(Bloomberg) -- Finance Minister Lan Fo’an announced in October that China would soon launch its largest effort in years to address risks from local-authority debt. That’s stoked expectations for a massive swap of so-called hidden debt that would bring a swath of borrowing on to local governments’ official balance sheets. The hope is that the process would reduce risks of default, lower debt-servicing costs and give local officials greater scope to support economic growth.
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What is ‘hidden debt’ and how much is there?
The term refers to the off-balance-sheet liabilities of local authorities. Most of those are tied to entities known as local government financing vehicles. LGFVs are companies that borrow on behalf of provinces and cities to finance investment in infrastructure such as roads, bridges, airports and industrial parks. LGFVs mushroomed after China introduced a mega stimulus package in late 2008 to offset the impact from the global financial crisis. At that time, local governments weren’t officially allowed to sell bonds — so they set up LGFVs to raise money and fund investment.
There’s no official figure for how much hidden debt is outstanding. The International Monetary Fund estimates LGFVs had over 60 trillion yuan ($8.43 trillion) of debt as of last year — equivalent to about half of China’s gross domestic product.
National policymakers have sought for years to overhaul the model of using hidden debt to fund construction. For one thing, returns on those investments have diminished, with the country effectively hitting a saturation point for major infrastructure. For another, the main revenue that local authorities once enjoyed to support large debt loads — cash flow from selling land-use rights — has dried up due to China’s property-sector bust. That combination of factors has left LGFVs in some regions teetering on the verge of default.
What has the government done with hidden debt?
As policymakers recognized potential risks to financial stability, they revised national law in 2015 and started allowing governments at the provincial level to sell bonds officially. Swaps began at a large scale — trading hidden debt for official local bonds. By 2018, some 12.2 trillion yuan of these swaps were completed.
That effort proved to be only marginally effective, however, and in 2019 national authorities took another step — allowing some counties in less-developed regions to replace their hidden debt with official bonds. Roughly 158 billion yuan in such bonds were sold that year in seven provinces, according to an estimate by China Chengxin International Credit Rating analysts including Yuan Haixia.
An even bigger step came in late 2020, when China introduced a security known as special local bonds for refinancing purposes. First, these were designed for weaker regions to reduce their off-balance sheet liabilities. Later, the initiative expanded to include economic powerhouses like Beijing, Shanghai and Guangdong. In 2021, the southern province of Guangdong became the first to claim it had successfully eliminated hidden debt. By mid-2022, a total of 1.13 trillion yuan of the special refinancing bonds had been issued, according to China Chengxin International estimates.
The program was rolled out for even more regions since last year. Lan, the finance minister, said in October that more than 2.2 trillion yuan of local bonds was sold in 2023 for the swaps and repayment of arrears to corporations, and another 1.2 trillion yuan quota was set for this year.
So, now what’s the plan?
Lan said in his Oct. 12 briefing that policymakers plan a one-off quota for swapping local hidden debt that could amount to the biggest initiative of recent years. The government will publish more details once the legal process is completed, he said.
He didn’t specify whether this quota will apply to local bonds, as has been the case for some time now, or whether the central government itself could issue securities for this purpose. That would be big news, because national authorities have long had a principle of instructing local officials to “take care of your own baby” with regard to borrowing obligations. The thinking has been that a central government-led cleanup would raise moral-hazard risks.
Bloomberg previously reported that China is considering letting local authorities issue as much as 6 trillion yuan in bonds through 2027, mainly to refinance off-balance-sheet debt.
As for when more news may come, the National People’s Congress, which oversees the government budget and debt ceiling, is set to hold its annual session in March. Its executive body, the Standing Committee, meets every two months, with a huddle possibly taking place in late October or early November.
How will the new effort benefit the economy?
President Xi Jinping has labeled local government debt, property-market and financial-sector woes as the three “major economic and financial risks” facing China.
Intensified scrutiny of local borrowing has left provincial, county and municipal officials more cautious about new investment projects and pushed them to seek new sources of revenue. Some cities have pledged to “sell anything that’s not nailed down” to pay down debt.
Sometimes struggling to meet daily spending needs, local authorities have also resorted to delaying payments to contractors, imposing hefty fines and hitting companies with tax bills that can date back for decades. Such measures have contributed to a deterioration in business sentiment — prompting Beijing to warn against issuing excessive fines.
The new debt swap could lower interest costs for local governments and give them more time to pay obligations coming due as borrowing terms are renegotiated.
Depending on the size and contours of the program, it could also help local authorities pay arrears to companies, scale back tax-collection drives and ease off on the issuance of penalties. That in turn could help companies strengthen their own balance sheets and stabilize the broader business climate.
“Resolving the debt issue is a critical step in stopping a key deflationary downward spiral,” Morgan Stanley economists including Robin Xing wrote in a note on Oct. 13. And that’s “equally important to direct demand stimulus,” they said.
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