As China watchers try to get their heads around the myriad policy shifts at this week’s National People’s Congress (NPC), at least one thing is clear: the bubble just burst for local governments around the nation.
In the decade-plus since the 2008-2009 global financial crisis, municipalities engaged in a historic borrowing binge. And in the three years since the onset of Covid-19, they engineered huge land sales to generate revenues lost to lower taxes.
Yet policy priorities at the NPC signal that the autonomy local government leaders had to pump up gross domestic product (GDP) will be significantly eroded under President Xi Jinping’s more centralized rule.
In Xi’s third term, the theme is sizing up to be about top-down efforts to tame public debt accumulation. As such, local governments will lose some of their debt-issuing authority, while local administration will be reorganized in ways that give Xi’s inner circle in Beijing greater control.
Beijing will exercise a bit more authority over People’s Bank of China branches outside the capital. Certain municipalities will be combined. And bureaucracies are being streamlined as new Premier Li Qiang prepares to unleash a burst of supply-side structural reforms.
The first step appears to be the central government boosting national borrowings by roughly one-fifth to help reduce the need for debt-laden local governments to issue more IOUs.
As such, transfer payments from Beijing to local officials will increase to 10 trillion yuan (US$1.44 trillion), a nearly 4% jump. As part of this important pivot, the national government this year will issue $458 billion in general sovereign bonds.
All this is a clear recognition that many of the provinces pivotal to China’s achieving this year’s 5% GDP growth target are grappling with crushing debt burdens as property values crater.
True, the “government’s conservative growth target of 5% for 2023 recognizes that the pickup in China’s growth continues to face headwinds,” says analyst Martin Petch at Moody’s Investors Service. “These include the impact of slower global growth on China’s exports and risks associated with the property sector and local government debt.”
But it’s also a sign that Xi is moving China into a phase where the quality of economic growth trumps quantity.
Local government finances are a long-term headwind that needs urgent attention. It hardly helps that, simultaneously, local leaders had to spend big on Covid treatment and testing, swelling social security costs and increasing debt servicing costs as global yields surged.
The policy shifts signaled at the NPC shed some light on China’s rather restrained GDP this year, even as the Covid reopening boom boosts demand. It also makes clear that Xi’s Communist Party is no longer playing around when it comes to regional government debt excesses.
In the days leading up to the NPC, it was clear that a majority of municipalities face sizable funding shortfalls. In at least 17 of 31 local governments, the amount of outstanding debt tops 120% of average income. These pressures are forcing municipalities to reduce spending and stimulus, leaving it to the PBOC to cap any upward pressure on borrowing costs.
To be sure, this Beijing-municipality tussle has been years in the making. Since the Lehman Brothers crash, China’s hinterlands saw an explosion of local government financial vehicles (LGFVs) to fund giant infrastructure projects.
The way that LGFVs are set up is meant to circumvent borrowing restrictions through what is essentially off-balance sheet borrowing. But LGFVs have grown to a scale where they might affect Beijing’s sovereign credit trajectory.
Beginning in 2015, Xi’s government tried employing debt-swap arrangements with local governments to pull more of this hidden debt onto the public books. Then came Covid.
Since then, notes analyst Samuel Kwok at Fitch Ratings, local governments’ “diminished capacity to provide timely and sufficient support could raise the need for extraordinary support from the central government, especially given the significance of local and regional governments and LGFV debt in China’s economy. We expect the authorities to remain committed to containing systemic risk associated with the sector by proactively preventing widespread defaults in LGFV debt.”
One reason: Fitch believes the LGFVs of 10 provincial-level regions are “more susceptible” to refinancing pressure because of their sizable exposure to short-term bond maturities and higher borrowing costs, Kwok says.
They include Tianjin, Ningxia, Gansu, Liaoning, Yunnan, Qinghai, Jilin, Guangxi, Heilongjiang and Guizhou, most of which had negative net refinancing for onshore and offshore issuance in 2022.
Importantly, the National Development and Reform Commission, China’s economic planner, has already been rejecting scores of infrastructure projects submitted by local governments this year.
That’s quite a sea change from early 2022 when LGFVs replaced builders as the biggest buyers of land across the nation. These vehicles also became the top buyer of half-finished property projects overseen by China Evergrande and other possible defaulters. That’s when their increasingly outsized role in real estate started ringing alarm bells.
Yet the Xi approach coming out of the NPC seems to be more of the tough-love variety, incentivizing change without devastating local government debt outlooks.
After the economic chaos of 2022, says Zhang Xiaoxi, a Beijing-based analyst at Gavekal Dragonomics, financial regulators are trying to balance pivoting away from their recent focus on controlling debt, reducing moral hazard and favoring short-term stability.
One of the risks looming over the expected recovery this year is the potential for a bond market blowup if LGFVs were to default for the first time.
Provincial and municipal authorities’ off-budget investment programs still depend on state-backed companies being able to take advantage of implicit guarantees to raise money from the bond market.
“A public default by LGFVs would be a shock to this system and threaten financing flows to local projects,” Zhang notes.
Now, the talk is that authorities figure it’s “best not to risk this possibility, and to give some public support to off-budget borrowing,” Zhang says. “A large-scale bailout of many more LGFVs is still unlikely. But even selective support marks a retreat from financial discipline and will help take some risks to growth off the table in 2023.”
The International Monetary Fund this week raised is estimate of China’s LGFV debt to $9.5 trillion in 2022 versus $7.1 trillion in 2021. Zhang notes that the “past three years of unprecedented economic disruption, paired with a rising debt load, is now leading to mounting financial strain.”
Though no LGFVs are known to have missed a payment on a public bond, they’ve defaulted on private creditors roughly 166 times in 2022, Gavekal notes, compared with a total of 212 times during the previous eight years.
This pressure means it’s high time that Xi’s party got serious about setting the stage for cleaner local government balance sheets. The good news is this cleansing process is about to kick into a higher gear.
Follow William Pesek on Twitter at @WilliamPesek