Where is Wen Jiabao when you need him? China’s former premier is remembered for his decision to unleash a huge state spending plan after the 2008 financial crisis. Today’s leaders wish they could deploy similar fiscal firepower to kickstart their sputtering economy. The options before President Xi Jinping aren’t great. Yet letting some heavily indebted local governments’ investment arms fail would be better than keeping them on pricey life support or counting on an elusive rebound in consumption.
Wen exited the political stage a decade ago but his legacy lives on, for better and, mostly, for worse. His plan to throw 4 trillion yuan ($555 billion), or about 13% of China’s GDP in 2008, at everything from railroads to airports contributed to a debt overhang that’s still haunting Beijing today. In the 15 years since, China’s debt-to-GDP ratio has doubled to a whopping 280%, with the bulk of liabilities held by local government financial vehicles (LGFVs).
Most of these 3,000-plus entities were created by local governments during the 2008 crisis to skirt a central government ban on direct state borrowing. They were then contracted by regional governments to build public infrastructure, from uneconomical leisure parks and roads to slightly more cost-effective highways, subway stations and high-speed bullet trains. Many also developed land for regional governments before it was sold on to residential developers. Today those vehicles are a ticking time bomb that hampers China’s ability to spend its way out of the current economic doldrums. Economists are busy downgrading the country’s full-year growth to below the official goal of around 5%, which was already seen as modest, because an initial recovery following December’s pandemic reopening quickly faded. China is flirting with deflation as the property sector – which accounts for a quarter of GDP – has sunk and pandemic-scarred consumers and businesses hesitate to spend.
Xi’s dilemmas are compounded by his belief that the traditional stimulus playbook of boosting real estate has run its course. He has frowned at house prices that made Shanghai less affordable than New York and made an example of over-leveraged developers that disrupted the market, such as China Evergrande (3333.HK), which is struggling to restructure some $300 billion in liabilities. He has eased home purchase curbs recently to stabilise property sales, but they are still on course to decline around 10% this year, per Gavekal Dragonomics.
That leaves much of the heavy lifting to fiscal spending. Yet LGFVs’ debt stands in the way. These vehicles had already accumulated 80 trillion yuan of liabilities at the end of 2022, according to analysts at Guosheng Securities. Of that, 54 trillion yuan was interest-bearing, mostly owed to Chinese banks.
The bulk of these debts are separated from local governments’ balance sheets, but Beijing’s decade-long efforts to sever the implicit guarantee between local governments and their LGFVs have been largely unsuccessful. A third of LGFVs didn’t generate positive cash flow last year, according to Guosheng. And 60% of them, holding about 32 trillion yuan of outstanding debt, would struggle to pay interest with their own EBITDA, Citi analysts estimated. Yet local officials remain reluctant to let them default on public markets, for fear that such a shock would shut their regions’ funding access and even trigger a run on government bonds.
Beijing wants to buy time. Its latest move includes a mooted plan to allow local governments to raise 1 trillion yuan in total through bond sales to repay LGFV debt. The Ministry of Finance may also ask banks to extend loans and slash the interest. Zunyi Road and Bridge Construction, a LGFV in China’s Southwestern Guizhou province, set a precedent earlier this year, as its creditor banks agreed to roll over its loans for 20 years and halved interest on them. Xi could also help by letting local governments shuffle their debt into the state’s balance sheet since the central government has a debt-to-GDP ratio of just 20%.
The problem with these measures is that they wouldn’t reduce LGFVs’ pile of debt. A harsher medicine is needed. The shock therapy option for Beijing is to force a fire sale to raise much-needed cash. LGFVs have 133 trillion yuan in total assets, around 60% of which are in land and physical assets such as industrial parks, transport infrastructure and investment properties, according to Guosheng.
Local officials have pushed back at Beijing’s requests to sell, arguing most of these assets are illiquid, according to the Financial Times. But even if the portfolio of land and fixed assets was put up for sale at a massive 80% discount to entice vulture and bad debt investors, that would raise around 16 trillion yuan, enabling the LGFVs to pay back all their outstanding bonds. At a more optimistic 30% discount, the proceeds would jump to 55 trillion yuan, which would cover all outstanding interest-bearing debt.
Even with asset sales, it’s inevitable that some LGFVs, especially in poorer regions, will have to fail. Beijing fears that would break the banks. S&P analysts calculate that about 20 trillion yuan of LGFVs’ loans may be at risk of restructuring. Letting these loans roll over with interest slashed – as in Zunyi’s case – would result in a 5 trillion yuan hit to bank capital, and reduce banks’ average capital adequacy ratio by 2.6 percentage points to 12.6%; that’s still within regulatory requirements.
The stakes are high. Despite Xi’s distaste for propping up the economy through real estate, the danger is that a fire sale of LGFVs’ assets could spark a widespread fall in the value of collateral for bank loans and cause a deeper crisis of confidence. That, in turn, might deal a considerable blow to lenders’ balance sheets and destabilise the financial system.
That said, the banking sector is sitting on 335 trillion yuan of total assets, and bad loans, impairments and provisions will only be an issue once lenders come clean on them. So far, they are not. As of June 2023, Chinese commercial banks claimed that non-performing loans were just 1.6% of all loans. Investors have already priced in more damage and pushed the average valuation of those listed to less than half of book value.
The makeup of China’s growth makes drastic action on LGFVs even more imperative. Unlike in the United States and other Western countries, China’s growth is still driven by investment rather than consumption. Investment as a share of GDP is a lofty 40%, according to Oxford Economics, double that of the United States.
Chinese households have ample savings, having accumulated 17.8 trillion yuan of bank deposits last year alone. But darkening job prospects, a diminishing wealth effect from real estate, and scars from years of pandemic lockdowns have made them extremely reluctant to spend them.
If Xi won’t boost property wholeheartedly and is not able to count on consumers, his efforts to revive China’s growth have to focus on smashing the great wall of local debt.
