China’s debt-laden local governments pose challenges to economic growth, financial system

CHINA’S push to revive the economy this year by increasing infrastructure spending while warding off financial risks is facing headwinds from massive local-government debt, which is more than US$9 trillion and growing.

As debt obligations mount, some local governments are pushing banks to extend maturities and cut interest rates, sources said. Local government Financing Vehicles (LGFVs) have 5.5 trillion yuan (S$1.1 trillion) worth of onshore bonds coming due this year, the highest since 2021, according to Fitch.

A sharp drop in income from mainstay land sales and fewer options for raising fresh funds have fuelled concerns about LGFVs’ ability to meet debt obligations and its impact on the broader banking sector and markets.

The ability of fiscally stretched local governments to follow through on spending will also be a key test for China’s modest economic growth target of around 5 per cent this year, as LGFVs play a key role in funding infrastructure projects, one of the biggest growth drivers for the world’s second-largest economy.

So far, they have been no public reports of an LGFV default, but some have had loans extended.

“Black holes”

“The LGFVs have become the black hole of the Chinese financial system. They have been used to fill the gap between local government revenue and expenditure,” said Andrew Collier managing director at Orient Capital Research.

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“They have little or no profit, and cannot pay back their debt owed,” he said. “I expect many LGFVs to collapse, or to be quietly recapitalised by banks, putting some rural banks and some bondholders at risk of defaults.”

The total debt of China’s LGFVs has swelled to a record 66 trillion yuan (S$12.9 trillion), equivalent to half of the country’s economy, from 57 trillion yuan last year, according to an International Monetary Fund (IMF) report last month.

Concerns about their worsening credit profile come as the government is trying to lift the economy from the grip of a property debt crisis in the last couple of years, which saw a number of developers default on their debt and land sale revenues plummet, forcing Beijing to roll out a slew of supportive measures.

“LGFVs are under considerable pressure on debt repayment this year, because their income is often associated with real estate and land sales,” said Wang Tao, chief China economist at UBS.

Cautious lenders

Chinese Premier Li Keqiang listed “preventing and defusing local government debt risks” as one of the major tasks for the government in the upcoming year, when he delivered the government report on Sunday as China’s two sessions kicked off.

That priority comes as some Chinese banks with exposure to LGFVs are increasingly getting requests to extend their near-term maturities by as much as six months and reduce interest rates, three sources with knowledge of the matter said.

The sources, who declined to give details, could not be identified due to the sensitivity of the matter.

Chinese banks and other financial institutions have been cautious on new lending to LGFVs over the past years.

In recent months, some state-owned banks, asset managers, and insurers have been looking into their portfolios to screen LGFV borrowers with weaker creditworthiness and dispose them, separate financial sector sources told Reuters.

Faced with tighter credit criteria at home, LGFVs turned to offshore markets and raised a record US$39.5 billion via US dollar bonds last year, according to rating agency S&P. Offshore branches of Chinese financial institutions have been major buyers of the bonds, industry sources said.

Since late 2022, however, authorities have sharpened scrutiny of LGFVs US dollar bond issuance. The National Development and Reform Commission (NDRC) turned down requests from units with lower credit ratings, said two separate sources with knowledge of the matter, as part of its efforts to stem financial sector risks.

The NDRC and the China Banking and Insurance Regulatory Commission didn’t immediately respond to requests for comment.

Default worries

A deterioration in capital-market access can increase refinancing risk and deepen the liquidity crunch for the LGFV sector, Fitch Ratings said in a report last month, adding units in less economically developed regions are more at risk.

The worsening outlook for LGFVs has also made some shadow banks – lenders for sectors that are unable to tap bank funding directly – worried about their exposure to such units and averse to fresh lending.

“LGFVs used to be financed in the shadow banking (sector) but increasingly it has moved to the onshore bond market and, in some cases, offshore,” said Alicia García Herrero, chief economist for Asia Pacific, at Natixis.

“It seems clear to me that a number of projects may default with consequences for bondholders, specially offshore ones.”

Some analysts believe that Chinese authorities would avoid large scale of defaults by LGFVs as that would make debt market access tougher for both public and private issuers at a time when efforts are being made to revive the economy after the dismantling of three years of tough Covid-19 measures.

“LGFV debt itself as a share of GDP is still manageable at this stage. The key issue is to stop the fast growth and avoid default to trigger panic in the market,” said Zhiwei Zhang, chief economist at Pinpoint Asset Management. REUTERS