There is currently widespread concern that China’s economy is in worse health than previously assumed. Key figures on Chinese manufacturing, retail sales, and investment have all recently come in lower than expected. The country is not recovering as quickly as expected under rigorous zero-COVID measures. And it’s all tied up in a mountain of debt that local governments are facing.
The issue is that historically, China has relied on local government spending to drive the economy, and that strategy is running out of steam.
Analysts say that while China is exploring more drastic steps to address the dangers posed by the local government debt problem, there are less opportunities to reduce systemic risks in the state-dominated financial system.
Analysts have cautioned that the costs might be enormous if Beijing does not act quickly to settle the real estate market problem, which has implications for local governments and has already put the banking system under pressure.
According to Alicia Garcia-Herrero, chief economist for Asia-Pacific at Natixis, “overall, while the structural consequences of a disinflating real estate bubble cannot be avoided, Chinese policymakers should focus on limiting potential spillovers into the financial sector and thereby systemic risk.”
“The price will be higher the longer they wait to do so.”
Beijing stated last month that “a comprehensive solution” was required to address the local government debt situation due to its urgency.
There are dangers associated with policy support not being provided on time or effectively to the larger economy, according to Wang Tao, chief economist for China at UBS.
Wang cited the issue of how to deal with local governments’ wasteful expenditure when they already make up 90% of China’s fiscal resources.
The [central] government must also steer the economy away from the property- and local government-led growth model and towards a more sustainable and high-quality one, Wang added this week. These structural challenges include an aging population and limitations on access to advanced technology from abroad.
“The internal deliberation may require time and cause delays in delivering efficient policy responses,” the statement reads.
According to a Saturday article in Caixin magazine, China’s central bank may establish up an emergency liquidity tool with banks to give local government financial vehicles (LGFVs) low-cost funding with longer maturities.
Since the global financial crisis in 2008, LGFVs—hybrid companies that are both public and private—have multiplied in order to get around constraints on local government borrowing.
Local governments’ ability to repay LGFV debt has come under increasing scrutiny as their land sale income have been pinched by the weak real estate market. Despite this, many have continued to borrow money to pay for expensive infrastructure projects in an effort to spur growth.
The proposal outlined by Caixin, according to Logan Wright, partner and director of China Markets Research at Rhodium Group, is “very early and a small step.”
However, he continued, such a strategy would increase market risks for provinces or regions that get little to no funding for refinancing bonds.
According to the US-based Rhodium Group, as of July, LGFV loans made up 20 to 25% of all bank loans in China, while LGFV bonds made up 51% of all business bonds and LGFV credit accounted for roughly 13% of all financial assets across the system.
Domestic investors own the majority of China’s local government debt, and the banking industry is thought to have a sizable exposure to LGFVs.
According to Rhodium Group, any type of debt resolution will result in loss-sharing throughout the system, with China’s banking and nonbank institutions bearing the lion’s share of the losses.