China's determination to resolve its local debt overhang and stagnating growth will likely spread the burden around, including to banks. This is according to panelists at S&P Global Ratings' recent "China Credit Spotlight" conference.

Debt of local government finance vehicles (LGFVs) are growing at a slower pace, but a comprehensive solution remains elusive. That leaves lenders to face more LGFV-related losses in the years to come, panelists warned.

The event, held on Sept. 24, 2024, also saw panelists debate the appropriate level of stimulus that could avert a Japan-style "lost decade." Some argued bigger actions may be needed to revive demand, while others emphasized policy makers' prioritization of long-term stability over short-term fixes. On the day our event was held, China announced the biggest set of stimulus measures since the pandemic.

Market watchers are anticipating more measures to come from the National People's Congress later this month. Discussions at our conference shed light on what options policymakers still have and what financial risks they face if these plans don't work. Issues discussed include:

• How is the LGFV debt problem different now? What is the ultimate solution?
• How are the local governments dealing with LGFV debt?
• Will banks and asset management companies (AMCs) end up taking the loss on these debts?
• Can China turn things around or will it see a "lost decade" like Japan?
• When will issuance from China recover? Is this a structural problem?

How is the LGFV debt problem different now? What is the ultimate solution?

Laura Li (S&PGR):  There are two key differences between the debt resolution this round and the round that was completed in 2018. First, the problem is much bigger now, as overall LGFV debt has nearly doubled since then, leading to much higher refinancing pressures. Second, the government is more determined this time and has pushed a "package of measures" with more coordination among key stakeholders.

Ultimately, the solution is for LGFVs to become viable businesses. We have seen temporary fixes, but a comprehensive and effective solution is still lacking. LGFV debt growth has slowed to high single-digit rates from the previous double digits, but further progress on tackling their debt problem will depend on the continuation of current measures, on further tightening over financing discipline, and on focusing on investment returns rather than just spending to build as before (see "Is It Working? China's LGFV Debt De-Risk Program One Year On," published on RatingsDirect on July 25, 2024).

So far, progress on this varies significantly across regions. Over the past year, LGFVs of larger cities such as Tianjin and Chongqing have proved to have better access to financing. Those of lower-tier cities like Zunyi and Liuzhou see no material improvement in cash flow adequacy and still show very weak cash coverage to short term debt. These cities are all from regions that officials have identified as "highly indebted". (see "Your Three Minutes In China's LGFV Debt Resolution: Buying Time Is Buying Bad Habits," Sept. 5, 2024).

Many localities are urging their LGFVs to consolidate into larger entities, but this does not necessarily lead to better operations or cash flows. LGFVs in lower-tier cities face more challenges, given they have less access to resources and financing, and most of their assets are property and land related, which are now in distress. For them, business transition will take a long time (see "China Brief: LGFVs Face Credit Differentiation As Transition Deadline Looms," Oct. 17, 2024).

Question 1

How are the local governments dealing with LGFV debt?

Wenyin Huang (S&PGR):  Local governments have been helping LGFVs refinance by bringing them together with their lenders rather than directly undertaking their debt. They also issued bonds to swap for the LGFVs' hidden debts. In 2023, some Chinese renminbi (RMB) 1.4 trillion of such bonds were issued.

Authorities aim to complete the clean-up of hidden LGFV debts by around 2028. At the end of 2022, the Ministry of Finance noted that a third of such debt has already been cleaned up. Although the total remains unclear, some areas have disclosed their progress. Beijing, Shanghai, and Guangdong said they are done, while other areas said they are on track.

Local governments, even the 12 provinces identified as highly indebted, are still able to fund existing or nationally strategic projects, which helps moderate the growth impact. That said, they have limited capacity for more fiscal support to the LGFVs, given revenue headwinds from sluggish growth and weak land markets, and given the fact that most are nearing local debt ceilings set by the central government.

On approach, officials have been more vigilant on large, soon-maturing public debts of more important LGFVs, but less so on others. In lower-tier governments with weaker capacity, we could see more tolerance for lower-impact events such as defaults on nonstandard debt. Officials are realizing they cannot kick the can down the road forever, but clear deadlines from the central government can drive more proactive measures such as consolidation.

Will the banks and the AMCs end up taking the loss on LGFV debt?

Ryan Tsang (S&PGR):  Policy banks are likely to lead LGFV restructurings, especially in highly indebted regions, given commercial banks remain cautious, and tend to focus on "safer" entities. LGFVs with heavy debts tend to be refinanced at below-market rates, which pressures the banks' net interest margins.

If the deals don't work, banks will either restructure again or take a loss. Lenders are already taking big losses on some non-standard debts. In Liuzhou Dongcheng's case, lenders took a 15% haircut. If the restructured deal doesn't work, Bank of Guilin, which refinanced the remainder, may eventually take a loss or restructure again.

On the ground, the picture is quite mixed, as shown by our studies of Zhejiang, Chongqing, Shaanxi, Gansu, and other provinces. Generally, larger banks in wealthier regions have more capacity to take losses and support LGFVs, while smaller banks in less wealthy regions have less capacity. In Gansu, for example, the two local banks with the most provincial exposure are under pressure and are constrained in extending more credit.

Given this, we expect consolidation in the rural banking sector to continue. The number of rural commercial financial institutions in China has already fallen to less than 3,800 now from over 38,000 in 2001. So far in 2024, over 200 small banks were absorbed or merged. Further reforms in the sector will take about a decade.

As for AMCs, the national big four continue to help clean up local bank balance sheets to restore some lending capacity, but they are also under pressure. Two of them are rebuilding their own balance sheets while the other two face other issues. Their capacity to help has been constrained. Local AMCs also provide some support, but on a much smaller scale.

Question 2

Can China turn things around or will it see a "lost decade" like Japan?

Joanna Chua (Citi):  China may already be on that path. Insufficient, incremental policy support over the past year has raised the risk of prolonged stagnation. Under-delivery of fiscal and monetary stimulus depressed demand and exacerbated deflationary expectations, which further depressed demand.

Multiple objectives, including national security, financial stability, and GDP growth, have diluted policy effectiveness. Meanwhile, real estate weakness and significant state intervention have dragged on private sector confidence and investment.

The central government does have a strong balance sheet. It can use fiscal transfers and more aggressive support to boost demand. Such measures, however, may need to be targeted to avoid imbalances such as those from the infrastructure boom post the global financial crisis.

A key challenge now is that households have been hoarding savings and deleveraging, leading to a chronic shortage of aggregate demand. To reverse this and to generate positive multiplier effects, it may not be enough to just give them some downpayment to change cars or appliances. More meaningful physical transfers to consumers may be needed. This could take the form of "use it or lose it" mechanisms that ensures spending, for example, through digital platforms.

KimEng Tan (S&PGR):  China's condition is not as dire as it seems. Growth is slower, but that's not unexpected. Policymakers are trying to inject just enough support to prevent destabilizing developments. They are prioritizing long-term stability over short-term fixes. The market has been criticizing China's debt-fueled growth for years, but when they actually do something about it, observers tend to worry too much.

China has learned from Japan's experience. Its approach looks incremental, but this reflects the government's intention to reduce reliance on moral hazard and excessive lending and investment. This can prevent a prolonged slowdown like the one Japan went through.

China's conditions now are also very different. Its financial system is relatively healthy--healthier than that of Japan before the "lost decade." China has more room for maneuvering and more potential for growth, and it still has policy tools at its disposal.

Beijing does not see fiscal transfers or boosting household leverage as the best solutions. It prefers a long-term approach focused on stability and reforms. A lack of consensus on how to deal with the current situation has led to policies that may have looked incoherent at times. That said, the government will take more actions if it deems it necessary to stabilize the situation.

When will issuance from China recover? Is this a structural problem?

Charles Chang (S&PGR):  No, the drop in global bond issuance from China or Asia in the last few years is not structural in nature. It is largely due to the rapid rate hike cycle in the U.S. and the property bond defaults in China. Issuance from China fell by half in 2022 and by another half last year.

On recovery, this year is the turning point. Year to date, issuance from Asia is 30% higher, and from China, 60% higher compared with last year. This is due to the start of the U.S. rate-cut cycle and the drop in defaults in China since last year. Credit quality is now less an obstacle, given three-quarters of Asian issuers, and over 80% of Chinese issuers are now rated investment grade.

Related Research

• China Brief: LGFVs Face Credit Differentiation As Transition Deadline Looms, Oct. 17, 2024
• Chinese Local Governments Brief: The Search For Alternative Revenues Won't Be Easy, Oct. 9, 2024
• Your Three Minutes In China's LGFV Debt Resolution: Buying Time Is Buying Bad Habits, Sept. 5, 2024
• China's Local Governments: Capacity To Support SOEs Will Be Tighter For Longer, July 8, 2024
• China Tier-One Local Government Risk Indicators Chartbook, July 22, 2024
• Is It Working? China's LGFV Debt De-Risk Program One Year On, July 25, 2024
• China's bond market reforms key to growing with less debt, June 14, 2024
• China Local Governments: The Slow Road To Stabilization, June 13, 2024
• China Local-Government Stimulus Is Buying Time, April 18, 2024
• Record Bond Rejections To Squeeze China's Lower-Tier LGFVs, April 11, 2024
• China LGFVs' Bigger Housing Role: Risk Control Matters, March 27, 2024
• China's Distressed AMCs: Government Support Will Be There, Feb. 2, 2024