Beijing Must Bail out Local Government Debt, Macro-leverage Still Needs to Increase: Zhongtai Securities


A leading Chinese economist says China could be courting disaster if it permits local governments to default on their debts as part of a strategy to encourage greater fiscal discipline.

Li Xunlei (李迅雷), chief economist with Zhongtai Securities, said any loss of trust in local government bonds could cause a regional financial crisis, particularly given the precarious confidence of investors amidst China’s gradual recovery from the Covid pandemic.

China’s local government leverage remains pressing concern

In an opinion piece published on Sina, Li Xunwei said the high debt levels of China’s local governments remain a source of keen concern for the Chinese market as well as government policymakers.

“The scale of local government debt and the solvency of local governments are receiving increasing attention,” Li wrote.

“Institutional investors such as banks, insurance companies and investment funds are the main holders of local government bonds.

“They are generally worried about the hidden risks of local government debt such as municipal investment bonds and non-standard bonds. For example, the Development Research Center of the Guizhou Provincial Government recently pointed out that ‘debt reduction work is extremely difficult and cannot be effectively resolved by relying on one’s own ability alone.'”

While there still remains much dispute surrounding the precise scale of local government debt, Li points out that there can be no doubt as to its rapid increase, as well as the potential perils it could create for China’s financial system.

Is China’s local government debt ratio the highest in the world?

While China’s total government debt ratio isn’t conspicuously high, Li argues that its local government debt as a percentage of GDP is likely the highest in the world.

The leverage ratio of the Chinese government is currently around 100%, which is significantly lower than the figure of 145% for the United States, 260% for Japan, as well as lower than the figures for Italy, Canada, France and the United Kingdom.

However, China’s local government debt (including hidden local debt) accounts for as much as 74% of GDP, which is likely the highest in the world. This compares to 28.8% in the United States, 36.6% in Japan, 20.9% in Germany, and 9.4% in France.

“Comparing the leverage ratio of the central government of other major economies, China is almost the lowest, while the leverage ratio of its local governments is the highest,” Li wrote.

Li imputes this severe imbalance to the fiscal system instituted in the 1990’s by Premier Zhu Rongji, amidst far-reaching overhaul of China’s state-owned enterprise (SOE) sector and banking system.

“Since the implementation of the tax-sharing fiscal system in 1994, the certainty of central fiscal revenue has increased, while the pressure on local fiscal revenues and expenditures has generally risen,” Li wrote.

“Ten years ago, there were many discussions in academic circles about the mismatch of financial and administrative powers between the central and local governments. The general view was that we should either increase local fiscal powers or reduce the administrative powers assumed by local governments.”

Local governments can no longer rely on land transfer revenues

The imbalance between central and local fiscal allocation managed to achieve provisional sustainability in the first decade of the 21st century, thanks to the boom in China’s real estate market that provided a convenient source of revenue to local governments.

“As the real estate sector entered a boom phase after 2000, local government revenues from land transfers rose steadily, and the pressure on their fiscal expenditures diminished,” Li wrote. “Local governments really began to feel debt pressure from 2010, because the economic growth rate has continued to decline since that period.”

The fiscal challenges of local government are on track to worsen as revenue from land transfers begins to dry up in the face of an ailing property market.

“In 2022, China’s negative population growth and urbanization process slowed down, indicating that real estate has entered a downward cycle, which means that land finance will be difficult to sustain. In 2022, the land transfer fee revenue for local governments dropped by nearly 2 trillion yuan compared with the previous year.”

Bond issuance exacerbates local debt burdens

The decline in land transfers as a revenue source for local governments has prompted them to turn to alternatives such as special bond issuance. In tandem with central-local fiscal imbalances, these measures have served to significantly exacerbate China’s debt burdens.

“In 2015, local governments began to issue special bonds, and local debt has grown rapidly since then,” Li wrote. “Special bonds are generally repaid through corresponding special income or government funds.

“However, due to the rapid growth of special bonds, the growth of land transfer fee revenues has lagged far behind, resulting in a substantial increase in the balance of local debt.

“Since 2019, the year-on-year growth rate of special bonds has remained above 15%, which is about three times the actual GDP growth rate. This mode of debt growth has exceeded the bearing capacity of local governments.”

This burdensome debt level will make it more difficult for Chinese authorities to implement counter-cyclical fiscal policies in future to keep the economy on an even keel when required.

“In the future, the rapid growth of local debt is bound to be restrained,” Li wrote. “That is to say, the strength of the counter-cyclical fiscal policy may be reduced, which means that it is unlikely for us to see a large-scale stimulus policy in the future, and the economic growth rate will be closer to the potential growth rate without stimulus.”

LGFPs another source of peril

In addition to their own bond issuance, local governments have made extensive recourse to local government financing platforms (LGFP) as a sources of revenue by means of debt raising.

China’s new budget law and its Document No. 43 (43号文) stipulate that LGFPs are “market-oriented business entities,” and local governments do not bear responsibility for their urban investment debt (corporate bonds and medium-term notes).

Li points out, however, that China’s capital and money markets still view LGFP debt to be high-credit bonds that enjoy the backing of local governments.

“It is difficult for [LGFVs] to become completely independent and purely market-oriented enterprises that have nothing to do with the government,” he wrote.

“Urban investment debt mainly includes two methods of financing – bank loans and bond issuance. The former method is the main method, but the scale of the latter form of debt financing is not small. Its balance at the end of 2022 is estimated to be more than 13 trillion yuan.

According to Li, since 2011, the nationwide balance of urban investment interest-bearing debt has expanded rapidly, with an annual growth rate of more than 10%. By the end of 2022, this debt hit 54.1 trillion yuan, for a more than 7-fold rise compared to the figure of 6.4 trillion yuan in 2011.

“Urban investment platforms (LGFVs) have actually become the main form of local debt, and the scale is significantly larger than the sum of local government normal bonds and special bonds,” Li points out.

Local and central government must maintain confidence in local bonds

Confidence in local government and LGFV debt has come into question of late, with China’s economy still staging a recovery from the Covid pandemic and the debt woes of certain provinces, such as Guizhou in the south-west, receiving heightened media attention.

“At present, the market is generally worried about the growth of local government debt and the decline in the growth rate of fiscal revenue or even negative growth,” Li writes.

“Especially in the northeast and central and western provinces with weak financial resources, the yield of urban investment bonds is generally higher than that of the developed eastern provinces and cities. In 2022, the land transfer fees of 13 provinces covered less than 100% of government debt interest, as compared to five provinces in 2021.”

Given the copious volume of bonds issued by both local governments and their affiliated financing vehicles, however, Li believes that it is not prudent for the central government to permit defaults, which would undermine market confidence and have potentially disastrous effects.

“The balance of bonds on the Chengtou (urban investment) platform is about 13.8 trillion yuan, and there has been no case of default so far, indicating that urban investment bonds are still high-grade credit bonds endorsed by local governments,” Li wrote.

“However, non-standard defaults on urban investment platforms occur from time to time, while bank loans are extended and repayment methods are often adjusted.

“The default of Henan Yongmei Coal’s debt has negatively impacted the bond market in Henan province and even the whole country. The phenomenon of credit stratification has intensified, and some economically weak areas have been marginalized. For example, financing costs in Qinghai, Yunnan, and Tianjin have continued to rise in recent years.

“Against the backdrop of a slower-than-expected economic recovery, investors’ appetites for risk have dropped significantly. To this end, local governments should ensure that urban investment bonds are paid on time.

“This is because a breach of contract will not only fail to solve the debt problem, but will worsen the regional credit environment, making it difficult and expensive for local state-owned enterprises to obtain financing. From the perspective of regional economic development, government authorities still need to continue to borrow to achieve stable economic growth.

“Therefore, there is an urgent need to enhance the confidence of urban investment creditors. First of all, we must ensure that these bonds do not default.”

Should Beijing help bail out local governments?

Given the importance of maintaining the stability of regional financial markets, Li called for China’s central government to help local governments deal with their debt challenges.

“At this critical stage of China’s economic transformation, it is particularly important to maintain the credit of local governments and prevent regional financial risks. Therefore, before the LGFVs are completely decoupled from government authorities, confidence in urban investment bonds still needs to be maintained.”

“The central government has proposed that ‘each household takes care of its own children,’ implying that it will not pay for local government debt. However, I propose that we should provide some disadvantaged provinces with considerable support.”

Li advocates that the central government provide local governments with strong support in improving the terms of their financing by means including:

  • Helping local governments to reduce debt costs via refinancing.
  • Extending debt terms – particularly for non-bond debt.
  • Using policy banks or commercial banks to provide low-interest funds to reduce debt costs and facilitate rollovers.

China’s leverage ratio still need to increase

While Li considers it imperative for the Chinese central government to help regional authorities with their debt challenges, he also believes that China will need to raise its leverage ratio further in order to drive economic development in future.

“In international terms, China’s macro leverage ratio is indeed not low,” Li wrote. “According to figures from the National Institution for Finance & Development (NIFD), it stood at 263.8% in 2021, which is close to the average level for developed countries.”

Li blames China’s high macro-leverage ratio on its belated development starting from 1978, which could lead to it “becoming old before it becomes rich.” This stands in stark contrast to the experience of developed economies in East Asia and the West following World War II, that became affluent before widespread demographic ageing set in.

Li warns that China’s demographic woes may have just begun, and that in order to compensate for a shrinking labour force the country may need to raise its leverage ratio to maintain growth.

“In 2022, China’s total population experienced negative growth, and at the same time, it entered the stage of accelerated ageing, with an ageing rate that will be faster than that of developed countries.

“Therefore, in order to develop into a modern and powerful country, we need to increase investment, which requires a further rise in the macro-leverage ratio.

“However, compared with Western countries, the leverage ratio of China’s enterprise sector is obviously too high, reaching 154%, so there may not be much more room for further leverage.”