Primary land sales are wobbling in China, disrupting a key source of revenue for local governments. S&P Global Ratings believes this will accelerate the transformation in the way local government financing vehicles (LGFVs) operate. These vehicles, which execute development and infrastructure policy, will need to invest more in projects that produce cash flows to cover costs.

In our view, the impact will be particularly distinct for smaller financing platforms owned by lower-tiered governments, such as districts, counties, or smaller cities. These lower-level LGFVs rely more on land sales and their owners have limited financial resources compared with higher-level government arms, such as provinces and larger municipalities. They will face higher borrowing costs and some will likely ramp up short-term financing to stay afloat. We think a select few could fall into distress.

Nonetheless, we don't see a broad credit deterioration of LGFVs over the next 12-18 months. Our expectation is that the vast majority of LGFVs will remain solvent since they are still backed by a largely stable refinancing environment. Pulling out the rug rapidly would be too risky for China. This is based on our interpretation of the policy directives which describe "financial stability" as a top priority.

Why The Model Is Changing

We estimate that local-government land sales could decline by 20% in 2022 and a further 5% in 2023, magnitudes that have been observed in previous downcycles. This is a turning point because such sales play a critical role in funding development budgets. Land-related development has driven growth in the past but may have also encouraged debt-fueled investments for these vehicles. Governments could assign land development to LGFVs then sell land to developers to fund local investment. Recent volatility in property markets underlines the downside to such financing models.

With slower land sales, LGFVs will have to wait even longer to recoup their huge development outlays (see chart 1).

Chart 1

This will directly strain LGFVs' operating cash flow, especially for lower-level LGFVs--we estimate at least 60%-70% of their revenue is from land development-related businesses.

Two factors will control the fallout, in our view. First, related investments can be postponed accordingly. As a proxy, since last year, China's total land sales-related investments slowed down, allowing an overall surplus to emerge after years of deficit (see chart 2). Second, we believe most LGFVs will be able to refinance, even with negative net operating cash flow. The sector perennially operates under these conditions, and will not be cut off immediately, even as the mandate to change hardens.

Chart 2

Transition Easier Said Than Done

Falling land sales should accelerate change under the LGFV model, which began several years back, when central policymakers guided local governments to improve return structures on its infrastructure projects and to gradually rein in what policymakers have categorized as "hidden debt". This debt is borrowed or guaranteed by LGFVs beyond government issuance quotas but is set to use government budgetary means to repay. At the same time, governments are also under directive to be more disciplined; and their revenues are suffering due to hardships including COVID, and now waning land sales. Stricter government financial discipline points to more selective support to LGFVs, requiring them to become more self-reliant for new market-based investments (see "Gansu Provincial Highway Upgraded; Chongqing Nan'an Downgraded; Ratings On Four Chinese LGFVs Affirmed," Aug. 30, 2021).

Given this hidden debt is estimated by the market to be at least a quarter of China's GDP, any success in resolving this will likely take several years, if not much longer. Beijing's policy initiative to eliminate what it considers hidden debt has been given a 10-year horizon from 2018.

As LGFVs pursue business transformations, growth in new investment and debt will likely decelerate. This is because investment returns will become a crucial consideration. Undertakings will need to be designed and structured so that project cash flows can cover investment costs. We expect this will be a tough transition, because LGFVs have largely been focused on infrastructure projects that bring in broader returns for the local economies, rather than ones that are commercially profitable.

This task will be particularly difficult for lower-level LGFVs. The sector has largely been ineffective, thus far, in heeding China's calls for improved cash generation. Nor have injections of state-owned operating assets managed to reverse the overall cash flow pattern, though deficits have narrowed. Most continue to rely on new financing to bankroll investments (see chart 3). Many lower-level LGFVs' lack solid competitiveness for genuine market-based businesses and the expertise in managing such investments and operations.

Chart 3

Still A Role For Lower-Level LGFVs

Lower-level LGFVs will still have a role in undertaking key infrastructure projects, however. Their future investments are likely to shift toward more visible project returns at scales with more controllable spending, such as small-to-midsized urban renewal and certain in-city new infrastructure. The previous crude "demolition and reconstruction" model won't be as feasible and will likely fade out. Also, government authorities and creditors (including banks and other financial institutions) will play a stronger role in screening out qualifying projects under tightening regulations.

We note that China's latest five-year plan highlighted urban renewal, for the first time, as an important channel to expand domestic demand and stabilize investment. Accompanied by the "new infrastructure" ambition, this is closely in line with China's "dual-circulation" economic strategy of developing more domestic drivers of growth. To improve housing affordability, the central government requests that affordable rental housing represents more than 30% of new housing supply over the five years ending 2025.

In our view, LGFV consolidation will not be a magic bullet. Since several years ago, a number of provinces have been promoting consolidation of the sector, for example merging city-, district- and county-level LGFVs, to improve financing capabilities, operating efficiency and oversight. In recent months, Jiangsu, Yunnan and Guizhou provinces have introduced policies to clear up insolvent and non-functioning LGFVs. Mergers alone cannot produce self-sufficiency, in our view; this will come through investment and financing efficiency. The brutal reality is--bigger does not mean stronger. It can easily take years to integrate different LGFVs effectively to create advantages in financing, let alone produce synergies.

Credit Differentiation Alongside A Protracted Transition

China's policy environment will continue to sustain LGFV refinancing for the most part, given the sector's importance to financial system stability. Refinancing has always been far more crucial than direct government support for most LGFVs to stay afloat, especially while they are resolving hidden debt and moving gradually down the long road toward self-sufficiency.

China central government has provided some refinancing support via the launch of a hidden-debt resolution pilot program. This allows local governments to use a portion of their refinancing bond quota to replace some county-and district-level hidden-debt (with such LGFV debt being the riskiest, in our view). The program focuses on hidden debt from economically weaker regions with high repayment pressure, mostly in the less developed southwest, northwest and northern China. Last year, the Ministry of Finance outlined Chinese renminbi (RMB) 612.8 billion of such hidden-debt refinancing bond quota, with more than 99% of it being issued already by end July this year.

That said, some LGFVs could fall through the cracks. Liquidity-crisis risk has become more acute for lower-level, non-core LGFVs whose government owners have relatively constrained financial resources. Such LGFVs face heightening refinancing risk as well as more hurdles for transition, because their government owners have limited alternatives or assets to provide support. At the same time, bank support could also wane given tighter funding conditions could mean they become more selective with lending to these weaker names. Significantly higher borrowing costs and reliance on short-term financing can further exacerbate their situation.

Examples of sector distress so far this year include:

• In April, Hohhot Chunhua Water Development Group Co. Ltd., a city-level LGFV from Inner Mongolia, was overdue on bank loans and non-standard debt totaling RMB746 million.
• In August, another city-level LGFV, Jilin Railway Investment & Development Co. Ltd., delayed payment on RMB14 million of loan interest payment.
• Less than two months ago, the inability to refinance in the bond market revealed the liquidity crunch at LGFVs in Lanzhou city, the provincial capital of Gansu.

Beyond these examples, dozens of district- and county-level LGFVs from less-developed provinces such as Guizhou, Yunnan, and several others have defaulted on non-standard debt, including trust plans, wealth management products, and private-placement bonds, this year.

Credit differentiation is likely to deepen. Increased regulatory monitoring and public signalling--such as the recent circular 15 (issued directly to banking and insurance institutions) on effectively resolving hidden debt--will make it harder to get bank financing for unrestricted use. Capital markets are also tightening access of weaker LGFVs (see "Riskier China LGFVs Be Warned: Capital Markets May Cut You Off," published Oct. 6, 2021).

An effective resolution for many will still rely on improving investment efficiency through market-based transformation. This means there is a long way to go.

Editing: Cathy Holcombe

Digital design: Evy Cheung

Related Research

• China Property Strains Will Roll Off Local Governments, And Land On Their SOEs, Nov. 11 2021
• China's Contagion Risks Rise, Nov. 10, 2021.
• Guangxi Liuzhou Dongcheng Downgraded To 'B+' On Heightening Refinancing Risk; Outlook Negative, Oct. 29, 2021
• China Property Watch: Strains In The Key Of 'B', Oct. 27, 2021
• Riskier China LGFVs Be Warned: Capital Markets May Cut You Off, Oct. 6, 2021
• Gansu Provincial Highway Upgraded; Chongqing Nan'an Downgraded; Ratings On Four Chinese LGFVs Affirmed, Aug. 30, 2021
• Institutional Framework Assessment On China's Local Governments Raised On Central Government's Tightening Control, Aug. 30, 2021