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Understanding China’s local government debt risk

Recent media reports on China’s debt-ridden Guizhou province pleading for Beijing to bail it out [1] have raised market concerns about billions of dollars in local government debt which has been seen as ‘the canary in the coalmine’. The issue with impoverished Guizhou’s sizeable debt burden is illustrative of problems at China’s local government financing vehicles (LGFVs). [2]  

While we believe the size of the LGFV debt is unlikely to become a systemic risk, [3] the singular risk posed by LGFVs could be a source of volatility in China’s financial system over the medium term as Beijing continues to retreat from its implicit guarantee policy.

The LGFVs’ debt repayment issues relate to a sharp drop in land sale revenues and caps on their ability to tap alternative sources of funding.

What of LGFV risk?  

Assessing the outlook and implications of LGFV-related risk requires an understanding of the different types of LGFVs and Beijing’s attitude towards them.

Firstly, size matters. In winding down its implicit guarantee policy, Beijing has in recent years allowed large state and non-state companies to fail. They include Evergrande, Huarong Asset Management and the HNA group. By implication, Beijing could also let go of any of the thousands of LGFVs that it deems to be non-systemic.

Secondly, there are two types of LGFV: quintessential and hybrid. Although both are local government-owned entities, the latter have more diversified holdings and behave like state-owned enterprises (SOEs). For example, a hybrid LGFV may finance public housing as a local government would do, but it can also invest in commercial property, just as a private company can.

Beijing has been pushing many LGFVs to diversify, hoping they could generate more revenues and depend less on local government coffers. However, since this process began in 2015, these LGFVs have become more fragile due to excessive risk-taking and poor risk management. It means that the risk of LGFV default is concentrated in these hybrid LGFVs. 

Thirdly, Beijing views hybrid LGFVs as more dispensable than quintessential ones. The commercially diversified nature of hybrid LGFVs means they function like (local) SOEs. As Beijing retreats from its implicit guarantee policy, which has resulted in rising defaults in recent years (Exhibit 1), it has allowed (local) SOEs to fail in the hopes of imposing market discipline on the state sector to reduce moral hazard.

Hybrid LGFVs are thus not on the bailout priority list and will have to deal with their debt obligations on their own rather than count on the local or central government.

Limited resources mean tough choices

The bottom line is that faced with tight budgets, local governments must make tough choices on where to spend their limited resources. Since tackling the debt problem is likely to be prohibitively expensive, if push comes to shove, they will likely let the less important hybrid LGFVs fail.

As long as systemic risk is contained, the central government cannot be expected to intervene. Beijing sees a controlled default process as a way to weed out bad assets and reduce debt in the system by allowing the bad companies to fail or default.

Nevertheless, depending on the scale of hybrid LGFV failures, Beijing may have to erect a firewall before regional financial instability becomes systemic instability. Striking a balance between invoking market discipline and preventing systemic instability is difficult, requiring accurate judgment of the risks and the timing of intervention on Beijing’s part.

Beijing could be at risk of a policy miscalculation, creating a Black Swan event. Also, it cannot – nor does it want to – save every hybrid LGFV. In short, there are likely to be more LGFV defaults in the coming years as China’s debt reduction and restructuring processes move ahead.

Given the central role of LGFVs in funding infrastructure projects, which play a key part as one of the main drivers of growth for the world’s second-largest economy, dealing with their financing and spending issues will be an important test for China’s modest economic growth target of around 5% this year.

References

1 For example, see “China Province Steps Up Its Plead for State Aid on Debt Woes”, Bloomberg, April 24, 2023, or “China May Have to bail Out One of Its Poorest Provinces”, CNN Business, April 27, 2023 (here), or “One of China’s Most Debt-Ridden Provinces Asks Beijing for Help in Now-Deleted Online Post”, South China Morning Post, 12 April 2023 (here).  

2Chi on China: China’s Systemic Risk (II/II): Local Government Debt”, 14 May 2014 (here).  

3 See reference in footnote 2. 

Disclaimer

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
Environmental, social and governance (ESG) investment risk: The lack of common or harmonised definitions and labels integrating ESG and sustainability criteria at EU level may result in different approaches by managers when setting ESG objectives. This also means that it may be difficult to compare strategies integrating ESG and sustainability criteria to the extent that the selection and weightings applied to select investments may be based on metrics that may share the same name but have different underlying meanings. In evaluating a security based on the ESG and sustainability criteria, the Investment Manager may also use data sources provided by external ESG research providers. Given the evolving nature of ESG, these data sources may for the time being be incomplete, inaccurate or unavailable. Applying responsible business conduct standards in the investment process may lead to the exclusion of securities of certain issuers. Consequently, (the Sub-Fund's) performance may at times be better or worse than the performance of relatable funds that do not apply such standards.

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