In Depth: The Never-Ending Battle to Curb China’s Hidden Debt

Regulators are once again playing whack-a-mole to stamp out practices local government financing vehicles (LGFVs) are employing to evade efforts to curb their borrowings.

Having loosened the reins on local government debt last year to help the economy recover from the impact of the Covid-19 pandemic, authorities this year have resumed their long-standing campaign to control and defuse financial risks. One of their main targets is hidden local government debt and in particular the borrowings of the financing vehicles they control, typically local state-owned investment companies.

In a document sent to financial institutions recently, the China Banking and Insurance Regulatory Commission (CBIRC) laid out a series of measures, both existing and new, to tackle the problem and fix loopholes that have allowed LGFVs to skirt rules on borrowing limits. The Guiding Opinions on Banking and Insurance Institutions to Further Improve the Prevention and Resolution of Hidden-Debt Risks of Local Governments has not been published but some of its contents have been revealed in analyst reports and by sources who spoke to Caixin. Guiding opinions (指导意见) are documents issued by government authorities to communicate policies and put forward views and solutions on issues of importance.

Defusing risks from hidden local government debt was listed as one of the top priorities for fiscal work in 2021, with the Ministry of Finance telling lawmakers at the annual meeting of the National People’s Congress that the problem must be tackled (link in Chinese) to help safeguard overall national security and maintain sustainable economic and fiscal development. Although no local government has failed to repay a bond, the rising debt burden and slowing economic growth is increasing the risk of a default that could trigger instability in the country’s financial markets.

There are no official publicly available figures for the scale of local governments’ hidden debt (隐性债务), which refers to their financial liabilities that do not appear on their books, but some estimates put the number at around 50 trillion yuan ($7.7 trillion).

The research arm (link in Chinese) of ratings agency China Chengxin International Credit Rating Co. Ltd. estimates the hidden debt, which is also referred to as implicit debt, was in a range of 45.4 trillion yuan to 51.6 trillion yuan in 2020, with LGFV-related debt accounting for more than 80% of the total. Analysts at Guosheng Securities Co. Ltd. estimated (link in Chinese) the hidden debt rose 15% to nearly 50 trillion yuan in 2020, slowing from a rate of 20% in 2018 and 37% in 2017 when the Politburo ordered a cleanup of local government debt as part of a broader campaign to defuse financial risks.

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Among the measures included in the guiding opinions are directions to lenders to stop issuing new working capital loans (流动资金贷款) to LGFVs who have been identified as carrying hidden local government debt, borrowings that are ultimately the liabilities of local governments but have been shifted onto the vehicles’ balance sheets. The regulator issued the rule after finding that some LGFVs were taking out loans for working capital purposes but using the money to repay this hidden debt, bank insiders and analysts said.

The guiding opinions also tighten rules on the reclassification of LGFV borrowings which now not only needs to be approved by a bank, but also by the provincial government. The change is aimed at addressing the problem of hidden debt being wrongly reclassified as operational debt (经营性债务) by a bank. The regulator also prohibited LGFVs from adding new hidden debt and falsifying debt reduction.

The CBIRC made it clear in the guideline that no one should be under any illusion that the state will step in to provide a bailout in the event of an LGFV debt default, analysts at CSCI Pengyuan Credit Rating Co. Ltd. wrote in a July note (link in Chinese) after the document was issued.

The CBIRC’s latest crackdown follows action taken earlier this year to prevent growth of debt among the more risky and financially weaker LGFVs. The finance ministry introduced measures to link their ability to sell bonds with the amount of debt on the books of the local government that controls them. The rules were first rolled out in China’s two stock exchanges, where LGFV bond sales are relatively low, and then in the interbank bond market which accounts for about 90% of bond trading on the Chinese mainland.

Those measures sent net LGFV bond issuance plunging to a negative 108 billion yuan in May, the first decline since September 2018, according to data from Wind Information Co. Ltd. Although it has since rebounded and amounted to 100.8 billion in August, issuance was still 52% lower than a year earlier, according to data (link in Chinese) compiled by CSCI Pengyuan.

China’s local governments have long played a cat-and-mouse game with the central authorities over debt as they try to juggle orders to boost investment to meet economic growth targets, which involves finding trillions of yuan to fund it, while simultaneously ensuring they don’t take on too much borrowing that would threaten their ability to repay it and increase risks to the stability of the financial system. LGFVs were born out of local governments’ need to find ways of raising money without it appearing on their books.

After a report (link in Chinese) by the National Audit Office in 2013 raised red flags over the size of local governments’ liabilities and the debt hidden off their balance sheets in LGFVs and other vehicles, the government embarked on a cleanup.

In 2015, in an effort to improve transparency and give local authorities a more systematic and open way to fund their spending, provincial-level governments were finally allowed to issue bonds, known as general-purpose bonds (一般债券). They were also allowed to issue special-purpose bonds (专项债券) to fund long-term investment on commercially viable infrastructure and public welfare projects.

The Ministry of Finance started a three-year debt-swap program to allow local governments to shift their existing borrowings into bonds that generally carried lower interest rates. There were also measures to clean up hidden debt, including regulations controlling the amount of debt LGFVs could take on and banning local governments from bailing them out.

But new measures to control local government liabilities and hidden debt were frequently followed by innovative ways to get around them, prompting policymakers to tighten supervision of debt management further to try and close loopholes.

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One of the latest games the guiding opinions are aimed at stamping out is the practice of using working capital loans to repay hidden debt. Banks have been instructed to tighten reviews of working capital loan applications to make sure they are compliant, bank insiders told Caixin.

The practice of using this type of short-term loan to repay hidden local government debt may reduce the headline figure of outstanding liabilities, but the debt is still on LGFVs’ balance sheets and makes their finances more unstable because it increases their exposure to short-term debt and the pressure of having to constantly roll it over, fixed-income analysts at Guosheng Securities wrote in a July report (link in Chinese).

The rules raised concerns among banks and other creditors that the change could lead to a cash crunch among LGFVs and that many would struggle to continue operating. As a result, the CBIRC clarified in August that the rules would only apply to new loans and that lenders would be allowed to roll over existing working capital loans for vehicles even if their balance sheets showed they carried hidden debt for local governments.

A number of LGFVs are so dependent on working capital loans that should they lose access to them, their daily operations would be negatively affected, Yuan Quanquan, an analyst at CSCI Pengyuan Credit wrote in a note (link in Chinese) in August, describing them as a “minefield” that investors need to watch out for.

The CBIRC guiding opinions also seek to prevent the reclassification of hidden debt on the balance sheets of LGFVs as operational debt. In 2018 the Ministry of Finance issued regulations compelling local governments to submit data about their hidden debt. It put forward six options for local authorities to reduce their hidden debt, one of which was to allow them, under certain conditions, to reclassify the liabilities as operational debt.

One of the criteria was that the liabilities were backed by income-generating assets, including those with corresponding franchise rights such as water utilities and public transportation, analysts at Tianfeng Securities Co. Ltd. wrote in a July report (link in Chinese) on defusing hidden debt.

However, some vehicles were found to have falsified information in order to qualify to switch hidden debts backed by public welfare projects into those backed by income-generating projects so that they could be reclassified as operating debt, a source at an LGFV in a city in eastern China told Caixin on condition of anonymity.

Previously, a bank alone was able to approve the application to have debt reclassified, but the CBIRC’s guiding opinions stipulate clearly that now the provincial government also needs to give the nod, the source said.

The new guiding opinions show regulators are serious about stopping local governments and LGFVs from adding new hidden debt, Yuan from CSCI Pengyuan Credit wrote in her August note. She said she expects the regulator will be inspecting financial institutions to make sure they are complying with the measures.

The crackdown is making it harder for LGFVs in less developed and debt-ridden regions to get financing as investors concentrate their exposure on large, financially healthy LGFVs, some analysts said. From January to July, net bond financing of LGFVs declined 13.2% year-on-year, but relatively affluent provinces like Jiangsu and Zhejiang and some other provinces such as Jiangxi and Hubei saw issuance rise, while some poorer regions in northeast and southwest China including Liaoning, Heilongjiang and Yunnan provinces saw net issuance fall as the value of maturing bonds exceeded new sales, according to another CSCI Pengyuan Credit report (link in Chinese) published earlier this month.

Buildings are under construction in Guangzhou, South China’s Guangdong province, in March 2020. Photo: VCG

A number of low-rated LGFVs have found it difficult to issue bonds, a source at the fixed-income asset unit of a securities firm told Caixin on condition of anonymity, citing internal research. Some LGFVs in western China were not able to sell bonds in the usual way and were forced to resort to “structured issuance,” (结构化发债) the source said, referring to a now banned form of sale where the issuer buys part of the bond itself or has a related party do so to artificially inflate demand. The coupon rate on some bonds has reached as high as 10%, the source said, almost double the average of 5.49% (link in Chinese) for AA-rated bonds sold by LGFVs in August, research from CSCI Pengyuan Credit shows.

The higher interest rates reflect bond investors’ concerns about the growing risks attached to weak LGFVs, although analysts generally agree that the risk of default is still low, given that the companies are allowed to roll over existing bonds and policymakers have pledged not to create new risks in their efforts to defuse existing financial risks.

Local governments are also under pressure to avoid defaults.

“Officials generally have obvious incentives to ensure that LGFVs with hidden debts don’t go into arrears, partly because of the performance evaluation system for local government officials,” said Feng Xuming, a researcher at the Chinese Academy of Social Sciences, a state-backed think tank.

Dealing with debt risks should be incorporated into evaluation systems for officials, the State Council said in its contingency plan (link in Chinese) for local government debt risks released to the public in November 2016. Officials responsible for risk events must not be promoted before risks are resolved and leaders should be held accountable even after they have left office, it said.

Some analysts warn that tighter oversight on hidden debt could crimp domestic demand and add to the downward pressure on economic growth, as spending on infrastructure and public welfare projects by local governments and LGFVs are a key driver of GDP.

The recent regulations on hidden local government debt and the property sector and the measures to cut carbon emissions would pose risks to economic growth, Lu Ting, chief China economist at Nomura International (Hong Kong) Ltd., said at a forum (link in Chinese) in July. “In fact, the downward pressure on economic growth in the second half of this year, especially in the fourth quarter, and the spring of next year is quite high.”

Huo Kan contributed to this report.

Contact reporter Guo Yingzhe (yingzheguo@caixin.com) and editor Nerys Avery (nerysavery@caixin.com)

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