China is inching back to fiscal consolidation. After years of record debts, depleted revenues, and wide deficits, the center wants local governments to get their budgets in order. S&P Global Rating believes this will prompt officials to let struggling, non-critical SOEs slip into default or restructuring.

In so doing, the country is just reverting to its prior policy of gradually delinking local and regional governments (LRGs) from their exposure to sizable SOE debt (see "Institutional Framework Assessment On China's Local Governments Raised On Central Government's Tightening Control," published Aug. 30, 2021, on RatingsDirect).

We believe this measure is aimed at managing the country's large local government debt levels. However, the many domestic and international investors that have invested in SOE bonds may get left in the lurch.

The move to fiscal conservatism will happen gradually, and only at the margins at first. We assume Beijing will still allocate generous special-purpose bond quotas to local and regional governments (LRGs) for 2023. This will ensure fiscal buffers are in place while the country embarks on a bumpy recovery (see "The Clock Is Ticking For The Debt-Led Growth Of China Local Governments," published Feb. 21, 2023).

However, while Beijing will continue to allow LRGs to expand direct debt, it will squeeze governments on their debt-raising through state-owned enterprises (SOEs) controlled by LRGs. The center has long had misgivings about this practice. The SOE debt raised was largely off the balance sheet of the LRG, and therefore hidden, at least untill Beijing starting clamping down on this in 2015.

If LRGs are accumulating excess debt, policymakers prefer that this is on balance sheet, visible, and therefore addressable before problems emerge.

LRGs have widely used local government financing vehicles to create hidden debt; we view these vehicles as a subset of the SOEs covered in this report.

There is much at stake. We estimate the aggregate debt of local SOEs at Chinese renminbi (RMB) 80 trillion-RMB90 trillion. This comprises one-third of China's total debt (excluding government direct debt, but including household and corporate borrowing). It is a massive volume to which onshore and offshore investors are exposed.

Local governments racked up debt during the COVID crisis to stimulate a sluggish economy. This debt raising came as collapsed land sales hit LRG revenues, after the property market turned down.

The Chinese economy is reverting to normal growth levels following the end of pandemic controls. The property market could also feasibly stabilize in the second half of this year. Accordingly, we assume the government will ease on stimulus measures, and tilt very gradually back in the direction of fiscal caution (see "China's Earlier Policy Shift Advances Its Recovery," published Jan. 18, 2023, on RatingsDirect).

This would put China on the same policy stance before the COVID breakout, which was to wean the country off debt-led growth, and toward a more diverse, consumption-led economy. We assume some SOEs will be collateral damage of this new direction.

Table 1

Tightening SOE management won't stop the deterioration in the finances of local SOEs.  The center continues to limit local governments use of SOEs for debt-raising. Of particular interest to Beijing is SOE borrowing that is not backed by any meaningful cash flow. For example, Beijing recently introduced a new risk weighting on bank lending to certain non-commercial SOEs (see "China's Tightening Capital Rules To Hit Aggressive Banks," Feb. 22, 2023.)

The central government started fortifying some of these measures in 2020-2021. For example, China has been asking LRGs to more tightly monitor SOEs and their capacity to make bond repayments. The center has also curtailed SOEs' more risky borrowings, by limiting entities' access to bank loans and new bond issuance.

These measures have not stopped credit events from cropping up among local SOEs during 2021-2022 (see table 1). We view these events as examples of credit deterioration, even if local market participants do not view them as defaults.

The tail risk mainly lies with SOEs controlled by lower-tier governments, including tier-two (city) governments and tier-three (county) governments (see charts 1a and 1b). Many LRGs continue to use SOE investment to promote local growth, especially to fund infrastructure sponsored by LRGs.

Most of the SOEs pulled into this role have weak credit profiles. This implies contingent risk for the LRGs. If an SOE fails, the local government may come under irresistible pressure to restore their operations, including bailing out their financial obligations.

Chart 1a

Chart 1b

Involuntary spending cuts signal fewer resources to support SOEs.  China will return to a more fiscally conservative stance. We are just unclear on the timing of this adjustment, due to our uncertainties about the pace of the country's GDP recovery.

We expect its economy to grow at around 5% during 2023-2024. This is a healthy growth level, but China remains exposed to risks posed by COVID and the property sector, not to mention a global slowdown and and other (geopolitical) wildcards.

The debt metrics of China's LRG sector have increased since the country deregulated LRG bond issuance in 2015. The sector's ratio of direct debt stock to total revenues rose to 124% in December 2022, by our estimates, from 77% in December 2018.

This puts some local governments in danger of breaching policymakers' soft threshold of 120%. Out of a total of 36 LRG issuers, 24 LRG regions were set to exceed this ratio, as of December 2022. In December 2018, only five LRGs were hitting this ratio (see chart 2).

Chart 2

The sector's deficit ratio will range from 15%-20% over 2023-2024. This ratio is the balance after capital account expressed as a percentage of LRG sector revenues.

This compares with our expectation the deficit ratio was 20% in 2022. We assume this measure will improve mildly. Highly indebted LRGs may be forced to make more spending cuts, to rein in their fiscal deficits.

LRGs might first scrutinize their support to the SOEs they control. The regulation views LRG spending to support their SOEs as noncritical (see "A Showdown Awaits As More China Local Governments Stretch Fiscal Boundaries," July 4, 2022).

LRGs' budget resources to support SOE could be in form of subsidies or capital injections. The cash is usually not enough to meaningfully improve SOEs' creditworthiness. However, they serve as vital signals to investors of a government's commitment to support an SOE, should it topple into stress.

LRGs may choose to shift resources among the SOEs they control. This may involve an asset transfer, capital injection, or a liquidity bridge from a healthy SOE to a less healthy one. The availability of such resources is in aggregate diminishing, following SOEs' increased involvement in highly indebted projects to sponsor local growth (see chart 3).

Chart 3

SOEs: The Ties That Unwind

We believe the highly indebted LRGs are under the greatest pressure to cut ties with SOEs. This may begin with reduced SOE support, followed by diminished SOE investment. This may result in slowing growth if the local economy is investment driven.

Our analysis compares the leverage of the aggregated SOE sector, by region (see box). Our key findings include:

• SOEs controlled by lower tier LRGs (on a whole-city basis, including tier-two and tier-three governments) are generally less self-sufficient (see charts 1 and 4). This could be driven by lower tier LRGs' tendency to use SOE debt-financed investment to promote their growth; and
• There appear to be large divergences across regions, or even across cities in the same region (see chart 4). Highly indebted SOEs are largely domiciled in cities with low incomes or which face structural challenges to their growth.
• We further see indicators that some regions are using their SOEs to generate fast growth. This can result in quickly rising leverage ratios (see chart 5). Some SOE credit events are from regions that show such fiscal tendencies.

Chart 4

Chart 5

Policy positions aim at balancing risks and growth. 

Chart 6

Reduced support for troubled SOEs and greater tolerance for SOE defaults could be a double-edged sword for LRGs. The primary effect would be to unravel the risks presented by SOE debt, by distancing the entities from their LRG owners. The secondary impact, however, could be reduced local economic growth and stability.

Some LRGs that are home to defaulted, high-profile SOEs have subsequently experienced slower growth and investment, for example.

In saying that, we also anticipate LRGs will increasingly use broad policy powers to address SOE insolvency. They are looking beyond conventional approaches such as bailouts. LRG measures to kickstart the property market during the second half of 2022, are an example. This includes prodding developers and banks to cooperate on a debt resolution, particularly resolutions that would breathe life into stalled property project.

By contrast, LRGs together with their SOEs have committed few rescue packs so far.

While China will still encourage LRGs to better manage their SOE risk, most LRGs will also continue to support local growth. China authorities usually opt to fortify risk controls when the macro conditions are favorable, and relax their scrutiny when the economy or sector turns down.

For example, the authorities deepened measures to control local SOE risk in 2018, slowing infrastructure investment. Authorities then reversed these steps when the property sector slumped in 2022 (see chart 6). Many LRGs have recently encouraged SOEs to support local growth by borrowing and investing.

The policy cycles ebb and flow, but the long-term trend is clear: Beijing wants to ease the country off a reliance on investment-driven growth. Officials will grow increasingly tolerant of short-term pain stemming from SOE stress, in our view. And as governments distance themselves from troubled SOEs, bondholders may feel the strain.

Editor: Jasper Moiseiwitsch

Related Research

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• China Local Governments: Fiscal Expansion To Continue To Support Growth, Nov. 28, 2022
• Chinese Tier-Two Local Government Risk Indicators, Nov. 23, 2022
• China Cities Diverge To Navigate Property Slowdown, Nov. 1, 2022
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• Local Government Debt 2022: Rising Risks Keep Global Borrowing High, April 12, 2022
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• Institutional Framework Assessment On China's Local Governments Raised On Central Government's Tightening Control, Aug. 30, 2021