China’s local government leverage: elephants in the room

Since the abandonment of China’s zero-COVID policy in November last year, its economy has emerged from dormancy. The rebound has been reflected in stronger domestic tourism and box office spending, as well as public transport usage.

But since March, this rebound has waned. Sectors outside services (especially manufacturing and property) have been shut out of the recovery. Ongoing efforts to control leverage are producing problems. While pain remains acute in the , financing arms of local government, so-called local government finance vehicles (LGFVs), are also under strain.

LGFVs: finance with baggage

Simply put, LGFVs are used by local governments to finance projects (typically in infrastructure), granting localities access to bond markets. Any debt taken out is paid off from the proceeds from the new asset and the revenues from local governments.

As China’s economy grew, these financing arms became increasingly leveraged and dependant on land sales for repayment. This leverage is now substantial, amounting to about 50% of GDP, two-fifths of all government debt.

This stress has come at a bad time for China’s local governments. With much of this LGFV debt coming due in the next two years and land sale revenues hit by property sector turbulence, there are anxieties around how much of this debt will be repaid. Though defaults in bonds have not yet occurred, strain in bank loans (where there have been over 160 defaults since 2022) signals considerable pressure on local governments.

Shored up? Local government default risk

Though the fallout from an unexpected default of an LGFV would be severe, probably triggering a credit squeeze, we don’t think it’s likely. Ability to pay is less of a risk than it appears, in our view. Consolidated government (including LGFVs) remains a net financial creditor, despite the ratcheting up of leverage. The state also has the liquidity to support its localities if they run into difficulties – with cash deposits of over 30% of GDP.

Willingness to pay is another matter. Central government is unwilling to write blank checks to solve the LGFV problem, fearful of encouraging moral hazard and breaking its policy of no bailouts. The problem of LGFVs has been left to local governments. Debts (in absolute terms) of LGFVs are concentrated in the richest provinces. Only where local governments are not able to bail out LGFVs would the central government step in, mostly by wielding its influence on state-owned banks and other state-owned enterprises (SOEs) and asset management companies to support stressed vehicles. This tension has left anxieties around these vehicles to fester.

The risk of an unforced error lingers. As we learned during the global financial crisis, liabilities held off the balance sheet have a capacity to surprise. Authorities will have to closely monitor the risks associated with LGFVs if they want to avoid any crisis. In a state-led economy like China, this task is hard but not impossible.

Investment impact

The weak fiscal position of local governments and their financing vehicles has a couple of implications. It constrains Chinese stimulus and could therefore limit spillovers to the global economy, particularly via commodity prices.

For Chinese assets, we think coming agreements over the allocation of LGFV debts could drive a temporary rebound in performance, but in light of the longer-term challenges facing the economy, this reprieve should not be mistaken for a sustained recovery.