Call it luck or stellar crisis management. One of the most indebted countries in the world, China has not yet experienced a full-blown financial crisis. There were some close calls. In 2019, the government had to seize a regional bank for the first time in decades, to prevent a run on deposits. Last year, a wave of real estate developer defaults ended with homebuyers threatened with mortgage boycotts. The fear of both has gone away. One could also argue that China is now a safer place for investors after Beijing tightened regulations on unregulated local banks and aggressive home builders.
But there’s another elephant in the room: borrowing from local government financing vehicles. For years, municipalities have relied on these off-balance sheet entities to finance infrastructure and support the local economy. According to International Monetary Fund estimates, LGFV debt is set to rise to 57 trillion yuan ($8.3 trillion), or 48% of China’s GDP, in 2022.
This is fiscal maneuvering on an epic scale. LGFV borrowings are roughly the same size as official central and local government borrowing combined. Bank loans aside, these vehicles regularly raise money from corporate bond issues, which account for more than 40% of the total market. Last year, his outstanding amount had reached about 36 lakh crore yuan.
Investors are nervous. LGFVs’ ability to service their debt is poorer than that of developers, with their mandate being non-profit and providing public services. According to data compiled from Gavecal Dragonomics, the average return on assets among LGFV bonds in the first half of 2022 was only 0.4%. Meanwhile, these 1,800 issuers aren’t compensating buyers for the risks they’ve taken, paying only 4.3% interest on average.
To make matters worse, once assets decline, municipalities may not be in a position to help their LGFVs, even if they wanted to. Before COVID, regional authorities received about 20% of their income from land sales. Last year, this important revenue stream declined by 23%.
If anything, it is another way local authorities turn to the LGFV to fix their financial problems. In 2022, as developers retreat to shore up their cash flows, these entities will grab more than half of the residential land sold, further worsening their balance sheets.
Already, the poorer provinces are lobbying for a central government bailout. In a now-deleted online post, Guizhou, in landlocked central China, said it was struggling to solve its debt problems. In December, Zunyi Road and Bridge Engineering Construction Group, a local LGFV, received a partial bailout from its lenders, swapping 15.6 billion yuan of short-term borrowings into low-interest 20-year loans. But apparently this was not enough. Another LGFV in the province best known for its flamboyant baijiu was on the verge of turning a blind eye last year.
Granted, Beijing has organized massive bailouts in the past. In the 2014 audit, two-thirds of the LGFV debt was explicitly recognized as a government liability. In ensuring four years, more than 12 trillion yuan of such borrowings were swapped for official local-government bonds. But the current 57 trillion yuan is on a different scale. President Xi Jinping’s government is walking a very tight rope.
With some luck and investor confidence, China may be able to ease this financial crisis as well.
Gavacle’s Shaoxi Zhang makes an interesting point. The poorest provinces, such as Guizhou, are more vulnerable. But they also have smaller amounts of LGFV loans outstanding, as they are considered risky and cannot be easily issued. So, the next time one of these sectors causes panic among bond investors, Beijing can still swap all of its borrowings into official government bonds.
There’s a big if to that argument. It believes the next scare will be triggered by ones like Guizhou, which has a long history of defaulting on private creditors. If instead, the surprise comes from more prosperous provinces, such as eastern Zhejiang or Jiangsu, which also happen to be the largest issuers, all bets are off. Beijing may not be able to contain that kind of explosion and China’s Minsky moment may well arrive.
Certainly, LGFV has a brighter story to tell in that they have built an affordable, quality service for the masses. Unlike the US, people in China can ride high-speed trains and take road trips at low cost. But the economy is in such a ripe stage now that fiscal authorities have to figure out how to pay for all that infrastructure. Beijing will have to tread very carefully this time.
Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. A former investment banker, she was a markets reporter for Barron’s. He is a CFA charterholder.
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