Default risk is rising for the state-owned enterprises (SOEs) that undertake economic stimulus on behalf of China's local and regional governments. Delayed payments by such SOEs could disrupt local credit-driven activities, and hurt the country's economic recovery. For this reason, S&P Global Ratings anticipates resolution activities will accelerate and widen.

China's top leadership discussed containment and resolution of local government debt risk at its latest politburo meeting on July 24, 2023. In an announcement after the high-level meeting, authorities highlighted "a basket of plans" to solve such risks. It did not provide details but, in our view, the market interpreted this as a reference to SOE risk.

Many local SOEs are weak and dependent on local-government support to continue their operations. This is particularly so for local government funding vehicles (LGFVs), a large sub-set of nonfinancial SOEs, that focus on infrastructure development to sponsor local economic growth, and tend to have the weakest stand-alone credit profiles among state-owned companies.

In this article, we address investor questions about what these burdens could mean for local governments, their SOE entities, and banks in China.

Frequently Asked Questions

What is the size of debt accumulated by companies controlled by local and regional governments in China?

We estimate debt stock by local government controlled nonfinancial SOEs will be about Chinese renminbi (RMB) 100 trillion (US$13.9 trillion) by end-2023, or about 80% of China's GDP. This is up from 40% of GDP a decade ago. This figure includes debt from more commercially minded companies, but the majority--roughly two-thirds--is by LGFVs (see definitions in sidebar below).

The LGFVs tend to operate with very marginal operating cash flows and have very high leverage. Moreover, they and other local government-controlled entities have grown debt faster than the broad market in recent years, implying ongoing risk accumulation (see chart 1).

Chart 1

Why have credit events been rising for LGFVs or the wider local-government SOE sector?

The primary driver is local governments' weakening capacity and willingness to provide support.

Local government fiscal positions are stressed, following excessive spending of reserves against COVID containment and a property slowdown. Moreover, with ongoing softness in the recovery, some fiscal expansionary measures are likely. And given that, at the same time, these governments need to repair steep deficits and large debt levels, some might be forced to cut spending to support SOEs (see "China's Local Governments Are Shedding Their Ties To Struggling SOEs," published on RatingsDirect on March 1, 2023).

Such a reduction comes at a particularly hard time for the SOE sector, including LGFVs, given outsized credit growth.

So will SOE defaults jump?

We expect more credit events for nonpublic bonds such as bank loans, commercial bills, trust loans and other financing products. We view these types of events as rising default risks.

It's unlikely that we'll see a large spate of SOE defaults over the next couple of years. This is given China's priority to avoid systemic risk that could stem from a relatively small portion of its SOE debt, and its ability to bridge liquidity shortfalls with funding resources if necessary.

That said, default risk is still accumulating for public bonds, and highly subject to local government's capacity to provide support. SOEs in low-tier regional governments face higher risk, because local resources will deplete more quickly in a broader crisis, particularly in weak lower-tiered regions.

China's central government has reiterated its long-standing message that local governments are accountable for the creditworthiness of their SOEs. Does this imply the local governments are under obligation to meet the debt-repayment obligations of most SOEs?

China authorities expect the local governments, as the controlling shareholders of local SOEs, to rein in corporate-arm risks and be accountable for poor creditworthiness. This is not quite the same as committing these governments to automatic bail-outs.

Rather, we expect the LRGs will prioritize support for "key SOEs" while strengthening SOE debt risk oversight. That means debt is less vulnerable for the key SOEs.

In a nutshell, here's our view on the reactions to rising SOE default risk:

• Hidden debt largely under key SOEs will be firmly supported by their local-government owners, directly and orderly from budget resources.
• Local governments would likely try to use nonbudget resources to assist key SOEs in trouble. This could involve shifting resources among the SOEs they control, including asset transfer, capital injection, or a liquidity bridge from a healthy SOE to a less healthy ones (see "China's Local Governments Are Shedding Their Ties To Struggling SOEs," March 1, 2023).
• In the event of widespread credit stress, China's banking system is a potential backstop. This route is something that generally needs central-government coordination, in our view.
• Credit events could rise for some SOEs if their default or exit would not create spillover risks or large disruptions to local development. In other words, default risks are higher for small-scale companies.

In our view, the ability to support SOEs varies, given uneven economic profiles and fiscal power across China's wide scope of local governments (see chart 2 and "China Tier-One Local Government Risk Indicators Chartbook," July 23, 2023)

Chart 2

Will support to key SOEs and resolutions of 'hidden debt' be credit negative to LRGs' credit profiles?

We don't think prioritized support of key SOEs will worsen the credit profiles of most local governments. In our own assessments, we already include the debt of key SOEs in our tax-supported debt estimates. These supports could include subsidies or capital injections to continue their operations.

Our assessments also assume that budget measures will be used to gradually resolve hidden debt as defined by the central government, which has given local governments until 2028 to resolve the remaining off-budget liabilities. One way to do this is to swap out debt held by SOEs, and replace it with debt issued by the governments. That said, local governments need to get quotas from the central government for this, so there will be some constraints.

In our view, these burdens will fall over time, especially as hidden debt is resolved. We estimate accumulated debt size by key SOE at RMB20 trillion-RMB25 trillion by 2023 end, and the level will continue to come down as the number of key SOEs diminishes. This is in line with top-down policy direction to promote SOEs to undertake more conventional commercial activities.

Could SOE debt restructuring be an effective resolution, considering China's sizable banking system? And relatedly, is this straining the banks?

Debt restructuring with the help of banks cannot effectively unwind SOE risks. But it can help the sector buy time under the assumption that most SOEs will improve their stand-alone credit profiles over the long term.

One example is a restructuring of RMB15.6 billion worth of bank loans for Zunyi Road, an LGFV controlled by Zunyi city government in the relatively under-developed Guizhou province. This deal reduced the LGFV's immediate interest burden, which in turn lowers its default risk for other obligations, including bonds (see "Zunyi Road's Load Deal Won't Fix Its Debt Problems," Jan. 10, 2023).

The recent regulatory revisions on asset classification and capital charge suggests the central government anticipates more bank support for SOEs in weaker regions. For instance, restructured loans can be classified as special-mention loans instead of nonperforming, lowering provisioning burdens for banks. Meanwhile, classifying such loans as potentially problematic instead of "normal" also increases transparency.

Policymakers have also proposed a lower regulatory risk weight for ordinary public-sector entities--a new risk category--to alleviate capital pressure on banks if their exposures meet regulatory criteria. But to ensure risk is controllable, regulators may also introduce additional regulatory capital requirements for banks with concentrated exposure to local government financing vehicles.

In our view, more restructuring of SOEs or LGFVs in weak regions however could burden the smaller local banks (see "China Banks' Property NPLs To Peak At RMB660 Billion In 2024," April 19, 2023).

In a downside scenario for LGFV debt restructuring, would Chinese banks be hit hard?

First, our base case assumes any loan restructuring would be selective over time and on a case-by-case basis, because moral hazard considerations mean wholesale LGFV loan restructuring is unlikely.

In a downside scenario, we estimate that the commercial banks would face a RMB5 trillion hit to bank capital from restructuring LGFV debt. We arrive at this figure as follows:

• We assume about 60% of commercial bank loans to LGFVs, or RMB20 trillion (using Wind data), are from regions where the local governments' resources may be constrained, based on the local SOEs' high leverage and poor liquidity.
• All of these loans are restructured at the same time.
• The affected banks face a pre-tax loss rate of 34%. This is based on the change in present value of cash flows in Zunyi Road's restructuring case whereby the interest rate was halved to 3.75%.
• This hit amounts to RMB5 trillion and would in turn reduce the average capital adequacy ratios of the commercial banks by 2.6 percentage points to 12.6% (ranging from 16.1% for the megabanks to 8.8% for the rural banks). That is still within regulatory capital requirements.

In a more extreme downside scenario of banks having to restructure many loans, and with extreme discounts to the original yield, we believe central-government support would become vital. This would include recapitalizing the affected banks, mainly to maintain confidence in the banking system. For example, under approval from the central government, almost RMB400 billion of special-purpose bonds (SPBs) have been issued by local governments since 2020 to recapitalize banks in regions such as Gansu, Liaoning, Inner Mongolia, Henan, Heilongjiang, and Guangxi.

In our view, systemic stability is a priority for the Chinese government. So in a worst-case scenario, we do believe the large banking system could be leveraged to support weak SOEs. And in turn, the banks would also be supported, if needed.

Why is debt still accumulating for LGFVs, given China began addressing the risk of local-government debt burdens a decade ago? Will it ever slow down?

A rapid transition to more commercially driven business is hard, given the large roles these SOEs played in stimulating local development. The transition has also been further hampered by the pandemic and property sector turmoil, leading to additional stimulus through SOE borrowings. Moreover, legacy issues of debt accumulation still weigh heavily.

With China's economy recovering post-COVID, we expect the pace of new SOE/LGFV borrowings will moderate to be in line with broader credit growth. A moderation is also in line with policy targets to rebalance economic growth and risks.

Moreover, local governments now have more options to fund development. Provinces can support investment on public projects for their regions by issuing SPBs. This is more transparent and on-budget, and the SPBs often involve more due diligence, such as structures that identify project-generated cash flows for repaying the associated project debt.

Over time, we believe the lines will increasingly blur between LGFV sub-segment and conventional corporate segment. This is in line with China's policies to constrain off-budget activities by local governments (see "Institutional Framework Assessment: China Provincial Governments," Aug. 31, 2021).

Related Research

• China Tier-One Local Government Risk Indicators Chartbook and China Tier-One Local Government Risk Indicators Databook, July 23, 2023
• Skewed Funding Amplifies Default Risks For China LGFVs, July 6, 2023
• Stimulus Is A Highwire Act For China's City Governments Facing Property Go-Slow, June 20, 2023
• China Local Governments: Balancing Growth And Risk, June 5, 2023
• Spending Sprees Will Subside As China Refines Infrastructure Investment, May 29, 2023
• China Banks' Property NPLs To Peak At RMB660 Billion In 2024, April 19, 2023
• Credit FAQ: What The "Two Sessions" Say About Chinese Government Finances, March 19, 2023
• China's Local Governments Are Shedding Their Ties To Struggling SOEs, March 1, 2023
• The Clock Is Ticking For The Debt-Led Growth Of China Local Governments, Feb. 21, 2023
• China's Tightening Capital Rules To Hit Aggressive Banks, Feb. 21, 2023
• China Banks Have Fewer Places To Hide Problems Under New Rules, Feb. 13, 2023
• China LRG In Focus—Guizhou Province, Jan. 11, 2023
• Zunyi Road's Load Deal Won't Fix Its Debt Problems, Jan. 10, 2023
• Institutional Framework Assessment: China Provincial Governments, Aug. 31, 2021