that debt will be a big hit to profitability and balance sheets—at a time when net interest margins are already near record lows. 

And swapping much more LGFV debt into provincial debt creates problems too: moral hazard and, potentially, higher borrowing costs for Beijing over the long run as it assumes more direct risk for localities’ spending habits.

But ultimately, Beijing doesn’t have much of a choice. 

When land sales have weakened dramatically in the past, governments have often plugged the gap with LGFVs—especially since 2016. 

LGFV bond issuance has already begun rebounding in recent months as financial conditions have eased and the property market has slumped again. 

But this time, markets might not be able to absorb another big wave of issuance.

Meanwhile, reports of unpaid local government workers won’t do much to reassure already thrifty households. 

The time for can-kicking is done.