China's hidden local debt problem

China's central government has allowed provinces to issue more than RMB 1 trillion of special refinancing bonds to deal with the hidden debts of Local Government Financing Vehicles (LGFVs), which are estimated at $9 trillion. Beijing's handling of the municipal debt problem has become an elaborate piece of balance-sheet engineering. The idea is simple. Expensive off-balance-sheet loans are rolled into formal government bonds that carry lower yields.

Where the debt came from

The vehicles grew out of the stimulus of 2008. When Beijing launched its RMB 4 trillion package to counter the global financial crisis, local governments were barred from borrowing directly, so they set up companies to borrow on their behalf. These vehicles raised money from banks, trust companies and the bond market, and used land owned by the local government as collateral. They built roads, bridges, industrial parks and new districts at a pace no other economy has matched.

The model depended on rising land prices. Local governments financed much of their spending by selling land-use rights to property developers, and the vehicles' debts were implicitly backed by that income. When the property market turned in 2021, after Beijing restricted borrowing by developers, land sales fell sharply. Evergrande, once among the largest developers, has been in default for nearly two years, and Country Garden has missed payments on its dollar bonds this autumn. Without land revenue, many local governments cannot service the debts of the vehicles they created.

Swapping one debt for another

The swap will stop distressed local borrowers from defaulting in a disorderly way. It does nothing to make those entities solvent. LGFVs spent trillions on unproductive infrastructure and prestige property projects that bring in very little cash. Turning their commercial debts into public debt moves the burden onto the national balance sheet and drags down China's growth potential over the medium term.

The mechanics are straightforward. A province issues a special refinancing bond at a yield close to that of central government debt and uses the proceeds to repay the most expensive and most urgent LGFV loans, often those from trust companies or other shadow lenders. The interest bill falls and the maturity lengthens. Banks, which buy most of the new bonds, swap loans that might default for government paper that will not. The problem is shifted from the credit market to the budget, where it will be paid off slowly over years.

China has done this before. In 2015 Beijing launched a debt-swap programme that converted trillions of yuan of local-government borrowing into bonds over several years. That programme bought time, but the vehicles kept borrowing afterwards, and the hidden debt grew back. The current round is being sold as a one-off clean-up, which is what the last one was called too.

Who pays

The losers are the future budgets of the poorer provinces. Places such as Guizhou, in the south-west, borrowed heavily to build highways and bridges in regions with thin traffic, and their tax bases are too small to repay the debt. Some of their vehicles have already agreed to stretch bank loans over as long as twenty years. Money spent servicing old projects is money not spent on schools, health care or pensions, which squeezes the household consumption Beijing says it wants to encourage.

State banks are the other losers. They hold most of the local debt and will be pressed to accept lower interest rates and longer maturities, which erodes margins already hit by cuts to mortgage rates. A banking system tied up in rolling over old infrastructure loans has less capacity to lend to private companies, which drive most of China's employment and innovation.

The case for patience

The strongest argument for Beijing's approach is that China can afford it. Central government debt is low relative to the size of the economy, the debt is almost entirely in yuan and held at home, and the state controls the banks that own it. A disorderly default by a large local vehicle could trigger panic in the domestic bond market, and avoiding that is worth a great deal. On this view, the swap is prudent crisis management and the growth cost is manageable.

That argument is right about the crisis and wrong about the cost. The debt is not a liquidity problem that time will solve, because many of the assets it financed will never earn enough to repay it. Japan in the 1990s showed what happens when bad debts are rolled over instead of written off: banks keep weak borrowers alive, credit stops flowing to productive firms and growth stagnates for years. China already has the symptoms. Consumer prices were flat on a year earlier in September, youth unemployment reached a record in June before the statistics office stopped publishing it, and the central bank has cut rates twice since June without reviving demand.

What would change the call

A decisive move by the central government to take more of the debt onto its own books, which it can finance far more cheaply than provinces can, would reduce the drag. So would a recapitalisation of the banks or a restructuring that imposes losses on creditors and closes the worst vehicles. Markets are watching whether Beijing will raise its own borrowing and whether third-quarter growth figures, due this week, show consumers picking up the slack.

The refinancing programme will prevent a municipal credit crisis in the near term. The price of swapping shadow debt for government bonds is likely to be a decade of sluggish growth, borne by poorer provinces, state banks and the households whose public services will be cut to pay the interest.