China's Struggle with $13 Trillion LGFV Debt: An Unsuccessful Endeavor

Net financing turned negative for the third straight quarter
The trend comes amid the government’s efforts to rein in risk

By Bloomberg News:

China’s upcoming leadership meeting could be a pivotal moment for policymakers to address the US$13 trillion threat to Asia’s largest economy. While China’s property crisis dominates headlines, the nation’s municipal debt issues also demand immediate attention. The surge in local government financing vehicles (LGFVs) in recent years has led to off-balance-sheet debt nearly matching China’s annual GDP. The combination of default risks from major property developers and the abundance of LGFVs explains global investors’ concerns about the stability of China’s economy, especially amidst global uncertainty.

The second half of 2024 presents a challenging landscape for China to boost exports, with high US bond yields, Japan on the brink of recession, and Europe’s stagnant economy. However, there’s a silver lining: Xi Jinping’s Communist Party appears poised to address the looming LGFV debt crisis. Reports suggest an economic strategy meeting scheduled for July 15-18 aims to devise a solution for the enormous debt. In the forthcoming Third Plenum, Xi’s team is anticipated to permit local governments to retain a larger share of their generated fiscal revenues, which currently flow to Beijing. This necessary reform to China’s tax system could significantly mitigate immediate financial stability threats.

This could be a crucial move towards boosting investment in high-value manufacturing sectors and invigorating sluggish domestic consumption. The absence of social safety nets, leading mainlanders to save rather than spend, is a key concern. Enhanced revenues would empower local governments to invest more in innovative and productivity-boosting industries, reducing their dependence on property and land sales for survival. This would also lessen the appeal of issuing debt.

This pivot could be transformative, addressing China’s financial issues and fostering economic strength for sustainable growth. Since the 2008 Lehman Brothers crisis, Beijing has leaned on China’s 34 provinces for economic growth. Even earlier, regional leaders gained recognition in Beijing by surpassing national average GDP figures.

The nationwide infrastructure race has led to a bill for massive skyscrapers, highways, airports, hotels, stadiums, shopping districts, and amusement parks. LGFVs were instrumental in funding China’s huge infrastructure expansion, driving up land prices in a previously beneficial growth cycle. Before the real estate collapse, land revenue seemed an endless source of subsidies.

China’s growth model, heavily reliant on LGFV debt, is unsustainable, with debt exceeding half of the GDP and local governments spending 19% of fiscal resources on interest payments. Xi Jinping has an opportunity for a significant economic reboot, having pledged to recalibrate an “unbalanced, uncoordinated and unsustainable” economic model. Despite significant economic changes, many government ambitions remain unchanged. Success depends on Xi’s ability to implement reforms and create genuine consumer demand through structural changes, which are currently missing from the discussion.

The coming weeks could herald significant changes to China’s fiscal system, marking a major step towards Xi’s commitment to overhaul China’s $61 trillion financial sector. However, local governments may still struggle to support LGFVs due to declining land concession revenue. Economically robust regions, with stronger state-owned assets and financial resources, are likely to be more resilient. Vibrant capital markets and reforms could reduce economic volatility and allow municipalities to better distribute economic growth benefits. Analysts concur that substantial disruption is needed to boost China’s underperforming economy.

Xi Jinping’s track record over the past 13 years shows more talk than action on bold reforms. However, this may change as the Politburo aims to transform China into a high-level socialist market economy by 2035. The upcoming Third Plenum, unaccompanied by major leadership changes, could enhance reform implementation odds. The Plenum is expected to maintain the current economic framework, focusing on supply chain self-sufficiency and tech innovation. This month could be pivotal for Xi’s reformer legacy, with the Plenum likely to reaffirm support for private-sector expansion, a stronger state sector, and market-led resource allocation.

Ding suggests that steps will be taken to eliminate cross-region barriers, foster innovation and green transition, and enhance income distribution. Greater emphasis will be placed on security, addressing housing and financial sector risks, and bolstering supply chain resilience. Fiscal/tax reforms, crucial for long-term sustainability, will likely draw market attention. While these reforms could transform local governments, they may not boost GDP in the short term and could even create economic challenges. The ongoing focus on deleveraging the housing sector and LGFVs continues to apply downward pressure on growth. Recently, LGFVs have struggled to issue bonds due to intensified regulatory efforts to mitigate risks in one of China’s most debt-ridden sectors.

Laura Li of Standard & Poor’s points to ongoing regulatory tightening, making it increasingly challenging for low-rated LGFVs, even from wealthy provinces like Jiangsu and Zhejiang, to issue future bonds. However, allowing local governments to keep more tax revenues could significantly shift incentives. Economist Jonathon Sine explains that Beijing previously preferred to control revenues for governance and redistribution. Once transfers are considered, the central-local fiscal gap essentially vanishes. Unfunded mandates emerged post-1994 budget reform, albeit in a more nuanced manner. The issue lies in the intergovernmental transfer system, where funds are apportioned from Beijing to provinces, then to cities, counties, and townships. This process can take over a year, creating inefficiencies. Sometimes, provinces bypass cities, sending funds directly to counties. By reforming this complex financial system, China could enhance its economic efficiency, rectify skewed incentive structures, and bring Xi closer to achieving his high-quality growth objectives