Reassuringly, if you weren’t aware China even had a local debt problem until you read the headline of this article, China says it doesn’t have a local debt problem.
Via Bloomberg:
China said local government debt is manageable and authorities have enough financial resources to avoid risks from spreading, seeking to allay investor fears of possible defaults.
The official Xinhua News agency published a report Monday responding to recent concerns about local government finances. It quoted an unidentified official from the Ministry of Finance as saying government finances are generally healthy and urged local authorities to tackle their debts.
The current challenge is that “the distribution of local government debt is unbalanced, with some regions exposed to relatively high risks and under rather big principal and interest payment pressure,” the official said in the Xinhua report.
Beijing has urged local authorities to “hold on to the bottom line that no systemic risk will occur,” the official said.
The last paragraph of which is interesting phrasing.
So what’s the problem that isn’t a problem?
In short, China is laden with municipal debt — about 156tn yuan of it according to Goldman Sachs, a lot of it held off of balance sheets via financing vehicles (local government financing vehicles/“LGFVs”) favoured by local government — and had a shoddy 2022 from local government revenues. This has led to a couple of close calls. Per Société Générale:
Their broad revenues (general and fund combined) dropped by 11%. Within that, fund revenues, which consist mostly of land revenues, fell by 21%. Some provinces recorded particularly sharp falls, such as Tianjin (-62%), Jilin (-61%), Heilongjiang (-59%) and Liaoning (-56%). Meanwhile, broad expenditure still expanded by 3%. As a result, the local government broad deficit increased from 10.1% of GDP (or RMB11.7tn) in 2021 to 12.2% (or RMB14.8tn), 2pp above the pre-pandemic average (2015-19), requiring more direct transfers from the central government to plug the gap.
A Goldman note published last week answered some key questions:
What has led to the current stresses of LGFV debt repayment in provinces such as Guizhou and Yunnan? Falling local government revenues and the intensified cash shortage of LGFVs over the past few years have exacerbated the stresses of LGFV debt repayment in the most vulnerable provinces.
What are the likely solutions to local governments’ debt risk? In the near term, we may see more debt swapping and debt restructuring/extension to defuse imminent risk events. Utilizing SOE shares/profits and idle assets may also help alleviate short-term repayment pressures. Policy banks and large commercial banks could play a more important role in this process.
How would a potential default of an LGFV bond affect China’s economy and financial markets? It could pose downside risk to our investment outlook via crowding out effects on fiscal policy and credit supply. Policymakers will try to prevent bond defaults this year amid weak sentiment and uneven economic recovery, but we see risks on the rise, especially for the less developed inland regions.
Wéí Yáó and Míchéllé Lám at SocGen say what happens next is… basically up to the politburo:
The zero-COVID shock and the housing crash last year seem to have brought China’s implicit government debt stress close to a breaking point. The situation has barely improved this year, and more signs are suggesting that LGFV bond default risk is higher than ever. However, whether or how many outright LGFV bond defaults will occur depends on the central government’s judgement on the probability of such defaults triggering systemic financial risk.
Apparent exposure varies pretty widely, when self-financing rates and remaining quota capacity to raise money via local government bonds (LGBs). Charts here from Goldman, then SocGen:
The solution, Goldman says, lies in debt restructuring and payments extensions (what did you expect? they were hardly going to call for regime change, this isn’t JPMorgan). Basically, weirdly, Beijing probably won’t just sit back and allow its municipalities to blow up.
SocGen:
The government has a playbook in place, comprised of both soft (debt extension) and hard (debt write-off) restructuring measures – the former has been more common than the latter. The deleveraging process will have to speed up, become more visible and expand in scale in the coming years.
This playbook is getting more difficult to implement, however, as stresses grow. But this is China, so there will be a solution. What follows, SocGen reckons, is:
— Banks being lent upon to provide more lending capacity
— Interest rates being pushed down
and, possibly:
— Austerity measures at a local level
— Sales of state-owned assets
— Lean even harder on the banks
— Tap other state-owned institutions to hide debt losses
With some combination of the above, China will be able to make its way out, the analysts conclude, but the longer-term costs could be huge. Yao and Lam (their emphasis):
[T]here may be a heavy cost to restructuring slowly – Deflation. Keeping zombie LGFVs alive requires locking up even more financial resources, intensifying the problem of capital misallocation and undermining productivity. Banks and the broader financial system would have less capacity to support productive areas. Local governments would have less resources to improve public services and social welfare. Slower income growth would mean weakening aggregate demand, which would make it harder to sustain unproductive assets. The longer the debt restructuring takes, the longer such downward spirals could last, and the more entrenched deflation could become. After losing its construction growth engine and tipping into deflation, China’s trend growth rate could fall to 3-3.5% over the coming decade in both real and nominal terms, compared with 7% and 10% over the past decade.
In short, Japanification with Chinese characteristics — with some obviously huge implication for global macro. But as mentioned, Beijing says there’s nothing to worry about, so chill out.
