In Depth: As China’s Hidden Local Debts Shrink, a New Challenge Emerges

1. China’s ambitious cleanup of local government debt is entering a critical phase as mid-2026 approaches, with a sweeping 12 trillion yuan ($1.7 trillion) policy package rolled out in late 2024 to resolve officially recognized hidden local government debt [para. 1][para. 2]. The campaign to eliminate this hidden debt is largely on track to meet the government’s mid-2027 deadline, largely due to a massive bond-swap program shifting liabilities onto local government balance sheets [para. 3]. However, tackling the more difficult operational debt held by thousands of Local Government Financing Vehicles (LGFVs) is running into complications, including high-interest, noncompliant debt that banks are reluctant to touch, contributing to a growing liquidity strain for LGFVs [para. 4][para. 5].

2. The primary goal of the debt resolution plan is to eliminate all hidden debts and remove LGFVs from a centrally managed list by June 2027, using special-purpose bonds (SPBs) issued by local governments to swap high-cost hidden liabilities for lower-interest, longer-term official debt [para. 6][para. 7]. Progress has been significant: Finance Minister Lan Fo’an reported hidden debt fell by 3.8 trillion yuan from the end of 2023 to 10.5 trillion yuan by the end of 2024, and the number of LGFVs on the official list shrank by 71% from March 2023 to September 2025 [para. 8]. With at least 4 trillion yuan in SPB funds still available before 2028, market watchers are confident Beijing will declare victory on schedule in its hidden debt campaign [para. 9].

3. The more intractable problem is operational debt owed by LGFVs to financial institutions, which People’s Bank of China Governor Pan Gongsheng put at 14.8 trillion yuan at the end of 2024 [para. 10]. This operational debt is not officially classified as hidden government debt but still carries local government repayment responsibilities [para. 10]. A veteran researcher categorizes these debts into three types: debt with no corresponding asset (cash flow so poor it can only borrow to pay old debt), debt tied to non-cash-generating assets, and debt tied to cash-generating assets that can be rolled over on market terms [para. 11]. The most difficult part involves high-interest, non-standard loans often used to move funds around rather than for specific projects, and banks are unlikely to restructure such debt due to compliance requirements—all swapped debt must be tied to a clear, financially sustainable project [para. 12][para. 13][para. 14].

4. The resolution of hidden debt has had a paradoxical effect: while it lowered LGFVs’ borrowing costs, it transferred immense debt onto local governments’ official balance sheets, causing statutory debt to balloon from 40.7 trillion yuan at end-2023 to 54.8 trillion yuan two years later [para. 15]. Interest payments on this official debt are soaring, while land sales revenue—a crucial source of local fiscal revenue—has collapsed [para. 15]. For LGFVs, the situation is dire: while principal can generally be rolled over, strict curbs on new financing have cut off their main source of cash for paying interest, and many LGFVs have borrowed new funds just to repay old bonds [para. 16][para. 17][para. 18]. A proposal to suspend interest payments and capitalize them was studied but deemed to have too many drawbacks [para. 19]. Some LGFVs in Henan have issued offshore bonds with double-digit real interest costs, while others in Shandong have issued non-standard products with rates above 6% [para. 20].

5. With financing squeezed, local governments are turning to a new strategy: revitalizing state-owned resources, assets, and funds, championed by provinces like Hubei and Hunan [para. 21][para. 22]. This involves identifying and packaging everything from data to reservoir silt to space under bridges, then selling or securitizing them to raise cash [para. 23]. Hubei identified 21.8 trillion yuan of such resources and revitalized over 300 billion yuan last year [para. 23]. However, this approach faces challenges, including ambiguous ownership, difficulty in valuation due to lack of a mature market, and the risk of selling state assets too cheaply or failing to attract investors [para. 24]. A source from China Chengxin International Credit Rating Co. warned that securitization and leveraging can monetize future cash flow, merely postponing debt risk [para. 25].