Local government financing isn’t usually seen as a cornerstone of nation building, but China’s unsteady economic fortunes literally rest on its deeply indebted provinces, cities, and counties. More than any other major country, China’s ability to build infrastructure, fund technology, and provide social services relies on bureaucrats far from Beijing who have piled up massive amounts of debt in recent years.
Those shaky finances have come into focus as the Chinese economy slows amid a property crisis, depressed business and consumer confidence, and soaring youth unemployment. Governments from modern mega-cities like Tianjin and Chongqing to the backwater provinces of Guangxi and Guizhou have saddled themselves with debt obligations that an International Monetary Fund (IMF) research paper last year called China’s “Achilles heel.” Small wonder then that Moody’s Investors Service cut its credit rating for China last month to negative from stable.
The pain is already being felt across China as local governments struggle to repay those debts and Beijing accelerates an effort begun last year to restructure them. As one Chinese hedge fund advisor writes, “the depletion of local governments’ credit capacity has not only crowded out the rising demand for social security, but also undermined the financial health and confidence of Chinese households.”
That suggests little relief in the coming year for businesses and families whom Chinese leader Xi Jinping, in his New Year’s message to the country, uncharacteristically acknowledged are facing a “tough time” and “remain at the forefront of my mind.”
The fixed-income investment giant PIMCO wrote in September that uncertainty about China’s local government debt is unlikely to pose “systemic risk” to China’s financial institutions, but so-called “idiosyncratic credit events could occur over the next six to twelve months.” Translation: fasten your seatbelts. The Rhodium Group has estimated that four-fifths of more than 2,000 corporate entities called “local government financing vehicles” (LGFVs), which local authorities have set up to borrow from banks and issue bonds, are unable to cover the cost of interest payments. A big chunk of that borrowing was incurred after COVID-19 hit in 2020 and local authorities were required to implement strict “zero Covid” measures. One Chinese academic calculates that the resulting “Covid-induced deficit” totaled approximately 4.2 trillion yuan ($600 billion)!
Chinese banks and other government-linked institutions are the primary purchasers—and often the underwriters—of the LGFV bonds. But some private Chinese institutional investors and individual investors also have them in their portfolios because of the high yields, which have averaged 5-8 percent per year until recent restructurings. According to Fidelity International, LGFVs represent between 40 and 50 percent of China’s corporate bond market, while PIMCO estimates that Chinese banks’ loan exposure to the local government entities represents about 24 percent of corporate loans and 15 percent of total bank loans. Foreigners have largely steered clear of LGFV bonds, as their issuers are justifiably regarded as too risky.
The repercussions of all that borrowing are about to hit full force: LGFVs must repay (or refinance) $651 billion of renminbi-denominated bonds in 2024 alone. Yet that is only 7 percent of the total 66 trillion yuan ($9.292 trillion) of debt that the LGFVs were projected to have accumulated by the end of 2023, according to the IMF. And that does not include an additional 40 trillion yuan of debt that the IMF says is directly owed by the local governments.
However, Professor David Daokui Li of Tsinghua University insists that IMF estimates have underestimated debt because there is a need to include LGFVs practice using borrowed money as paid-in capital to fund subsidiaries, which then repeat the same practice with their own subsidiaries. This “pyramid structure,” he says, ends up disguising the true extent of LGFV obligations.
Nonetheless, the combination of the IMF’s estimate of LGFV and local government debt in 2022 (94 trillion yuan, or $13.429 trillion) equaled about three-quarters of China’s GDP ($17.96 trillion). That was far larger than the combined GDP that year of Japan ($4.23 trillion), Germany ($4.08 trillion), and France ($2.78 trillion).
Of course, debt in and of itself is not a sign of weakness. For example, US government debt in September 2023 was about 120 percent of GDP. The real issue is the ability to repay obligations, and China’s have become increasingly unsustainable at the local level.
Much of the LGFV borrowing has gone to fund infrastructure and other projects that cannot generate adequate revenue flows to service the debt. The Rhodium Group estimates that the median return on LGFV assets in 2022 was 1 percent, but the average interest rate on the associated debt was 5.36 percent. Of course, there are many reports of waste and corruption involving local investments.
To make matters worse, as China’s property market fell into crisis in 2021, local governments lost a major source of revenue from sales of land rights to developers. As developers collapsed under the weight of their own debts, local governments turned to LGFVs to buy the land. More than one-half of residential land purchased at auctions in 2022 went to LGFVs in transactions that totaled more than $324 billion. With residential and commercial construction unlikely to return to the record levels and prices of recent years, these purchases may prove unprofitable and the loans behind them unpayable.
The looming debt debacle places Beijing in a complicated policy bind. The central government relies on local governments—especially the country’s 2,850 counties—to provide a level of services unmatched by any other country, according to a 2018 IMF study. In the pre-COVID-19 period, local governments accounted for 85 percent of general government spending (89 percent with LGFV spending). That includes public pensions, unemployment benefits, and health programs. While Beijing transfers funds to local governments for these programs, local governments have been loaded down with considerable unfunded mandates over the years. David Daokui Li’s breakdown of 2020 local government debt shows that about 14 percent of obligations were incurred because of social spending.
In addition, Rhodium calculates that local government subsidies and tax incentives account for two-thirds of government funding for research and investment in science and technology at universities, research institutes, and state-owned and private companies.
Beijing is loath to see local governments default on their debts, but it also has shown no inclination to shift those vast sums en masse onto the central government’s books. Instead, over the past year it has announced programs to refinance, roll over, restructure, and reshuffle the local debt. Some bank loans have been extended for twenty-five years at lower interest rates, and provincial governments are accessing nearly 2.5 trillion yuan of unused central government funding for bonds to reduce funding pressures in cities and counties under their authority (with more bond financing expected to be announced when the National Peoples Congress meets in March). While the new bond issues have proved popular with some investors, the refinancings have faced some resistance from holders of the older, higher-yielding issues that are being replaced; only 59 percent of 2023 “redemptions” were approved by investors.
The government’s efforts to relieve the pressures building on LGFV debt so far pale in comparison with the total obligations that have built up in recent years across China, and however Beijing kicks the repayment can down the road, grassroots governments will remain on the hook for massive debts.
This could not come at a worse time for an economy shifting into lower gear and a population—more than 950 million of whom, by one recent estimate, live on less than $300 a month—already tightening its belts. With Xi Jinping’s government giving top priority to building a “modern industrial system” at the expense of spurring domestic demand, increasingly cash-strapped local governments will be hard pressed to meet the needs of their citizens.
Jeremy Mark is a senior fellow with the Atlantic Council’s Geoeconomics Center. He previously worked for the IMF and the Asian Wall Street Journal. Follow him on Twitter: @JedMark888.
At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.