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Cracks are emerging in one pillar of China’s debt market: local government financing vehicles (LGFVs). They were created to fund things like roads, airports, and energy infrastructure, but rarely generate enough returns to meet their obligations. This means that most depend on municipal subsidies to remain solvent. As many local authorities grapple with liquidity problems due to a housing crisis, concerns are growing about this $9 trillion debt market – prompting the country’s largest state banks to take action to stave off a credit crunch.
LGFVs were originally formed to circumvent a ban on municipalities from borrowing from banks or selling bonds directly on the market. The money raised is spent directly on things like infrastructure and government welfare projects, which can take a long time to complete and often have low returns. While LGFVs are classified as corporate debt, investors generally assume that local governments will be held accountable for them.
2. How did they become so important?
LGFVs have been central to government efforts to ensure China’s infrastructure and public services grow fast enough to sustain excess economic growth. They took off after the 2008 financial crisis, when the government launched a 4 trillion yuan ($562 billion) national stimulus plan, and have grown rapidly ever since.
3. How important are they for the Chinese economy?
The International Monetary Fund estimates that LGFV debt has nearly doubled over the past five years to about 66 trillion yuan ($9 trillion) — more than half of China’s annual economic output. According to data from S&P Global Ratings, LGFVs had about 13.5 trillion yuan in outstanding onshore bonds at the end of 2022 — about 40% of China’s non-financial corporate bond market. All types of financial institutions are exposed to them: commercial banks through their asset management units, insurance companies, mutual funds, investment firms and hedge funds. The overwhelming majority of their investors are locals as LGFVs are opaque and difficult to analyze for foreigners.
4. How did they become a big risk?
The real estate downturn in China dealt a severe blow to local governments as their income from property sales shrank. This, combined with an increase in public spending in response to the pandemic, left the majority of regional governments facing a serious funding shortfall. According to Rhodium Group, half of the cities have had difficulties managing debt interest payments over the past year. According to a report by China International Capital Corp. LGFVs received average government subsidies of 392 million yuan in 2022, the highest in nine years.
5. Has LGFV defaulted?
No. Even the most troubled local governments seem to prioritize paying bonds on time, given the potentially disastrous signal this would send if they were unable to pay their debts. However, some LGFVs have made last-minute payments, indicating difficulties in paying off debt.
6. What is the government doing about it?
As Bloomberg News reported in July, China’s largest state banks have started to ease. Banks like the Industrial & Commercial Bank of China Ltd. and China Construction Bank Corp. are offering loans with a 25-year term instead of the prevailing 10-year term for most corporate loans to qualifying LGFVs with high credit ratings, people familiar with the matter said, Bloomberg said. Some came with temporary interest rate relief. Past experience shows that a missed payment could trigger an increase in perceived risk, raising the cost of borrowing to prohibitive levels for some government agencies and government-related companies. However, a rescue of the sector looks unlikely as the central government seeks to discourage reckless risk-taking based on the assumption that the state will always come to the rescue when things go wrong.
7. What other risks are there apart from default?
The concern is that many local financial authorities are reaching a point where they will be forced to cut their borrowing – potentially stemming the flow of money that is a steady source of fuel for the Chinese economy. In that case, the timing could be ill-timed as investors are already concerned that the country’s recovery from pandemic restrictions has lost momentum.
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