China’s Local Government Debt: The Hidden Threat

At the close of 2020, China’s local government debt stood at $3.97 trillion. However, this does not include hidden debt, which is believed to be even larger.

The so-called “hidden debt” comes from entities that take loans, which are guaranteed by local governments. These loans do not appear on the balance sheets, but increase the indebtedness of the local government. A worrying trend, this debt has nearly tripled over the past 10 months. Economists at Goldman Sachs estimate that the hidden loans total around $8.2 trillion, roughly half of China’s GDP.

In an effort to curb local government debt, a number of financial institutions are connecting their systems with the Ministry of Finance, which is monitoring LGFVs. Additionally, banks will no longer provide loans to entities whose credit is guaranteed by local governments. Beijing is also curbing bond sales by local governments.

In order to be more in-line with international standards, the central authorities have been talking about having greater transparency. However, in addition to the hidden debt of the local governments, China also has about $1 trillion in so-called shadow banking debts. These are off-balance sheet loans from non-banking institutions, which are harder to trace and quantify when calculating China’s total public debt.

Other murky practices that add to China’s overall indebtedness are wealth management products and high-yield investment vehicles, generally used to fund property development. The wealth management products themselves are sold as low-risk, but the actual investments inside are often high-risk, obscuring the danger of default—similar to what happened during the U.S. mortgage crisis. As a result, the People’s Bank of China and the China Banking and Insurance Regulatory Commission have restricted wealth management products from investing in bonds with a rating of less than AA.

To avoid a collapse of China’s property market, which could threaten the entire economy, the government imposed new restrictions—known as the “three red lines”—in August 2020. First, the debt to asset ratio of a property developer cannot exceed 70 percent. Second, the debt-to-equity ratio cannot exceed 100 percent. And finally, property companies must hold cash at least equal to their short-term liabilities. Unless a developer meets these three criteria, they cannot borrow from a bank.

These new regulations and restrictions contributed to the increased use of shadow banking and other opaque credit systems, which remained outside of government oversight. Local governments generate about one-third of their revenue through selling land to developers. Ultimately, the borrowing of property companies and local governments, through unregulated credit, caused China’s public debt to skyrocket.

The wealth management products have been a significant source of funding for the LGFVs, particularly if the local governments are unable to obtain bank loans. Discouraging wealth management products from investing in sub-standard bonds will reduce the available financing and liquidity for local governments, exacerbating the decay of their economic situation.

Citing the increased risk caused by debt—buried below other debt and hiding other debt—global pension funds and institutional investors are dropping yuan-denominated bonds. The largest retirement fund in the world, Japan’s $1.75 trillion Government Pension Investment Fund, will no longer purchase Chinese sovereign yuan-denominated debt.

Meanwhile, the Chinese economy is suffering from COVID-19 restrictions, a decrease in global trade, supply chain disruptions, and power shortages. With an implosion of the real estate bubble predicted, if Evergrande, one of the largest developers, is allowed to default on its $310 billion debt, many experts believe that Beijing will opt for more spending in order to avoid an economic collapse. If that is the case, then we can expect the crack down on murky credit to fizzle out. Goldman is even recommending that central authorities increase the bond quota of local governments, using debt to create liquidity, to manage existing debt.

This recommendation is consistent with China’s current economic strategy, using debt to service debt. Approximately 60 percent of bonds issued by local governments have not been used for new investment, but rather to repay maturing debt in 2020 and 2021. Similarly, Beijing recently announced that it will address the current financial crisis by increasing infrastructure spending over the next five years, and investing in telecoms networks, satellite navigation, internet, smart logistics, and transport.