China's push to end local governments' reliance on off-budget debt has so far been ineffective, with state-owned entities (SOEs) continuing to bury liabilities. S&P Global Ratings estimates this is a Chinese renminbi (RMB) 20 trillion (US$3 trillion) problem, with local government hidden debt equal to about one-quarter of Chinese GDP.

The issue presumably keeps policy planners and investors in cold sweats precisely because the debt is hidden. Few know which government-linked vehicle could blow up next, or to what extent the central government or state banks might need to bail out insolvent entities. The solution of central authorities has been to force local governments to drag their liabilities into view, and onto balance sheets. They also want local governments to solve their debt problems with their own resources.

But as local governments contend with rising deficits and indebtedness, those objectives have been eclipsed. Most will be unable to end their dependence on hidden debt over the next two to three years. We expect the level of such debt to stay stable, but that it will become a smaller part of total local government debt, which will increasingly be on balance sheet.

Much of this accounted for in our models. We maintain a stable outlook on the sector's creditworthiness, and we note that no SOE carrying hidden debt has defaulted yet.

Local Governments Still Need Their Funding Vehicles

There are no official data tracking China's off-budget-borrowing. We developed a range of proxy measures using data from WIND, a Chinese financial information company, alongside government and SOE figures.

We focused on the balance-sheet-management of the SOEs where the local government was the largest shareholder. This included financially weak SOEs that operate largely in form of local government financing vehicles (LGFVs) to fund social spending with little cash flow.

LGFV debt served as a proxy for hidden debt, on the view that such liabilities are not on the balance sheet but are ultimately backstopped by the local government.

We found that while the quantity of China's hidden debt problem is steady, the quality of the total debt composition is changing.

Chart 1

Chart 2

Authorities want local governments to stop hiding debt. But it also wants the governments to keep borrowing to fund projects that promote fixed-asset investment targets and GDP growth.

These objectives are often at odds with each other. Local governments would be stretched to borrow more while recognizing billions of dollars in fresh liabilities--investors might flee.

The workaround has been to let local governments continue to hide much of their legacy borrowing, but to force them to put new debt on their balance sheets.

We expect the new debt will focus on projects with cash flows. The hope is that the new debts will be largely self-funding and will not contribute to some fresh credit crisis down the line.

We expect local governments' on-budget borrowings will rise more than 10% over the next two years, supported by central authorities' willingness to let local governments fund capital expenditure (capex) with bond issuance. We project local governments' off-budget debt will rise at the mid-single-digit level only over this period.

Chinese local government debt, including off-budget borrowings, should grow in line with national GDP over the next two years.

Chart 3

Role Of Debt To Hitting Economic Targets

China's local governments need debt more than ever, to plug deficit holes, meet GDP targets, and fund infrastructure. The composition of local government debt is reshaping as these dynamics play out.

We've noted that the provinces with a high dependence on investment-linked growth have struggled to match national GDP targets over the past two years.

Recent controls on LGFV debt have led to a slowdown of new investment in China, especially for infrastructure, with local governments unable to fully take up the slack. If the economy slows down more than expected, we believe that central authorities will allow LGFVs to borrow more to help the country hit its economic growth targets.

Chart 4

While local government bond issuance and bond stock will stay high by global standards, we expect rapid changes in the use of such funds. In addition to refinancing (see, for example, the program to swap LGFV debt for local government debt initiated by central authorities in 2015-2018), new debt will be increasingly put to cash-flow-backed projects.

This debt--so-called special-purpose bonds--will be key to fund local government capex and an important catalyst to commercial projects driven by the private sector. We expect such issuance to surge, with the approval of the central government.

Debt-raising plugging holes in local government budgets

Since 2015 local governments' budget deficits have been widening. We expect this dynamic to persist for the next two years. This can be primarily attributed to tax cuts enacted to promote local growth.

The central government in 2018 cut corporate profit taxes (mainly to benefit small to midsized enterprises) and personal income tax (mainly to benefit the poor), which meant revenue growth for most local governments stayed modest. Increases in capex in 2018 and the first half of 2019 have added to local governments' deficits and debt piles. Capex spending should continue to rise over the next two years.

The central government's commitment to making large cash transfers to local governments was meant to mitigate these deficit challenges. However, the transfers have not kept pace with the wider economy or the commitments of local governments.

Chart 5

The upshot is that, as local governments wrangle their ever-enlarging deficits and spend to support the economy, central authorities have been less willing to press them on that other matter: putting huge blocks of hidden debt onto the balance sheet.

Top Tier Of Local Government Less Burdened By Hidden Debt

In our survey, we looked at top 14 provincial governments, which accounted for about 70% of China's GDP in 2018. We compare their tier-one performance with that of the "whole province" data, which captures the performance of all tiers of local government.

We found a widening gap between the fiscal performance of the top tier of local government and the rest.

China has a highly centralized political system, and a five-level administrative system comprised of the central government and four tiers of local government.

Provinces, autonomous regions, municipalities, and cities with state-planning status comprise China's first tier of local government, and have the strongest ties with the capital.

This tier has sufficient buffers to manage the most severe market or economic disruption. This can be mainly attributed to their better discretion, especially in capex.

Chart 6

China's tier two governments are mainly composed of cities of provinces, prefectures of autonomous regions, and districts of municipalities. These local governments generally operate in deficit because they have large capex responsibilities, but limited fiscal resources.

Lower tiers of local government are often dependent on their tier-one peers, receiving funds from their bond issuance.

Assuming widening deficits among local governments, we believe local governments' access to external funds will remain key to their public finances. In our view, the stronger local governments will be able to issue new bonds to fund important infrastructure projects, easing their funding strains.

We predict the top tier of local government will move out of hidden debt faster than lower-tier peers. The biggest, richest and more politically connected governments have enough funding to end the practice. But the poorer local governments are adding more hidden debt. This means that China's US$3 trillion problem is not going away.

Appendix

Table 1

Table 2a

Table 2b

Table 3

Table 4

Related Research

• Institutional Framework Assessments For International Local And Regional Governments, July 4, 2019
• Credit Conditions Asia-Pacific: Return Of Uncertainty, June 27, 2019
• How Can China Cut Taxes And Maintain Low Budget Deficits?, March 11, 2019
• Lifting The Lid On China's Local And Regional Government Debt Levels, Oct. 16, 2018
• Chinese LRG Risk Indicators By Province, Oct. 16, 2018