The credit standing of China's tier-two local governments is diverging--the strong are getting stronger and the weak are getting weaker. S&P Global Ratings believes this gap will widen in the next couple of years, when we expect stretched tier-two finances to weigh particularly heavily on the weaker city/district governments.

The tier-two governments are experiencing an amplified version of factors broadly affecting China's local and regional government (LRG) sector. They rely heavily on land sales for their revenues, and China's property sector is in a downturn. While land-related revenues account for about one-third of LRG revenues, we estimate this metric is 40%-50% for many tier-two or tier-three LRGs (see "China Property Strains Will Roll Off Local Governments, And Land On Their SOEs," published on RatingsDirect on Nov. 11, 2021).

This is playing out in a climate of tightening fiscal discipline. Beijing wants companies to pull back their leverage levels, and is showing more tolerance for defaults. This has included allowing China Evergrande Group to continue to brush against the edge of insolvency, and to allow a swath of developers to default this year (see "Why China Property Firms Are Succumbing To Evergrande Effects," Nov. 18, 2021).

Beijing will likely require LRGs to cut capital spending just as they are contending with a shortfall in land-sales revenue. The weaker LRGs have less flexibility to cut spending on their already stripped-down budgets, especially for social expenditures.

A note on jargon. Tier-two LRGs inhabit the second tier of China's fiscal hierarchy of local governments (see chart 1). These LRGs are the immediate level below provincial governments, autonomous region governments, municipal governments, and cities under state planning.

Chart 1

We assess the creditworthiness of non-U.S. LRGs by combining our assessment of their institutional framework and individual credit profiles to arrive at the anchor, a core element for assigning an issuer credit rating. As such, we focus on the issuer-specific credit profile. For Chinese LRGs, we focus on assessing "LRG-level" credit factors. For instance, for city governments, we primarily assess the "city-level" credit metrics, which is an unconsolidated approach excluding any of its lower-tier governments.

"Whole city" measures encompass all the lower-tier governments that administratively and fiscally fall under an LRG, i.e. its lower-tier districts and counties.

Strains Facing The Tier-Two LRGs

We expect the fiscal profile on tier-two LRGs to remain stretched in the next couple of years, in line with a tightening trend seen by all Chinese LRGs (see "China Local Governments: Higher for Longer Fiscal Imbalances," Nov. 23, 2021.

In 2020, the balance after capital account (BACA) of tier-two LRGs marginally deteriorated compared with 2019. This was despite flattish operating revenue, and substantial spending growth that was rolled out to soften COVID's hit on the economy. Cash transfers from provincial governments and LRGs' robust land sales supported this spending growth.

Tier-two LRGs' debt burden continued to trend up in 2020, mainly due to a substantial increase of direct debt stock (17% of tier-two whole-city direct debt, and 14.4% of tier-two city-level direct debt). The debt growth of key SOEs was stable compared with 2019.

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Budget Performance Trends Diverge

The budget performance of China's tier-two LRGs will continue to diverge, in our view, meaning the gap between stronger and weaker tier-two entities should widen. Weaker LRGs will likely have less flexibility in cutting their fiscal spending than stronger ones during periods of fiscal strain.

This view is supported by the trend of the past couple of years of increasing divergence in the budget performance of tier-two LRGs. The debt of weaker LRGs has been rising faster than that of stronger LRGs. This gap is apparent when comparing the budget strength of provincial capital cities with that of non-capital cities, or that of top performing tier-two LRGs with the bottom performing ones.

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This divergence stems from weak LRGs' increased spending responsibilities, notwithstanding the efforts of the central and provincial governments to even out revenues through transfer payments. Weaker LRGs' relatively greater outlays on COVID measures (virus containment, stimulus, etc.) largely accounts for their greater spending growth.

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We compared the 26 provincial capital cities in our sample with non-capital cities, and find divergence in their total deficit. Meanwhile, non-capital cities' debt burden is climbing faster than that of capital cities, despite a lower initial level.

We also compared the total budget deficit for the top 24 LRGs (by fiscal standing) in our sample with the bottom 24, by ranking their five-year average balance-after capital account (BACA) ratio during 2015-2019 (see Appendix Glossary for term definitions). We notice that the deficit gap expanded when both measuring LRGs at the city-level, and at the whole-city level, in the past couple of years.

Tier-One LRGs Part Ways With Their Tier-Two Counterparts

The gap between tier-one and tier-two Chinese LRGs' budget performance is likely to continue to expand. Tier-one LRGs have more budget flexibility during periods of fiscal distress. In particular, they can shift spending responsibility to lower tier governments (see "Institutional Framework Assessment: China Tier-Two Governments," Aug. 31, 2021).

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Within China's tier-two LRG sector, there's a much larger divergence in budget performance and debt levels compared with the tier-one sector. This is because China's tier-two governments vary greatly in terms of their development, degree of urbanization, revenue generation, and spending commitments. COVID accelerated this divergence, but the trend has been in play for a long time and will continue in the years ahead.

Appendix

In doing this analysis, we considered whether our sample of tier-two LRGs reflected the universe of these entities.

Unlike our assessments of China's tier-one local governments risk indicator, which cover all of China's 36 tier-one governments, we cannot cover all of China's 400-plus tier-two LRGs. Instead, we selected 48 tier-two LRGs that we believed represented all such LRGs (see "Chinese Tier-One Local Governments Risk Indicator," March 19, 2020, and "Chinese Tier-Two Local Government Risk Indicators," Nov. 29, 2021).

Having a sample of tier-two LRGs allows us to see the city-level data for the tier-two sector. We can infer only the whole-city number for the tier-two sector by deducting tier-one provincial level data from tier-one whole province data. For Chinese LRGs, we focus on assessing "LRG-level" credit factors, while using "whole LRG" ones as supplementary.

The budget performance of the tier-two LRGs in our sample has been consistent with the sector, which gives us confidence the sample is representative. We have seen some gaps opening up in the performance of the sample and of the universe it tracks in the past couple of years. We believe this reflects the divergence in the budget performance of strong tier-two LRGs with that of weak ones.

The trend of our sample LRGs' debt burden ratio largely track that of wider tier-two sector, although its level is materially higher than the sector average. This is because our sample tends to include the larger tier-twos, which get more quota from the central government to issue more debt. Moreover, their key SOEs have robust access to debt from banks or capital markets.

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Glossary

Adjusted capital expenditure:

Own capital expenditure, adjusted up by capital items, plus transfer outflow under government fund account.

Adjusted capital revenue:

Own capital revenue plus transfers inflow under government fund account.

Adjusted operating expenditure:

Own operating expenditure, adjusted down by capital items, plus transfers outflow under general government account.

Adjusted operating revenue:

Own operating revenue plus transfers inflow under general government account.

Adjusted total revenue:

Sum of adjusted operating revenue and adjusted capital revenue.

Balance after capital account (BACA):

Operating balance plus capital account balance.

Capital account balance:

Adjusted capital revenue minus adjusted capital expenditure.

Consolidated operating revenues:

LRG's adjusted operating revenues, plus operating revenue generated by referenced local government-owned enterprises. Data are from 2020.

Direct debt:

Outstanding debt explicitly under local and regional government legal name.

Direct debt excluding onlending:

LRG direct debt after deducting onlent debt to lower tier governments.

Key state-owned enterprise (SOE) debt:

Debt of local government-owned enterprises with outstanding onshore bonds, whose debt repayment S&P Global Ratings deems as supported by LRG fiscal revenue.

Operating balance:

Adjusted operating revenue minus adjusted operating expenditure.

Tax-supported debt:

Local and regional government (LRG) direct debt plus Key SOE debt.

Whole LRG:

Accounts for all the lower-tier entities for which an LRG may have fiscal responsibility.

Writer: Jasper Moiseiwitsch

Related Research

• Chinese Tier-two Local Government Risk Indicators, Nov. 28, 2021
• China Local Governments: Higher For Longer Fiscal Imbalances, Nov. 22, 2021
• China Property Strains Will Roll Off Local Governments, And Land On Their SOEs, Nov. 11, 2021
• China Balances Policy Risk With A Need For Reform, Oct. 12, 2021
• China's Local Governments Will Address Evergrande--Quietly, Behind The Scenes, Oct. 4, 2021
• Institutional Framework Assessment: China Tier-two Governments, Aug. 31, 2021
• Institutional Framework Assessment On China's Local Governments Raised On Central Government's Tightening Control, Aug. 29, 2021
• China Provincial Governments' Risk Indicators, June 16, 2021