China is coming off another big infrastructure stimulus exercise, with record outlays last year to offset COVID shocks and a property downfall. On the surface, this is a familiar story, given the country has long boosted growth with debt-fueled investments in capital stock. Yet below the surface, change is afoot.

S&P Global Ratings sees two key trends for infrastructure spending for the rest of this decade. The first deals with absolutes, and is not too surprising. Infrastructure investments will ease alongside the economy. We expect real GDP growth to normalize at 4%-5% over the years to 2030.

The second trend is already quietly underway. Infrastructure spending is becoming more discriminate. Governments are and will continue to focus more on larger key projects that have sustainable payoffs. Many of those projects will likely be related to China's ambitious energy-transition targets and various infrastructure network improvements (such as transportation and water resources). In the first four months of this year, for instance, spending growth on power and utilities hit 24.4%, up 5 percentage points against 19.3% in 2022.

Nonetheless, in China, policy significance can sometimes override efficiency. Overinvestment remains a risk, and could weigh on the credit quality of infrastructure companies--even in cases where immediate returns or policy implications look solid.

Weaning Off Infrastructure Stimulus…

China's most recent infrastructure spending spree will likely taper as consumption rebounds from the COVID lockdowns and the property sector begins to stabilize. With the economy getting back on track, policymakers can resume reforms that began several years before recent economic shocks. That means urging local governments to steer away from investment-driven growth models.

That said, we don't anticipate infrastructure spending to plummet given the overall economy is not yet fully back on track. Local governments and their local government financing vehicles (LGFVs) have accumulated massive debt from prior development models. Abrupt cuts in spending could hurt local economies, thus magnifying leverage on a debt to GDP. Investment hit a five-year high of 11.5% year-on-year growth in 2022, when consumption stalled and property investment contracted (see chart 1). We expect:

• Infrastructure investment to increase in high single digits in 2023 and decelerate further in 2024.
• Up to 2030, infrastructure investments to gradually regress to low-to-mid single digits, in line with China's trend growth of 4%-5% annually.

Chart 1

More Restraint In Building Bridges And Culverts.

Even amid increases in headline infrastructure spending in the past few years, habits are shifting. Under the central government's directives to gradually strip away the financing function of LGFVs, local governments have had to increasingly finance public infrastructure directly from their budgets. In our view, this has curbed some types of investment excess, helping to divert more to other types of expenditures.

In particular, the share of urban public infrastructure spending in cities and counties has dropped to below one-sixth of China's total infrastructure investment since 2015-2016. (see chart 2).

Chart 2

The introduction of China's version of a municipal bond market is also part of more scrutiny to infrastructure spending, as fiscal spending becomes constrained. This is because approval of new "special-purpose bond" (SPB) issuance requires project returns as repayment resources. And urban roads and bridges, drains etc., generally don't produce cash flows. Hence the share of government fiscal infrastructure expenditure on such assets has been subsiding since 2020 (see chart 3)--when new SPB quota ballooned to Chinese renminbi (RMB) 3.75 trillion (up 74% from 2019) to finance projects with better returns.

Chart 3

LGFV financing has also continued to grow in recent years. Even so, the pace of expansion has slowed further during the infrastructure stimulus in 2022 (see chart 4). Moreover, in our view, a lot of the new funding is going into interest payments for debt buildup from excessive public investments in the past. These vehicles play a diminishing role in the country's infrastructure intensity, given it's much harder now for governments to turn to their LGFVs to raise financing for projects that don't have cash flows.

Chart 4

… With A Greater Focus On Key Projects

Policymakers have been highlighting effectiveness, implying new projects are subject to screening. This means funding will tilt toward key projects that are more financially viable, strategic, or both. New SPBs issued by local governments mainly bolster such projects, since the quota rose sharply in 2020 and has stayed elevated (see chart 5).

New SPB will likely fall, in absolute terms, now that the COVID shocks are passing and the economy stabilizing. The quota for 2023 is RMB3.8 trillion, which is lower than last year's issuance size. A lot of this has already been frontloaded--in the first four months, record high new SPB issuance of RMB1.64 trillion exceeded the same period last year. More SPB has been used for existing projects lately, to ensure continuity of financing rather than new projects.

The new SPB quota is likely to be reduced from 2024 onwards (see chart 5) as local governments tilt toward a less fiscally aggressive path when the economy stabilizes. (see "The Clock Is Ticking For The Debt-Led Growth Of China Local Governments," Feb. 21, 2023).

Chart 5

SPB will still play an important role in gradually displacing the role of local government corporate arms in financing development projects. Over the long term, LGFVs will need to operate on more commercial terms, closer in business models to the state-owned enterprises that are more self-sustaining and profit-driven.

Key state-owned enterprises (SOEs) have capacity to lead infrastructure spending

As local governments seek to regain control of their spending post-COVID, China's more commercially driven entities will likely take up a larger portion of overall infrastructure spending. Relative to debt-burdened governments and LGFVs, the higher-tiered (i.e. central and provincial level) infrastructure companies from economically advanced regions seem to have healthier leverage and stronger business fundamentals.

The companies also have established financing capability, cash flow adequacy, and sustainable capital structures. They also have a track record of manageable debt growth (see charts 6a-6b and 7a-7b). In our view, good business resilience will help provincial transportation SOEs to absorb the cash flow hit by COVID lockdowns in 2022.

Chart 6a

Chart 6b

Chart 7a

Chart 7b

Some of the major infrastructure SOEs will be busier than others. Their momentum differentiation will be in line with priorities outlined in the country's current five-year plan (2021-2025). The planning blueprint lays out clear goals for modern energy, water network, and transportation networks, among others.

Putting the brakes on highways and rail

Local governments and SOEs will be tapering their appetite for transportation projects. This is due to past aggressive investments in highways and rail. Some inland provincial highway groups have been struggling due to excessive expansions, and faced refinancing stress that was solved with the help of state-backed support: i.e., deals were to extend maturities and at lower cost.

Even specialists involved with high-profile, key projects have experienced debt-fueled growth. For example, China State Railway Group Co. Ltd. has accumulated over RMB6 trillion of debt. The country's primary railroad constructor is loss-making and centrally-owned.

Moreover, investment rebounds over the past couple of years may have somewhat exhausted growth in 2023-2025.

• Highway investment set to moderate because mileage expansion could subside to a low single digit over the next few years, per the five-year plan (see chart 8). Our estimates already incorporate a continued increase in construction costs.
• Railway investment growth could recover slightly from the low base after a continuous drop over the past few years, mainly because of a higher portion of new mileage will be high-speed rail, which costs double or more than those of conventional lines (see chart 9).

Chart 8

Chart 9

Power will power ahead

As a comparison, investment in power and utilities are becoming the top growth engine for infrastructure activity (see chart 10). This is on back by China's "dual carbon" policy goals to reach peak carbon output by 2030 and carbon neutrality by 2060. The power industry is crucial for decarbonization because it represents over 40% of China's total emissions.

Besides the very high strategic significance of a modern energy system buildup, investments in this arena are, in our view, also backed by sustainable long-term demand and returns. Modern energy investment is more sustainable than most other types on infrastructure spending, as underpinned by policymakers' clearly outlines energy transition goals by 2030.

The expansion of renewables capacity, and the facilitating power grid and storage investments obtain central and local governments continued support, financially and operationally.

Chart 10

Chart 11

Financing models are changing

As governments rein in their infrastructure spending and LGFV-debt raising, market-based funding is becoming more important. Beside SPB new issuance proceeds, bank loans and bonds will become a key factor in sustaining the intensity of infrastructure investment, before other tools (such as REITs) are capable of providing significant scale of funding.

The state-controlled financial system will be tasked with prioritizing market principles--good risk management and due diligence--while also working in concert with policy directives. Financiers are mostly state-owned policy banks and commercial banks. Overall mid- to long-term infrastructure loans have steadily swelled over the past years (see chart 12). As an example, China Development Bank has been cutting down its shantytown renovation loan while adding on more infrastructure exposure (see chart 13).

Chart 12

Chart 13

Bank financing may play a bigger role, as the surge in SPB new issuance in 2022 was a one-off (totaling around RMB4 trillion, including an additional quota of RMB500 billion approved in the second half). This, together with policy-based RMB740 billion of capital injection by policy banks as a phased booster, bolstered the infrastructure investment growth in 2022 to a five-year high. It is still uncertain if an additional quota will come in this year. That's despite the underlying effect of such policy-based financing will be largely in place over the next couple of years as most infrastructure projects take multiple years to complete.

More Tolerance For Infrastructure-Fueled Growth In Less-Developed Regions

Infrastructure spending will remain an important driver of GDP and catch-up development for some regions. The central government and the financial system will likely allocate resources to ensure a largely balanced development nationwide. Spending in western provinces are less profitable in general but play strategic roles to narrow regional differences, which is a key policy goal of the central and local governments. Such balancing is reflected in the share of government fiscal infrastructure expenditure and SPB new quota allocation (see chart 14).

Chart 14

In particular, some western provinces rich in renewable resources will likely sustain a boost in energy infrastructure investment. This will be mostly financed by funding transferred from the central government and bank loans, and implemented by central SOEs.

For instance, central power SOEs (plus several from major economic provinces in eastern China) are increasing capital spending for mega renewable-bases over the coming years. This fits with China's energy security needs alongside its energy-transition goals. The aim is that western provinces will transmit large volumes of power to urban and industrial centers in the eastern seaboard where the energy demand sits (see chart 16).

Chart 15

In general, we expect infrastructure investment to continue to grow faster from a lower base in some less-developed regions (see chart 16). These regions will also see further rapid investment in infrastructure as long as projects are aligned with the country's strategic priority.

Chart 16

Nonetheless, even in poorer provinces, credit constraints will cap investment excess. LGFVs and other platforms might find it hard to access new funding given generally more sluggish investment returns and much higher leverage used. For instance, Guizhou and Gansu suffered from subdued infrastructure investment (excluding power and related ) over the past couple of years (see chart 17), due to credit deterioration of some of their local platforms.

Chart 17

Legacy Issues Will Weigh On LGFVs, And Their Governments

We believe some debt-ridden lower-tiered LGFVs (i.e. city and county/district level) will have edged further toward distress scenarios.

Credit quality will continue to diverge for LGFVs. This is because the sector is weighed down by legacy baggage and many won't easily transition to more profit-driven businesses. Another key factor is that hard-hit local government will become more selective on which platforms they can support.

The weakening in land sales--a core source of local government revenue--could add to default risks. This is given many LGFVs' large upfront spending on land and related development was supposed to be mainly repaid from land sales counting on an eternal boom. That old model is in disarray.

For example, LGFVs from the cities of Lanzhou and Zunyi struggled to meet obligations, then were cut off in refinancing bids because of squeezed government financial resources. Depressed land sales since late 2021 has not seen significant signs of improvement yet. In the first four months, land sales plunged 22% year on year, following the 23% in full-year 2022.

Many local governments continue to rely on LGFVs to carry out public projects on their behalf. The debts associated with these activities are not officially recognized but private estimates have put the size at RMB30 trillion-RMB50 trillion (or 25%-41% of China's GDP in 2022). On the bright side, the problem is shrinking; a Ministry of Finance official said that one third of such debts had been resolved in a public speech.

Overinvestment Remains Hidden Peril

Investment efficacy is set to improve. Yet as we learned amid the recent shocks of COVID, infrastructure stimulus is the go-to fix in economic downturns. Even with tightened regulations, overinvestment may still come up in key sectors such as transportation, energy and water resources. In some cases, policy significance overriding economic efficiency may also distort decisions.

In 2022, China introduced a concept of "moderately advanced," which recognized that infrastructure remains a pillar of economic development, and a source of stimulus at times of downturn. However, policymakers want to see more investment in "new infrastructure," including projects with advanced economic returns.

In our view, it will be harder for infrastructure platforms in less-developed and debt-ridden regions to meet these objectives. Continued credit differentiation is squeezing the financing flexibilities and pushing up funding costs for such local platforms. Changes takes time.

Digital design: Evy Cheung

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