China’s Local Government Debt Woes Explained in Full – Chinese Academy of Social Sciences Says Illiquidity, Not Insolvency, Is the Issue


A researcher from one of China’s top state-sponsored think tanks says that the chief risk faced by local governments when it comes to their outstanding debt is illiquidity as opposed to solvency issues, in a detailed run down of the challenges and changes faced by regional fiscal conditions.

Xu Qiyuan (徐奇渊), a research fellow from the Institute of World Economics and Politics at the Chinese Academy of Social Sciences (CASS), says that despite long-standing concerns about their mounting debt burdens, the balance sheets of local governments in China are still in fine fettle.

“From a balance sheet perspective, there is no solvency problem for local government debt, and the risk of local debt is mainly reflected in liquidity risk,” Xu writes in a report published on Sina.

“China is a socialist country primarily comprised of public ownership. While local governments at all levels are indebted, they also hold a larger volume of state-owned assets.”

According figures from the “Comprehensive Report of the State Council on the Management of State-owned Assets in 2021” (国务院关于2021年度国有资产管理情况的综合报告), as of the end of 2021, the total assets of local non-financial state-owned enterprises stood at 206 trillion yuan, while their total liabilities were 130 trillion yuan (including municipal investment company debt), and the overall asset-liability ratio was 62.8 %.

“If the non-financial state-owned enterprises and national administrative state-owned assets are counted, total non-financial state-owned assets in China would exceed 360 trillion yuan,” Xu writes.

“If we say that based on the close relationship between the government and municipal investment companies, the government’s responsibility for repaying the debts of municipal investment companies should be included when calculating government debt; then, when considering solvency, the government’s actual control of state-owned assets should also be considered.”

This means that local governments have a range of asset-based measures at their disposal to deal with their debt burden including:

  1. The relatively direct “lease and sell assets” model;
  2. The “debt-to-equity swap” model, which involves asset management companies (AMC) and other entities becoming shareholders, enabling them to then withdraw via sales to third parties.
  3. The model of state-owned debtors selling equity to repay debts within China’s system of state-owned assets – such as the sale of equity by Guizhou Expressway Group to Moutai Group
  4. Negotiating with state-owned financial institutions to repay debts via roll overs and term extensions.
  5. Asset securitization models, including asset-backed securities (ABS) and real estate investment trusts (REITs).

Xu points out however, that despite China’s local governments having a range of methods at their disposal to pay off debts using state-owned assets, all of them are fraught with problems.

The first two methods both involve concerns over the loss of state-owned assets, and “the sale of shares to repay debts,” while negotiating debt alleviation with financial institutions is likely to cause moral hazard problems and lead to further accumulation of financial risks.

ABS are also essentially debt products that needs to be repaid with principal and interest, while local state-owned enterprises are also restricted by current provisions from issuing such instruments.

Practical challenge also attend REIT issuance by state-owned entities. The project companies for infrastructure projects in China generally do not fully own the underlying assets, leading to a lack of effective underlying assets for REIT products. Additionally, most infrastructure projects cannot satisfy the need for stable cash flow, while REITs also create double taxation issues.

“These concerns and obstacles make it impossible for local governments to readily mobilize assets to reduce debt risk even though they have huge state-owned assets,” Xu writes.

“Therefore, the risk of local government debt is mainly embodied in the illiquidity of state-owned assets.”

A brief history of Chinese government debt

Modern China resumed the issuance of government debt in 1981, following a 23-year period from 1958 to 1980 when “neither domestic nor foreign debt was issued.”

According to Chinese economist Gao Jian, at this early stage of reform and opening “everyone thought that the issuance of treasury bonds in 1981 was an act of last resort and would not be repeated.” Subsequent events have since brought Chinese fiscal practices in line with other major economies, and government debt has seen continuous growth.

Following the launch of the “Wuhu Model” (芜湖模式) in 1998, China’s local governments began to borrow to undertake development projects, leading to the accumulation of large volumes of hidden government debt. In 2014, China’s province-level governments obtained permission from Beijing to independently issue local government bonds.

According to Xu, as of the end of 2022, the Chinese government had accumulated about 60 trillion yuan in open debt – including approximately 25 trillion yuan in central government debt and 35 trillion yuan in local government debt.

Xu further points out that the interest-bearing debt of municipal investment companies with close ties to local Chinese governments amounts to nearly 60 trillion yuan.

The IMF estimates that around two-thirds of this 60 trillion yuan amount can be considered hidden government debt, adding a further 40 trillion yuan to the debt burden of local governments in China.

Consequently, Xu estimates that the Chinese government’s overall debt balance has increased from 0 to 100 trillion in a period of just over 40 years, which will inevitably arouse concerns about debt risks.

Concerns focus in particular on risk in relation to local government debt, because 75 trillion of this 100 trillion in Chinese government debt is concentrated at the local level.

Why has China’s hidden local government debt grown so rapidly?

Xu asserts that the fundamental reason why China’s local governments have accumulated a huge pile of hidden debts is that local governments are entrusted with “unlimited responsibilities,” including the maintenance of local living standards and the stabilisation of regional growth.

“Budgetary revenues, including transfer payments, are already stretched to protect and maintain government operations,” Xu writes. “When local governments need to promote infrastructure construction to stabilize growth and provide public goods, then they must use municipal investment companies to borrow money.”

In addition to burdensome official responsibilities, the debt levels of China’s local governments are further exacerbated by changes in the nature of their investment.

Infrastructure investment has shifted from the traditional mainstays, such as railways, highways, and airports, to the management of public facilities with a focus on urban municipal services.

“This means that the potential financial benefits of infrastructure projects are gradually shrinking,” Xu writes. “Consequently, the most distinctive feature of the financing structure of China’s infrastructure investment has been low yields (or even no-yields), lack of cash flow (or even no cash flow), the development of infrastructure which is a public good, and excessive reliance on market-oriented high-cost funds.”

According to Xu, this cost-benefit mismatch has two key characteristics:

  1. More expensive forms of debt are employed more extensively, which increases the cost of infrastructure financing. “From the perspective of debt financing for infrastructure development, the volume of funds used from low to high runs from treasury bonds, to local normal bonds, to local special bonds, to urban investment bonds issued by enterprises, to bank loans. However, the cost of these financing sources also runs from low to high.”
  2. Increases in overall debt levels despite stabilisation in nominal government debt levels. “Although the above-mentioned financing structure reduces the ratio of open national debt and local government debt to GDP, that is, reduces the government’s explicit fiscal risk, it increases the ratio of overall local government debt to GDP, which means increasing the fiscal risks of local government. This financing structure has transferred the fiscal and financial risks of the expansionary fiscal policy from the central government to the local governments, but the fiscal and related financial risks of the Chinese economy as a whole have not been reduced. On the contrary, due to the complexity and opacity of this financing structure, as well as the rise in capital and management costs, generally speaking, the fiscal and related financial risks brought about by China’s expansionary fiscal policy have not decreased, but instead increased.”

Local government reliance on land financing

A defining characteristic of China’s local government fiscal conditions over the past twenty years has been heavy dependence upon sales of land and the property sector to generate revenues, which Xu refers to as “land financing.”

Nearly 40% of the government’s total fiscal resources are directly contributed by the real estate sector. In 2020, the real estate sector directly generated 2.5 trillion yuan in taxes, while the housing construction sector generated 339.6 billion yuan in taxes.

Xu estimates that the revenue generated by real estate land (residential and commercial land) in 2020 was 7.9 trillion yuan. Given total taxation and real estate land transfer revenue (nearly 11 trillion yuan), it can be calculated that the direct financial contribution of the real estate industry in 2020 (as a share of the total revenue of general public and government funds) was 38.8%.

A key driver of this copious volume of funds has been rapid growth in land values as a result of China’s breakneck rate urbanisation. Local governments can leverage these land value increases via sales of the usage rights in order to generate revenue. Xu highlights this as a key facilitator of regional development in China’s recent economic history.

“Municipal investment companies based on local government’s land injections can be leveraged several times or even dozens of times over and undertake infrastructure construction, which drives urban development, credit expansion and economic growth.”

Changing conditions on the real estate market mean that this heavy reliance of land financing could soon be at an end, however.

“The real estate market has bottomed out rapidly over the past two years, land revenue has dropped sharply, and the expected value of land has weakened. This is greatly testing the [land financing] model,” Xu writes.

“The fiscal transformation of local governments will not only involve finding new sources of revenue aside from land transfers, but also exploring new models to replace or at least partially replace the key role of ‘land finance’ in the national economic cycle.”

Expanding China’s treasury bond market can help solve local government debt woes

Xu has also called for the Chinese central government to play a greater role in the provision of services and investment at the regional level in order to alleviate the fiscal burden on local governments.

“The key should be to optimize the expenditure responsibilities between the central and local governments and improve the infrastructure financing structure,” Xu writes.

“Specifically, the proportion of the general public budget, especially the central general public budget, as a share of infrastructure investment financing should increase.”

The chief means of achieving this will be to facilitate further development of China’s national bond market and step up the issuance of Chinese treasury bonds.

“On the debt side, it is necessary to increase the direct support of open government debt, especially national debt, for infrastructure. This requires an increase in the issuance of treasury bonds and local government normal bonds (which comprise official government debt).”

By these means, the central government can increase the share of central government debt to alleviate financial pressure on local governments.

“China’s national debt market is still not sufficiently developed. The issuance of additional treasury bonds is conducive to increasing infrastructure investment and deepening China’s treasury bond market.”

A shift in Chinese local government expenditures

Xu also highlights the need for changing the nature of expenditures made by Chinese local governments in order to alleviate their fiscal pressures, particularly given the evolving state of China’s development needs.

From the start of the reform and opening up era in the late 1970’s to the beginning of the 21st century, China primarily needed to tackle the challenge of inadequate investment.

As a consequence, one of the key missions for local governments in promoting economic development was to promote infrastructure development, prompting them to rely on land transfer revenues and the value of land for financing purposes.

Chinese infrastructure development has made considerable progress following the adoption of this model for several decades, however, which means local governments should change the nature of their expenditures.

“The key is to accurately understand the different functional orientations of local governments at different stages of economic development,” Xu writes.”

“China is about to enter the ranks of high-income countries, so local governments should pay more attention to consumption expenditures and increasing investment in people’s living standards, education and basic sciences

“Today, China’s economic output and per capita development level have greatly improved. High-quality economic development and public expectations for a better life all point to consumption playing a greater role in economic growth.

“Total social consumption is comprised of both household consumption and public consumption, and there is a positive correlation between growth in household consumption and growth in public consumption such as social security, education, and healthcare.

“The growth of public consumption represents the improvement of the quality of public services, and the income distribution gap can be narrowed through the equalization of education and medical security.

“The improvement of social security will also increase the income expectations of residents, which will promote household consumption.”

Xu further points out that the government’s own consumption spending on education scientific and technological innovation is the key to creating new drivers for economic growth, which can in turn help to increase fiscal revenues and reduce dependence on land financing.

“After boosting household consumption and technological innovation by means of public consumption, it will be easier to stimulate the market’s spontaneous investment demand and promote a virtuous cycle for the national economy.”

Infrastructure investment by Chinese local government will continue to increase productivity

While calling for changes to the composition of local government fiscal expenditures, Xu nonetheless points out that there is still room for further investment in productivity-improving tangible infrastructure.

“Most local government debt arises from the financing needs of infrastructure investment,” he writes. “Some people believe that China’s investment efficiency is declining, and its infrastructure development may be saturated, which means that we should not and do not need to continue to strengthen infrastructure investment to promote economic growth.”

Despite the dazzling footage of China’s grandiose infrastructure projects so often touted by state-owned media, actual data in Chinese infrastructure indicates that there is still considerable room for further growth and investment.

According to data figures Statista, as of 2021, there were 248 civil airports in mainland China, while in 2020, the number of public airports in the United States reached 5,217 (in addition to 14,702 private airports).

While China is renowned for high-speed rail development, figures from the “International Statistical Yearbook (2021)” (国际统计年鉴(2021)) shows that the total mileage of China’s railway system in 2019 was 68,000 kilometres, while the mileage of US railway system was 150,000 kilometres. The total mileage of China’s highway system in 2019 was 5.01 million kilometres, while for the United States it was 6.64 million kilometres.

“China’s population is more than four times that of the United States, and its land area is similar, but the volume of roads is only 75% that of the US, railways are at less than 50%, and airports less than 10%,” Xu writes.

“There is still room for improvement in municipal infrastructure construction.”

Many Chinese cities also suffer from the problems of shortage of parking lots and urban flooding, while there are still major shortcomings in “new infrastructure” such as information services and new energy development.

“In general, China’s per capita capital stock is significantly lower than that of the United States, and there is a lot of room for improvement in terms of investment efficiency,” Xu writes.

“In particular, if the spatial allocation of infrastructure investment is optimized, the efficiency of infrastructure investment can be further improved.

“Investment in infrastructure should be strengthened in metropolitan areas and urban agglomerations where population is flowing in, and incremental investment in areas where populations are flowing out should be more prudent to avoid wastage of investment.”