China's massive infrastructure program lies at the heart of crushing debt problems. It's not clear just how much local and regional governments (LRGs) have borrowed to support their capital-hungry projects since not all of it appears on their balance sheets. Most debt--some in the form of wealth management products--is channeled through local government financing vehicles (LGFVs) and have implicit government guarantees. Far more debt could be hidden in this way than disclosed in official LRG borrowings. We do know that China faces a maturity wall of LGFV onshore bonds in 2019-2021 that could be as steep as Chinese renminbi 3.8 trillion (US$560 billion). But can it be cleared?

S&P Global Ratings sees tentative progress. Growth in LGFV debts reportedly slowed considerably last year, suggesting tough regulatory measures to defuse the associated financial risks have started to kick in. July 2017 was a watershed moment when China's politburo finally admitted that the off-budget borrowings of LRGs were still piling up. It resolved to firmly curb the increase and cut overall debt levels. Transparency over spending and financing has improved in recent years, although not consistently or adequately. (See "China's Hidden Subnational Debts Suggest More LGFV Defaults Are Likely," published on RatingsDirect on Oct. 16, 2018.)

Keeping the lid on new debt isn't enough; it's also critical to pay down the existing LGFV debt. According to available data from WIND, a financial data service provider, the LGFVs' debt may have totaled RMB33 trillion (US$4.8 trillion) at end-2018.

Debt restructuring (e.g., swapping hidden debt for corporate debt) would offer a short respite by moderating the LGFVs' refinancing risk, spreading their maturity profiles, and reducing financing costs. In turn, the impact on credit profiles would be positive. But if the restructuring involves the participation of commercial banks operating primarily on commercial terms, rather than under a political directive, it may only tackle hidden debt that is supported by sound assets--and that could be a small fraction of the total.

Ultimate repayment of most debt will hinge on improving the LRGs' fiscal income. Increased capacity to repay debts could come from taxes and land sales, the issuance of more government bonds as a swap for hidden debt, or increased availability of other financial resources (see table 1). But these aren't quick fixes. It could take more than 10 years for regions with high off-budget debt to offload their burdens.

Chart 1

The burning question is whether debt-strapped governments will be able to quickly bail out LGFVs that become distressed. A government that fails to offer timely support for a major LGFV in need would shock the financial markets. But then again, few predicted that banking regulators would take over the troubled Baoshang Bank in May 2019, a move that broke investors' faith in the interbank market.

The stakes are high. If defaults or bankruptcies among high-profile LGFVs become epidemic, it would erode market confidence, tarnish government reputations, and destabilize the financial system. It could also shut down financing to other local state-owned enterprises, at least initially. This would be highly disruptive at a time when China is counting on infrastructure development, along with other fiscal stimuli, to sustain economic growth and social stability. The clock is ticking (see chart 1).

What's Aided The Slowdown?

The slowdown in new borrowings that are off-budget for LRGs suggests local governments, LGFVs, and financial institutions are adhering to the central government's directives, at least partially. The LRGs' financial flexibility to do so has been eased by a new regime introduced in 2015, which allowed them for the first time to issue bonds directly (see charts 2-3). In addition, the quota on the LRGs' new bond issuance has been increasing each year. The financial sector has also been focused on deleveraging, and that has squeezed LGFVs' access to funding. The "shadow banking" sector essentially shut down for most of 2018.

Chart 2

Chart 3

Behavior is slowly changing to rein in off-budget borrowings. The central government rolled out more stringent regulations for public-private partnerships (PPP), which have been growing in popularity to finance economically viable infrastructure and other projects (see chart 4). LRGs are now banned from guaranteeing returns or the redemption of the principal from PPPs, government purchase of services (or subsidized services), and investment funds. These are additional sources of hidden debt.

Excessive investments of LRGs are now subject to regulation. In a new rule enacted in July 2019, the central government further defined the scope, planning, decision-making, and supervision of government project investment. The aim was to address the problem of governments that wanted to support growth but lacked financial discipline, leading to excessive investments, low efficiency, and hidden borrowings through LGFVs or other means. But the execution and effects remain to be seen.

Chart 4

A key risk is that an economic slowdown could lead China to relax its tough stance on LRG and LGFV debts. This could trigger a return to high leverage to support infrastructure development among other stimulus measures. In the first half of 2019, the growth of fixed-asset investments was sluggish, at 5.8%. Of this total, infrastructure investment (excluding electricity) grew modestly at 4.1% (see chart 5). If a slowing economy combines with other internal and external headwinds, China is likely to use more countercyclical measures to support the economy. These include increasing the intensity of infrastructure investment and maintaining relatively easy credit conditions.

Chart 5

The Governments Are Buying Time

LGFVs won't be able to dig their way out of the hidden debt pits without assistance. The industry could face a liquidity crunch should policy and financing conditions turn against them. However, any bailout by an LRG would be subject to the endorsement of the local congress, and constrained by the large and rigid expenditure needs. Local governments are on a tight budget this year due to a slew of tax and surcharge cuts to prop up the slowing economy.

Policymakers are likely to be weighing up the benefits of instilling financial discipline against the possible market disruptions caused by failing to support LGFVs in distress. In the past decade, LGFVs have become dominant borrowers in the country's bond market (see chart 6) and bank portfolios. Most LGFVs have homogenous business models and financial profiles, and therefore are vulnerable to the same policy and financing challenges. In contrast, state-owned enterprises are sensitive to industry and market cyclicality, and have idiosyncratic problems.

Given the LGFVs' huge outstanding debts, what happens in that market will have a significant impact on China's financial system. LGFVs have increasingly tapped the bond markets in recent years, and weaker borrowers frequently rely on short-term paper to reduce financing costs and entice more risk-averse investors.

Chart 6

Central and local governments are buying time while reducing hidden debt through various methods that may take the next five to 10 years or more to become effective. Such a wide timespan speaks to the big difference in financial strength between different local governments, as well as the varying magnitude of their hidden debt.

Most proposals are mid- to long-term solutions (see table 1), and may not ease imminent liquidity stress for LGFVs. Moreover, they are subject to the fiscal performance and available resources of local governments. And visibility over implementing these solutions is low.

Table 1

Restructuring Has Regulatory Support

Among the proposed solutions, debt restructuring is a practical approach to easing liquidity stress for some LGFVs for the next 12-18 months, at least. This would spread debt maturities and reduce finance costs. Banks on their own or in syndicates would negotiate with LGFVs to restructure their borrowings on market terms, especially for those debts considered hidden. New loans with longer maturities and lower interest rates would be used to refinance hidden debt from either participating banks, other financial institutions, or asset management firms (see chart 7).

The regulators support debt restructuring. In October 2018, the State Council issued Circular No. 101 that urged financial institutions to sustain the reasonable financing needs of LGFVs, and outlined extension and debt restructuring as a solution. More recently, the State Council issued confidential guidelines that encouraged financial institutions to help restructure hidden debt; but we have limited information about the scope and execution details.

In our opinion, the regulators would be keen to transform the off-budget borrowings to corporate debt. Repayments would be supported by cash flows that come primarily from underlying assets, and without local governments undertaking to be a backstop.

Chart 7

Policy banks may take the lead in restructuring LGFV debt. According to media reports, China Development Bank (CDB) is spearheading discussions on resolving hidden debt with some LRGs that have a high debt burden (see table 2). CDB may extend loans mainly for shantytown redevelopment, toll roads, railway, and other infrastructure projects--areas for which most hidden debt has been raised.

Table 2

In our view, large banks with lower funding costs and a stronger capital base have more capacity to expand their balance sheets. They tend to focus on the debt restructuring of LGFVs owned by higher-tier governments. Small and midsized banks have a smaller capital base, and have struggled to gain access to funding in the interbank market since the Baoshang Bank takeover. Against the backdrop of rising corporate defaults in the private sector, banks are generally more inclined to lend to the state-owned sector, and that benefits larger LGFVs or those backed by stronger governments.

One problem with restructuring is the need for new debt to be supported by positive cash flow and financially sustainable projects. But most hidden debt currently funds unprofitable infrastructure and social projects. In our view, effective restructuring requires banks to evaluate the restructuring on a commercial basis and make decisions with less political interference. Commercial banks would participate voluntarily and selectively after balancing the likely risk and returns, and considering project quality and business opportunities. Accordingly, the banks would expect less government support for those loans post restructuring.

Table 3

Chart 8

Why 2020 Is A Critical Year

Regulators require debt held in asset management products to be resolved by the end of 2020. There's been limited visibility over how the LGFVs will repay these debts or swap them into bank loans.

Media reports suggest LGFVs have missed repayments on shadow-banking borrowings multiple times since 2018. Those borrowers are mainly associated with governments that are either lower-tier, badly debt burdened, or in economically less-developed regions.

In our view, lower-tier governments (i.e., below prefectural city) and their LGFVs face the most difficulties in alleviating their hidden debt burdens. With limited access to capital market and large bank facilities, these LGFVs count on local commercial banks and shadow-banking products for funding.

Over the longer term, we expect the government support to LGFVs to become normalized and that they will transform into similar entities as other industrial state-owned enterprises. To do this, most of the hidden debt will need to be resolved, and local governments will have gradually replaced the funding role of LGFVs with government bonds and other financing means.

LGFVs will still have systemic importance to the economy and the financial system over the next few years. Regulators are likely to be assessing the consequences, practicality, and timing of letting go of insolvent LGFVs.

In the meantime, hidden debt remains China's wild card.

Related Research

• China Credit Spotlight: The Staying Power Of A US$3 Trillion Local Government Problem, Aug. 22, 2019
• Research Update: Tianjin Binhai New Area Construction & Investment Downgraded To 'BBB-'; Outlook Negative; Off UCO, Aug. 22, 2019
• Research Update: Tianjin Infrastructure And Tianjin Rail Transit Group Ratings Affirmed; Outlook Remains Negative, Aug. 22, 2019
• Zhenjiang Transportation Downgraded To 'B+' From 'BB-' On Refinancing Risk; Outlook Negative, Aug. 8, 2019
• Postponed Bond Offering Reflects Offshore Funding Challenges For Tianjin SOEs, July 15, 2019
• China Might Throw A Refinancing Lifeline To LGFVs, March 14, 2019
• Why We Don't Link The Ratings On Local Government Financing Vehicles Directly To The Sovereign Rating On China, Jan. 29, 2019
• How Will China's LGFVs Deal With The Substantial Offshore Refinancing Risk In 2019?, Jan. 9, 2019
• SOE Shake-Up: China's Support For Its Ailing Enterprises Will Become More Selective, Oct. 17, 2018
• Chinese LRG Risk Indicators By Province, Oct. 16, 2018
• China's Hidden Subnational Debts Suggest More LGFV Defaults Are Likely, Oct. 16, 2018