As our “China’s Debt Hangover” has shown, China will need to reckon with its local debt problem sooner rather than later. Since 2022, the property sector bust and the pandemic have only made matters worse as local governments’ liabilities have risen and their finances deteriorated.
But wouldn’t the central government be the ultimate backstop that either bails out faltering local governments or extends grace periods for debt repayments? That longstanding assumption will likely be seriously tested this year as defaults of local government financing vehicles (LGFVs) loom.
To understand the rising risk of LGFV defaults, one needs to understand 1) the different types of LGFVs; 2) the government’s attitude toward them; and 3) timing.
First, not all LGFVs are made equal. There are two types of LGFVs: quintessential LGFVs and hybrid LGFVs. Although both are technically local government-owned entities, the latter type tends to have more diversified holdings and behave more like state-owned enterprises (SOEs). For example, a hybrid LGFV may finance public housing but also invest in commercial property at the same time.
Beijing had believed that by pushing LGFVs to diversify, they would be able to generate more revenue and become less dependent on local government coffers. Yet since this process began in 2015, these LGFVs became less solvent and more fragile, while their ambiguous status made it difficult to determine who was responsible for their liabilities.
In short, although getting LGFVs to stand on their own was well-intentioned, the unintended consequence of Beijing’s effort was creating a debt “Frankenstein”. Based on our estimate, that Frankenstein is equivalent to roughly $4.3 trillion of liabilities potentially at risk of default, or about one-third of total LGFV debt (see Footnote).
This does not mean all hybrid LGFVs will default. But the risk is concentrated among this type because of the second factor: the Chinese government views hybrid LGFVs as more dispensable than quintessential LGFVs. That’s because the more commercially diversified the LGFV, the more likely the central government will treat it like an SOE.
That’s problematic for the hybrid LGFV because since 2015, Beijing has become more reluctant to rescue local SOEs in the hopes of imposing market discipline and reducing moral hazard in the state sector. That view is shared among provincial governments, which means hybrid LGFVs are not on the bailout priority list and will have to deal with its commercial debt on its own rather than count on the government.
What’s more, when it comes to extending grace periods for debt repayment, banks are going to prioritize those quintessential LGFVs that are most important to provincial governments. But it takes a long time to work out such arrangements. For example, Beijing gave the green light in February 2022 for banks to extend lending to the Guizhou government, but it took ten months to complete the deal.
Three, there’s less appetite among city and county governments to spend money to rescue hybrid LGFVs in a year when they are facing severe fiscal constraints, even though they hold a considerable amount of LGFV debt.
This year will likely see a major source of these lower-tier cities’ revenue dry up: with population declining, their land sales are bound to contract, likely leading to flat land sales growth nationally. Moreover, new local officials will be more interested in investing in their signature initiatives instead of throwing good money after bad debts in a post-Party Congress year when maintaining stability is no longer paramount.
The bottom line is that in an environment of constrained finances, local governments must make tougher choices on where to spend limited resources. Since tackling the debt problem is already prohibitively expensive, the less important hybrid LGFVs are more likely to be hung out to dry.
The outstanding question is once LGFV defaults start to happen, will Beijing allow it to snowball? As noted above, Beijing has tended to view limited defaults in a positive light as a way for the market to weed out bad assets. But because of the scale of insolvent hybrid LGFVs, Beijing will likely have to erect a firewall somewhere before regional financial stability is seriously threatened.
Achieving both of those goals requires a delicate balance and an appropriately timed intervention on Beijing’s part. Yet the reality stands that the Chinese government cannot nor does it want to save every hybrid LGFV, which means we may have to get used to seeing their defaults in coming years.
Footnote: Total LGFV liability is estimated to be ~$13 trillion, $6.5 trillion of which we assume to be hybrid LGFV debt (50%). About two-thirds of that $6.5 trillion we consider to be at risk of default, which equals $4.3 trillion.
Houze Song is a fellow at MacroPolo. You can find his work on the economy, local finance, and other topics here.
Can you write about the footnote? Seems like a huge point to not relegate to a footnote.
"About two-thirds of that $6.5 trillion we consider to be at risk of default."