The sword of Damocles is hanging over Chinese local governments. After the 2008 financial crisis, Beijing began embracing economic stimulation as it scrambled to prop up growth and protect its near-universal employment. In doing this, the central authorities demanded that local governments bear the brunt of the fiscal and financial responsibilities for road, railway and other infrastructure projects; it rewarded them with lucrative credit and looser oversight amid a skyrocketing real estate market. A decade later, local debt – and the tangled web behind some of the loans – has become the greatest pain to the economy as local revenue fails to keep pace with spending, investment returns fall and the property market dips. And all of these are plucking at the single thread holding the sword over the heads of local governments, threatening the once unimaginable: default – along with all the resulting social and political fallout.
The exact size of the debt taken on by local governments and related entities is a mystery. According to recent official accounts, the total amounted to 16.6 trillion yuan ($2.48 trillion), or 20 percent of the gross domestic product, making it significantly less than debt in the corporate sector (now at 167 percent of GDP). Even the rapidly surging household debt is higher at nearly 50 percent of GDP. If the central government's figure of 12 trillion yuan is included, the total official government debt is only 37 percent of GDP, way below the 60 percent figure that is considered prudent by international standards. It is also significantly lower than that of most developed countries, including Japan (200 percent) and some European states. However, a large amount of the local debt is hidden in off-budget spending. In various ways, it has the implicit backing of local governments, meaning the total and the risk have been underestimated.
Weaving a Tangled Web
To understand the evolution of local debt, one must look at its development in the years since the 1994 tax reform. As the central government reasserted its fiscal authority, local governments lost much of theirs. Local jurisdictions' share of total tax revenue fell from roughly 70 percent to 30 percent amid a previously imposed prohibition on their direct issue of bonds. The changes forced them to rely more on the central government's distribution of funding to meet local expenditures. But since 1994, local spending has outstripped central funding, and local governments have been tasked with paying for everything from infrastructure development to education and public health.
The funding shortage led local governments to seek ways to circumvent the rules, pushing them toward shadowy pseudo-corporations known as local government financing vehicles (LGFV). These businesses act as a bridge between banks and local governments, which used land sales from the booming real estate market to finance their spending and the LGFVs to keep the spending off the budget. When the financial crisis hit in 2008, the pseudo-corporations rapidly became the primary financing platforms for local governments. The LGFVs often raised credit through various types of loans made by banks, insurers or other financial institutions from their off-balance sheet; they came with a promise of high returns and often with an implicit guarantee from local governments or real estate as collateral.
The shadowy and unregulated nature of such financing has prompted Chinese authorities to crack down on pseudo-corporations since 2014 and to move their debt on to the government balance sheet through debt swaps. Still, even at the most conservative estimates, LFGV debt stands at about 20 trillion yuan, and only 25 percent is believed to have been counted as official local debt. Beijing has also greatly expanded the financing authority of local governments by allowing the issuance of local bonds by provinces, municipalities and some cities. Those bonds now make up a majority of the 16.6 trillion yuan in official local debt. In addition, the central government has worked to insulate local governments from the risky LGFVs.
While limiting LGFVs, Beijing has also – intended or not – opened alternative, and more subtle, financing channels for local governments. The central government has been encouraging public-private partnerships (PPP), which bring in private capital and shift some risk to the private sector. However, a majority of these partners are not private but local government-affiliated entities or local state-owned enterprises in disguise. Moreover, the PPPs are concentrated in the traditional infrastructure sector, and some of the riskier ones have skirted borrowing restrictions. This has led to even riskier unofficial debt, which was estimated at 18 trillion yuan at the end of 2017.
Control and Consequences
All together, the debt which is backed by an implicit guarantee from local governments or which is linked to government-affiliated entities could total anywhere from 40 trillion to 50 trillion yuan. By comparison, total fiscal revenue from both central and local government was 17 trillion yuan in 2017. In addition, a large portion of this debt is closely intertwined with risky businesses, including unprofitable infrastructure projects, zombie local state-owned enterprises and the highly speculative real estate market.
To contain this risk, the central government has aggressively sought to rein in local governments' borrowing over the past two years and control the expansion of credit as part of its broader campaign to decrease overall liabilities. The drive has produced some positive results, but not without blowback. Local governments are now using more subtle disguises for their debt as financial constraints slow the economy, increasing the costs for local governments in servicing their debt. And looming on the horizon is a massive amount of local debt that will reach maturity in the second half of 2018. For just the official local debt, each month after June will require a 100 billion yuan payment as three-year bonds mature. This figure does not include shadow debt, meaning the known LGFV payments will add 1.35 trillion yuan to the burden in 2018. This repayment load, in combination with risky projects and a stagnating real estate market in many parts of the country, is raising the prospect of a local debt crisis for some down the road.
Dealing With Default
China has no precedent to follow in handling the debt defaults of local governments or related entities. But scenarios have already begun playing out in certain locations. In some provinces, such as Zhejiang, the government has stepped in to demand that banks extend credit to ailing local firms. In Inner Mongolia and Xinjiang, large infrastructure projects or risky ones under a public-private partnership are being canceled to pre-empt further debt exposure. In an extreme case from Hunan province, the cash-depleted city of Leiyang has had to delay paying its public servants because of a sharp drop in tax revenue from real estate and coal. Most of the incidents have been isolated and contained, but tight liquidity and escalated trade tensions with the United States are adding to uncertainty.
In a move to deal with their financial vulnerability, Inner Mongolia and Tianjin earlier this year reduced their reported tax revenue by at least a quarter, further raising questions about their ability to repay the debts. Indeed, in Inner Mongolia, an LGFV failed to make interest and principal payments on shadow loans worth 4 billion yuan; as a result, the firm is close to becoming the country's first pseudo-corporation to default.
In many ways, the move by Inner Mongolia and Tianjin to shrink local income figures is as much a political campaign to appeal for a bailout as it is a move toward statistical accuracy. The notion that the central government will ultimately bail out local governments on the edge of default is pervasive among the localities. The belief is particularly strong given the potential social and political fallout, and the potential loss of confidence in Chinese local governments. More importantly, local officials are acutely aware of how the local financial burden originated through the highly imbalanced central-local tax structure.
To tamp down that expectation and reel in the borrowing spree by local governments, central authorities have repeatedly stressed that they will strictly refrain from bailing out local governments and illicit loans. But Beijing must walk a fine line between its centralized tax structure and tight monetary position, and the risk of default and local governments' using the possible social consequences as leverage. Aware of this, the central government has moved urgently in recent months to accelerate reform of the tax structure, to ease the burden of public services for local governments and to promise a bigger tax base, including the long-delayed property tax. While Beijing has signaled that it is easing off its aggressive deleveraging campaign, the process is uncertain. The central government has conflicting priorities over boosting domestic consumption while avoiding a future credit crunch. And its capabilities will be tested as it copes with the challenges of socio-economic restructuring, a slowing economy and deteriorating global trade.