Local government debt threatens China’s economy – 08/25/2023 – Market

Once known as one of China’s poorest provinces, the mountainous region of Guizhou has become famous over the past decade for a different reason: it is home to some of the tallest bridges in the world.

From the 565-meter-high Duge Beipan River Bridge, which connects Guizhou with neighboring Yunnan Province, to the 332-meter-high Pingtang Bridge, which spans the Caodu River Gorge, Guizhou’s investment in infrastructure has helped to lift the province out of poverty, earning special praise from President Xi Jinping.

But high ground also comes at a high cost. Guizhou’s debt totaled 1.2 billion yuan (R$800 million) at the end of 2022. With a debt/gross domestic product ratio of 62%, it is one of the most indebted provinces in China.

The huge amount of loans accumulated by Chinese provinces, many of them through local government finance vehicles (LGFV) – investment companies that take on debt and build infrastructure on behalf of local governments – has become a huge problem. for the second largest economy in the world. The heightened tension between local and central governments over debt comes as Beijing searches for new models of regional economic growth.

“LGFVs are a legacy of the old supply-expanding growth model that relied on heavy investment to create jobs and income,” said Chi Lo, senior investment strategist at BNP Paribas Asset Management in Hong Kong. “China’s growth structure is changing now. When it changes, the old financing vehicles that served the old economy become obsolete.”

Local governments, normally supported by funds from Beijing and profits from land sales, have long been encouraged to borrow to finance regional development.

The first LGFV was created around 1998 to finance the construction of a highway. The practice gained traction after a 4 billion yuan (R$2.68 billion) stimulus package in 2009, which encouraged provinces to invest and boost growth. Banks viewed LGFVs –implicitly backed by local governments– as safe customers, and by the end of 2022, China’s official local government debt totaled 94 billion yuan (£12.98 billion), according to an estimate by the Goldman Sachs.

Local government finances have collapsed during the coronavirus pandemic, in part due to rising Covid-related public spending and a drop in the sale of land they have depended on for revenue. With a huge pile of onshore debt repayments due in 2023 and 2024, pressure has increased on local governments, who are already struggling during an economic downturn.

“Local debt is rising uncontrollably,” said Victor Shih, a professor of Chinese political economy at the University of California San Diego. “The dependency of local governments on the central government and on debt issuance is getting worse and worse, very quickly.”

A near-delinquency by Zunyi, Guizhou’s second-largest city, in December stoked worries of a systemic financial crisis and hopes of central government bailouts. Zunyi restructured its 15.6 billion yuan loan from banks in January, shocking creditors. China’s Securities Regulatory Commission pledged last week to avoid defaults on LGFV bonds.

Beijing has decided to send teams of officials from the central bank, the Ministry of Finance and the securities watchdog to more than 10 provinces with weaker finances to look over their books and find ways to reduce debts. Government balance sheets will be evaluated to decide how best to reduce bad debt and debt. Academics, experts and others have already briefed the authorities, including Premier Li Qiang, according to representation documents obtained by the Financial Times.

One suggestion is to exchange part of the estimated 59 billion yuan for “hidden debt” – loans that are unaccounted for and often obtained through private channels for official local government bonds. China’s financial information agency Caixin reported on Sunday that up to 1.5 trillion yuan could be exchanged. But, as former finance minister Lou Jiwei has repeatedly argued in public speeches, many of these swaps would only delay the resolution of the problem, ultimately increasing leverage.

Experts are also expected to suggest increasing the maturity of loans to LGFVs to 25-30 years and lowering interest rates, giving LGFVs some breathing room to find new sources of revenue. Banks would indirectly absorb the costs. The risk of such restructuring has led some investment banks to reassess the ratings of state-owned banks with high exposure to LGFVs. Commercial bank profits would be 6% lower if 10% of their LGFV loans were restructured, according to a historical stress simulation conducted by Wang Jian, an analyst at Guosen Securities.

The most direct way to reduce debt would be to sell assets. In Guizhou’s case, experts have for years suggested selling or partially pledging its stake in Kweichow Moutai, the world’s most valuable liquor maker, said a person familiar with the talks. But despite pressure from the central government to sell, local governments were reluctant.

“The central government’s assumption is that the asset is more than enough to pay the debt, which is true to some extent,” said Ivan Chung, managing director of Moody’s Investors Service. “But it’s a question of how quickly these assets can be turned into cash, especially in the weaker western provinces.”

This reluctance speaks to tension between local and central governments over the debt problem.

“The mindset underlying [da resistência] it’s politics,” said a senior state banker who handles Guizhou local government debt. “Bridges and roads are built in response to calls for economic growth and poverty reduction. But why should localities now assume all costs on behalf of the central government?”

In a statement addressed to local authorities, the Finance Ministry said in February: “If the baby is yours, you are the one who should hold it… The central government will not bail it out.”

In May, the financial department of Guiyang, the provincial capital, said in a statement that it had “done everything possible” to deal with its debt. The statement was later taken down from the agency’s website.

In the longer term, experts argue that the role of LGFVs in China’s economy needs to be fundamentally overhauled.

In a presentation to Premier Li in July, Luo Zhiheng, chief macroeconomic analyst at Yuekai Securities, said local governments should reduce their debt-fueled spending and rely more on tax revenues or central government funds for investment. This would be in line with China’s attempt to “rebuild the tax revenue base”, Luo said, according to a copy of the presentation seen by the Financial Times. More taxes on property and personal income could be implemented when the time is right, other experts said.

Another solution is to allow the central government to raise more money. “There is still room for the central government to run deficits. But I think it is widely understood by economists in China to be the last fiscal ‘ammunition’ the Chinese government has,” Shih said.

The impact of the debt crisis has been evident in the services provided by local governments.

In the far north province of Heilongjiang, residents struggled to heat their homes in winter after local gas suppliers tightened supplies. Businesses blamed the lack of government subsidies.

In the city of Zhangjiakou, in Hebei province, where part of the 2022 Beijing Winter Olympics were held, local budgets are increasingly strained.

A civil servant in Zhangjiakou, who requested anonymity because he was not authorized to speak to the media, said he no longer trusted receiving the payment. “Getting paid is like rolling dice,” said the server. “You never know how much you’ll get in your next monthly payment.”

Building the bridges in Guizhou was a decades-long process. Unraveling the complex web of local finance can also take years.

“The cleanup process is likely to be costly and economically painful,” said Lo of BNP Paribas. “It’s a controlled default process to weed out bad assets and deleverage the system, allowing more bad LGFVs to go bankrupt… while the restructuring and debt reduction processes move forward.”

(Contributed by Edward White, Seoul)

Translated by Luiz Roberto M. Gonçalves