China's local government financing vehicles (LGFVs) have been racking up debts for years. It's now a burden that's too big to ignore. Economic softening, sinking land sales, and rising refinancing risk and interest burden are raising the potential for disorderly defaults and systemic risk.

S&P Global Ratings believes that Beijing's so-called "basket of measures" establishes a plan for tackling this issue. However, Chinese renminbi (RMB) 1.36 trillion raised through the program to reduce immediate liquidity risk just puts a small dent into the problem.

In the period Oct. 6 to Nov. 17 this year, 27 regions raised about RMB1.36 trillion through the issuance of special refinancing bonds (SRBs), according to news provider Wind. Upcoming issuance may bring this total to RMB1.5 trillion, as reported by media. The 27 regions span provinces, province-level municipalities, and autonomous regions out of a total 31.

The funds are likely for replacing hidden debt, off-budget borrowing, among local government funding vehicles (LGFVs) and settling overdue construction payables. Chinese media have also reported that the central bank will support state-owned lenders in cutting rates and terming out loan tenors for LGFVs, among other steps to ease debt strains on the vehicles. The central bank governor also said it could provide emergency liquidity loans to banks extending financing to LGFVs, if needed.

Investor appetite for LGFVs' new bond issuance has markedly improved since Beijing introduced its program. However, these initial measures alone will not solve the entities' debt problem. While LGFVs from "high risk" regions have been able to issue new bonds recently, they typically have only do so at short tenors. This implies a lack of longer-term confidence in the market.

Below we address investors' queries regarding the new measures.

Frequently Asked Questions

Can RMB1.5 trillion in special refinancing bonds address the liquidity needs of LGFVs?

The immediate needs, partially yes; the longer-term risks, no. The mooted RMB1.5 trillion SRB plan is meaningful when compared with the roughly RMB1 trillion–RMB2 trillion in short-term maturities that the most strained LGFVs are facing (see "China Policy Patches Alone Won't Fix LGFVs' Fraying Liquidity," Sept. 7, 2023). However, the sum is less than half the RMB4.4 trillion in LGFV onshore bonds maturing between October 2023 and December 2024, and it pales in comparison with the RMB49 trillion debt owned by public-bond issuing LGFVs as of end-2022, as per our estimates through Wind data.

There is little transparency about the allocation of a proposed debt-to-bond swap--e.g. what type of obligation the proceeds will retire, or the amounts. It is hard for us to therefore gauge the effectiveness of the program. While the use of proceeds is loosely termed "for replacing existing debt," the market believes authorities will use it to replace LGFVs' hidden debt. And the outstanding hidden debt of these entities is likely much larger than RMB1.5 trillion.

We expect all LGFVs that are owed sizable sums by governments to compete for limited swap quota. In our view, SRB issuance will be mostly used to stem liquidity stress that, if not dealt with, could lead to market or social instability, or to replace high-cost debt. To add to the complexity, some investors might not accept prepayment on the high-yield bonds they hold.

There is a wide distribution of investor appetite across the provinces, as shown in the coupon spread between LGFV bonds and bonds issued by local governments.

SRB issuance is clearly skewed to certain "high-risk" regions (i.e. economically less developed or highly leveraged localities). Thirteen provinces that have seen net bond funding outflows of LGFVs, or coupon spreads of over 200 basis points (bps) over comparable local government bonds (LGBs) during the period, accounted for 72% of SRB issuance so far.

There's also a wide divergence in SRBs issued this round across provinces.

Guizhou's SRB issuance in this round, for example, is many times the volume of its immediately maturing LGFV bonds. This suggests the amount raised in Guizhou could cover more than just maturing bonds and may also address loans and nonstandard debt owed by their LGFVs.

By contrast, Tianjin's and Chongqing's SRB issuance amount is about 40% of their immediately maturing LGFV bonds.

Tianjin and Chongqing have large amounts of LGFV bonds outstanding. Bond investors there are still on the hook.

Chart 1

Investors' reluctance to take on longer-term LGFV exposure from high-risk areas creates constant refinancing risk. The recent measures haven't fully allayed investor concerns, as apparent in yield moves for LGFV bonds.

For example, the yield on one-year notes issued by Tianjin Infrastructure Investment Group Co. Ltd., has tightened by around 550bps since early August. The yield on the entity's three-year bond has tightened around 350bps in the same period. The issuer is the largest LGFV in Tianjin by assets and bonds outstanding.

We do note, however, that Tianjin Infrastructure was able to print a 2.5-year tenor bond on Nov. 14. It was the firm's first bond to exceed a tenor of two years since 2021--so clearly the basket of measures is having some positive effect.

The LGFVs that are still able to roll over cheap debt are typically located in affluent provinces. They are under less imminent liquidity pressure, with some exceptions. For example, the combined SRB issuance in affluent Zhejiang, Jiangsu, Fujian, Shandong is about 6% of total issuance. Regions that have declared themselves as free of hidden debt, namely Guangdong, Shanghai, and Beijing, haven't issued any SRBs in this round.

Table 1

Moral hazard is likely to be a side effect of all these measures. Moreover, if LGFVs and their government backers don't address the legacy debt, disorderly systemic risk may ensue, causing market turmoil.

For LGFVs that can still borrow cheaply, they retain a strong incentive to seek funding for growth to eke out a market-oriented profit, which is typically not public-service related. They may not have borrowed cheaply if lenders don't view them as LGFVs.

To what extent will the swap program alleviate the LGFV debt problem?

The debt-to-bond swap and potential loan-interest reduction deals are likely aimed at cutting systemwide interest servicing burden, as well as addressing the immediate liquidity needs of stressed LGFVs.

Nevertheless, the measures directly address a core LGFV problem: the compounding effect of unpaid interest costs. About 10.4% of the increase in LGFVs' net debt last year stemmed from the rolling over of interest deficits of RMB600 billion that cannot be covered by internal cash flow, by our calculation.

LGFVs have less access to "flexible-use" sources of capital to fund their interest costs. Those sources typically include nonstandard debt and offshore bonds.

Nonstandard debt is more costly than conventional borrowing and leads to limited room for growth--barring leasing.

Regulators have also tightened onshore bond issuance for LGFVs from highly leveraged localities, or those carrying hidden debt. Such entities cannot typically increase their onshore bond exposure on a net basis.

Regulators have furthermore tightened approvals for offshore bond issuance. Net issuance in offshore bonds by LGFVs was negative US$6.6 billion in the first nine months of 2023. Issuance volumes have shriveled this year for bonds issued in free trade zones, and predominantly denominated in offshore renminbi.

The upshot is that LGFVs have fewer channels to fund their ballooning interest payments. Given interest deficits, in a hypothetical scenario in which LGFVs halted all investments, their debt would still grow 1.0%-1.5% annually. The weakest vehicles would see a much larger portion of their debt growing just to service interest expenses.

Reducing interest rates alone--without a write-down of principal--is unlikely to stop this compounding effect of costs for the LGFV sector.

However, principal write-down doesn't seem to be on the cards. Past notable restructuring cases in China indicate that lenders prefer cutting interest rates or extending tenors, to accepting haircuts on principal. Restructuring of debt for Zunyi Road & Bridge Construction (Group) Co. Ltd. saw its loans termed out by 20 years. In another restructuring, half of Yongcheng Coal and Electricity Holdings Group Co. Ltd.'s bonds were extended, with the other half settled in cash.

Chart 2

What are some likely outcomes of potential LGFV defaults?

No LGFV has so far failed to repay a public bond. However, there have been numerous delinquencies on trust loans and commercial bills. Other have sought to restructure bank loans. Lanzhou City Development Investment Co. Ltd. even delayed staff wages while still managing to repay its bonds, according to domestic media reports.

For Gansu province, the net LGFV bond outflows lasted almost two years, since August 2021, when a Lanzhou-based LGFV struggled to repay a bond. The bond outflows have since turned to modest inflows in the recent quarter.

Investors perceive LGFVs in a given region to be linked. The entities often have intercompany loans and cross guarantees. Investors as such tend to group such vehicles by their region, while de-emphasizing fundamentals when investing.

The practice can create more systemic risks (see "Overaggressive Borrowing Is Backfiring For More Of China's LGFVs," Oct. 30, 2023). Otherwise viable entities in a given region may see market support evaporate if one or more fellow LGFVs default on bonds.

The approach results in an anomaly. County/district-and-lower-tier LGFVs in coastal provinces can attract a lower bond risk premium than provincial LGFVs based in some high-risk provinces. This is despite the former group often having weaker stand-alone fundamentals. (see "Skewed Funding Amplifies Default Risks For China LGFVs," July 7, 2023).

Investors have made their misgivings apparent about some LGFV bonds from high-risk areas by pulling their capital. Should an issuer default in a region that investors aren't flagging, perhaps due to administrative slippage in rescuing a failing entity, the shock could trigger capital flight. Such an event might dilute the effectiveness of this round's measures.

Will the China property slump spill over to the Chinese LGFV sector?

Yes. The LGFV sector is already feeling the pinch from China's property downturn. Ironically, it had hardly benefited from the prior property boom, because local governments typically leveraged the vehicles significantly for investments, while timing of reimbursing land and urban infrastructure development work done is uncertain.

LGFVs based in economically weak cities in which land sales crashed have seen their funding tighten sharply. The urban infrastructure developer Lanzhou City Development Investment Co. Ltd. and the metro operator Kunming Rail Transit Group Co. Ltd. were illustrative of such trends.

The lackluster land market continues to be an issue. According to GF Securities, total land sales in China declined 27% year-on-year (yoy) to RMB2.46 trillion in the first nine months of 2023, on the back of a 34% decline the year before.

LGFVs nevertheless are still buying a significant share of land to prop up local markets. According to GF Securities, LGFVs bought 34% of all land put up for sale, or RMB847.3 billion during the first nine months of 2023. The same-period ratios were 36% in 2022, and 21% in 2021. The central government's crackdown on LGFV land buying last year did reduce the absolute amount of land LGFVs purchased by 31% yoy, however (see "China's LGFV Land Grab: Things That Can't Last Won't," Nov. 14, 2022).

The risks stemming from LGFVs' land purchases are significant. Most LGFVs don't have strong expertise in land and property development. Their land purchasing mainly props up land prices, and tops up local government coffers at the expense of more debt at LGFVs. Governments, meanwhile, may take their time to reimburse LGFVs for their land clearance costs.

We estimate LGFVs' inventory to have grown 13.9% yoy to RMB28.1 trillion as at June 30, 2023, making up 23% of total assets. The growth was 9.6% in 2021.

What would be the LGFVs' role in its infrastructure spending over the coming years?

LGFVs will play a shrinking role in funding new infrastructure investments but will remain operationally relevant. LGFVs act more as agents to manage infrastructure projects with funding raised by governments. The demand and supply pullback has already slowed LGFV debt growth, which climbed 11% in 2022, compared with compounded annual growth of 15% over the prior four years (see "Spending Sprees Will Subside As China Refines Infrastructure Investment," May 29, 2023.)

The trade-off for being large recipients of SRB bonds probably mean greater restriction on participation on new projects, in our view.

The above spending refers to traditional LGFV-involved sectors such as transport, urban infrastructure, and township development. Sectors such as power and telecoms will be supported largely by more economically viable central or provincial SOEs. The LGFVs that may increasingly find themselves on the sidelines will somehow need to find more revenue to climb out of their debt hole.

Editor: Jasper Moiseiwitsch

Related Research

• China's Fiscal Bid To Stanch Local SOE Debt Risk, Nov. 2, 2023
• Overaggressive Borrowing Is Backfiring For More Of China's LGFVs, Oct. 30, 2023
• LGFV Strains May Inflict A RMB2 Trillion Hit On China Regional Banks, Oct. 18, 2023
• China Policy Patches Alone Won't Fix LGFVs' Fraying Liquidity, Sept. 7, 2023
• Skewed Funding Amplifies Default Risks For China LGFVs, July 7, 2023
• Spending Sprees Will Subside As China Refines Infrastructure Investment, May 29, 2023
• Zunyi Road's Loan Deal Won't Fix Its Debt Problems, Jan. 10, 2023
• Contagion Risk Has Risen For China's Local Government Financing Vehicles, Sept. 5, 2022