Some of China's local government financing vehicles (LGFVs) will step up their investments in urban village renovation, affordable-housing and related infrastructure. S&P Global Ratings thinks this will increase financial risks for entities involved over the next two years—though also, potentially, somewhat facilitate their eventual transition to more commercial-focused operations.

The investments are being driven by China's top-down "Three Major Projects" initiative. The policy is aimed at stimulating investments and tackling housing problems in large cities. Some existing related projects and plans will likely be folded into the drive. We estimate that LGFVs involved could fund up to half of the undertaking, which could run to the order of Chinese renminbi (RMB) 3 trillion-RMB4 trillion over the next two years.

While the annual investments are small relative to outstanding LGFV debt, financial risks could rise for participating entities if the projects are not structured well or the property downturn deepens. Still, policy-driven land and housing-related projects could be more cash-generating than traditional development-related projects by LGFVs. This would, to some extent, fit with the reform path aimed at gradually making the sector more self-sufficient and less leveraged.

The Three Major Projects Initiative Will Focus On The Bigger Cities

The policy will focus on China's larger cities where, in our view, underlying supply-demand fundamentals are stronger.

The Three Major Projects initiative is also more targeted than past infrastructure-related stimulus plans. This is given urban-village renewal and affordable housing could help address structural issues and be a more efficient utilization of resources than other options.

Nonetheless, the policy will require credit-driven spending for the LGFVs involved, which could hold back their efforts to reduce their debt burdens.

The Relevant LGFVs Will Contribute By Raising More Debt

We believe about half of the debt burden for the Three Major Projects initiative will likely fall to LGFVs engaged in land and property development. This implies RMB750 billion of new debt on their balance sheets for each of the next two years.

Our assumptions include: (1) investment size based on slightly more conservative figures than consensus market estimates; (2) a required minimum capital ratio of 20% for the projects in scope; and (3) our assumption that about 20% of investments will be undertaken by local/central state-owned enterprises (SOEs) and not the LGFVs themselves.

These amounts are in and of themselves manageable, relative to the sector's total debt stock of about RMB60 trillion, by our estimates. Most of the participating LGFVs will also likely get good financing terms, including longer-tenor debt. Given probable reductions in other types of spending and investment, we estimate the Three Major Projects only increase LGFVs' overall debt by about 1% each year in 2024-2025.

Nonetheless, these endeavors may expose the involved LGFVs to higher market risks and slow asset turnover.  This will depend on whether housing demand is sufficient in certain regions. And it won't be easy for some of the LGFVs involved to handle additional debt, particularly amid sector-wide liquidity deterioration (see "China Policy Patches Alone Won't Fix LGFVs' Fraying Liquidity,"published on RatingsDirect on Sept. 7, 2023).

Past local-government property-related investments have exhibited sluggish profitability and low asset efficiency. Our analysis of land and development-focused LGFVs in the megacities show that:

• Debt is dozens of times the gross profit in most megacities, and even higher than 100x for a few (see chart 1). This is due to very thin margins for most policy-driven property projects.
• Inventories can be a very high proportion of current assets. It can easily take five or more years to fully digest inventory (some may even need over 10 years), as indicated by extremely low inventory turnover rates (see chart 2).
• Liquidity strain is mainly due to mismatches between asset life and financing for aggressive land and property development by LGFVs (also seen in chart 2). LGFVs from one-third of the 21 megacities have cash to short-term debt ratios less than 40%.

Will it be different this time around? The assets under Three Major Projects are cash-generating on the surface, either through land and property sale or rental.

But the returns are highly unlikely to reduce LGFV debt on an overall basis over the next few years at least. This is because of caps placed on rental/selling prices, huge upfront outlays, potential slow asset turnover and weak profitability. Moreover, the payback period on rental properties is long, even in many megacities.

Market Forces To Be Reckoned With

Local governments are setting targets to contribute to the Three Major Projects efforts. Market risks could heighten for LGFVs if investment directives and market demand deviate. For example, if some of the projects are launched in regions with insufficient demand or poorly structured. Key risks include:

Payback periods could be long for urban village renovation (the largest portion of new spending).   A lot of complexity and costs are involved in clearing land, resettling residents, then selling or leasing it for new purposes, such as various new homes, commercial services, industrial parks, carparks and other facilities. The scale of such projects are often quite large, requiring eight to ten years, if not longer, to fully complete the reconstruction.

Inventory risks, even for affordable housing.  This will require some very skillful management, given supply overhangs are already high for small-sized apartment inventory in big cities (see chart 3). This implies that acquisition and renovation (i.e. a digestion of existing inventory) could be more effective than new construction. Several non-top-tier megacities, including Chongqing and Jinan, have used entities to acquire thousands of unsold homes from their respective markets for such repurposing since last year.

Chart 3

That said, entities may also want to use this opportunity to develop the vast land holdings they acquired to boost local land sales in recent years. We believe commercial risks have kept accumulating (see "China's LGFV Land Grab: Things That Can't Last Won't," Nov. 14, 2022). Delays in planned construction starts have been widespread and LGFVs cooled their land purchases last year.

Finally, local policymakers will need to balance creating affordable housing for lower-income families and new migrants with maintaining stability for the much larger commercialized home market. This is because the latter is crucial to market sentiment, land sales and the broader economic momentum.

Nationally, housing oversupply is likely to remain an issue, though problems faced by small cities are more severe. Total floor area of unsold home has been creeping up to a six-year high. It now stands at a total of 331 million square meters as at end 2023 (see chart 4). This is equivalent to around 5 million of small-sized homes.

Chart 4

Policy restrictions and population trend don't bode well either

Buyers or tenants of affordable housing need to be eligible, such as having low income, without home ownership, and some other specified conditions. To rein in the misuse of public resources, policy directives have banned affordable housing from being traded in the open secondary market or being left vacant. Such restrictions may further dampen demand.

China's population has been declining over the past two years. The urbanization ratio is inevitably increasing at a slower rate from years prior. Indeed some megacities have even had population decreases (see chart 5).

Nonetheless, we think urbanization remains a driver, if less so than in the past. China's urbanization rate is still much lower than most developed economies; the World Bank forecasts China's this ratio will expand another 9 percentage points by 2035, from 66.16% in 2023.

Chart 5

Local Government Will Likely Reallocate Not Increase Spending

Overall, spending by the local and regional government (LRG) sector is unlikely to materially increase because of these initiatives. This is against the backdrop of headwinds for LRG revenue and largely unchanged new quota for special-purpose bonds (SPB)--the primary funding channels for the LRGs. We expect housing-related projects in the megacities will come at the expense of other projects deemed less-effective; e.g., highways, railways, and airports in selected regions.

Furthermore, governments will likely repackage planned social housing and redevelopment spending under the new. Spending to areas covered under the Three Major Projects is already sizable. We estimate social housing projects and urban renewal alone comprised about 10%-15% of the approved new SPB quota in the past three years.

Additional debt burdens on governments stemming from their LGFVs and other key state-owned enterprises are also relatively neutral. Moreover, we expect the initiatives could help the commercial transition of some LGFVs and could put some vehicles on a more self-sustainable path, thereby lessening the need for SOEs to rely on government support for survival.

Borrowing Patterns Leading To Varying Credit Impact For Governments

The quota for new SPB borrowings will stay at RMB3.9 trillion in 2024, largely unchanged from last year. However, a greater proportion of this funding program could end up going toward megacities and projects under the new initiative.

Permitted usage of these bonds has expanded to two new areas in housing in 2024, i.e. urban village reconstruction and affordable housing for sale.

SPB funding is also likely to be redirected from regions where debt burdens are higher and expected demand for projects lower. We anticipate a divergence in fiscal priorities among Chinese city governments, reflecting their distinct development objectives and idiosyncratic fiscal circumstances.

How Are Banks Participating In The Property-Related Projects?

In our view, policy banks are likely to continue to take a lead role in funding many of these policy driven property related projects, while large commercial banks are likely to participate in a selective manner.

S&P believes:

• The impact to policy banks and to participating commercial banks will be uneven, driven by the intensity of their participation, and their existing expense and funding structure.
• The involvement of commercial banks is rather manageable, in our view, and the impact is unlikely to be significant.
• For policy banks, a low cost-income ratio (e.g. at 8% for China Development Bank in 2022) provides flexibility to make such loans.
• Given policy banks' mandate, a low interest margin is expected. These loans are not likely to drive their existing low net interest margin much lower.
• Net population flow of a city/region and household income growth would be important factors in supporting project cash-flow and hence underlying credit risks to banks.

As at mid-March 2024, over 30 cities have together obtained over RMB1 trillion of banking facilities for urban village renovation, and over RMB100 billion loans have been extended. In 2023, policy banks and some large commercial banks participated in a RMB100 billion loan program to finance the purchase of affordable rental houses in eight pilot cities (Tianjin, Chengdu, Qingdao, Chongqing, Fuzhou, Changchun, Zhengzhou, and Jinan).

Interest-rates for these loans were low and loan tenor were long. For the RMB100 billion loan program, lending rate was under 3%, while the loan tenor was up to 30 years. The take-up of the RMB100 billion affordable rental house loan program has been low so far because of low demand in the current weak property market.

Two Steps Forward, One Step Back?

Overall, we view the Three Major Projects as a step forward for the LGFVs. More weight is being given to market principles than past policy-related undertakings.

In our view, some of the coming transactions could provide a transition opportunity for the LGFVs. This is because they are looking to be more self-sustaining over the long term, in part by taking on projects that generate at least some returns.

Nonetheless, the situation is far from perfect. Some policy restrictions could curb the LGFVs' ability to incorporate market-based principles into project structures. Another issue is whether this top-down directive crowds out other transition opportunities. Like with many reforms in China, the path taken may involve two steps forward, and one back.

Editor: Cathy Holcombe

Digital design: Evy Cheung

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• SLIDES: China City Governments Risk Falling Into A Debt Trap, Feb. 20, 2024
• China Policy Shift May Saddle LGFVs With A Fresh Problem: Stranded Assets, Jan. 25, 2024
• China's RMB350 Billion Policy Push May Help Developer Destocking, Jan. 24, 2024
• China Property Watch: A Slow, Sequential Recovery In 2024, Oct. 16, 2023
• China Policy Patches Alone Won't Fix LGFVs' Fraying Liquidity, Sept. 7, 2023
• China's LGFV Land Grab: Things That Can't Last Won't, Nov. 14, 2022