Daily Management Review

China Cannot 'Extend And Pretend' Much Longer With Municipal Debt


China Cannot 'Extend And Pretend' Much Longer With Municipal Debt
The "basket of measures" that China has committed to do to reduce the risks associated with local government debt are likely to include special bond issuance, debt swaps, loan rollovers, and something that Beijing really detests: using funds from the central budget.
China's local governments are crucial to the country's economy, and Beijing has given province and city leaders lofty growth goals to accomplish. However, following years of excessive infrastructure spending, declining land sale profits, and rising COVID costs, economists claim that debt-ridden municipalities now pose a serious threat to China's economy.
Chinese leaders expressed concern last month about a potential chain of municipal debt defaults that might shake the financial system by promising to aid with debt relief without providing any specifics.
Compared to when Communist Party leaders wanted "strict control" of local debtsin April, economists viewed this message to be more helpful.
They claim the message is that Beijing has realised it needs to urgently pour money into the issue.
That might be a significant step forward in finding a solution to China's municipal debt dilemma because Beijing has long insisted that local governments resolve their own issues.
"The local debt problem is complex so you cannot simply say you don’t want to take responsibility," said Guo Tianyong, professor at the Central University of Finance and Economics in Beijing, explaining the politburo's directions.
According to two policy experts who spoke to Reuters, the degree of any central government engagement and any restrictions imposed on it are still up for debate. Also uncertain is whether the bundle of actions will be a multi-year or short-term strategy.
Investors will need to know these specifics in order to assess how decisive and durable Beijing's answer will be.
"The size of any restructuring and the scale of the problem Beijing acknowledges is important to the success of this effort," said Logan Wright, a partner at Rhodium Group.
In 2022, local government debt increased from 62.2% in 2019 to 92 trillion yuan ($12.8 trillion), or 76% of overall production. Local government financing vehicles (LGFVs), which cities utilise to collect money for infrastructure projects, are responsible for a portion of it. The LGFV debt is anticipated to increase to $9 trillion this year by the International Monetary Fund.
The central government, which has frequently issued advisories regarding "hidden debt risks," is concerned that the figures are even greater when any debt issued outside of municipal balance sheets is taken into account.
Beijing is in a precarious situation: either intervene in at the risk of promoting more irresponsible spending, or remain silent while the economic model collapses with serious ramifications for growth and social stability.
"A principle should be established: not all debt will be assumed by the central government," a policy adviser told Reuters on condition of anonymity.
"This could lead to moral hazard."
The advisor recommended that all parties involved—financial institutions, local governments, Beijing, and society at large—bear some of the burden to avert that danger.
The majority of experts predict Beijing would urge state-owned banks to continue refinancing expiring debt with longer-term, lower-interest loans, a tactic known as "extend and pretend."
However, the banks must exercise caution based on the importance and urgency of any refinancing operation. Restructuring their debt damages their own financial position and limits their ability to fund other sectors of the economy.
After a recent business trip to two troubled provinces, a source at a state bank told Reuters that for many local governments, "to keep vital functions you need transfers from Beijing and to develop you need to issue bonds - the central leadership is aware of that."
Local governments will be held accountable, especially in terms of transparency.
Analysts predict that local governments will employ leftover bond issuance quotas from the previous year to replace "hidden debt" with official bonds on their balance sheet, with up to 2.6 trillion yuan to be issued.
Such a move has been done before. To replace off-balance sheet debt, local governments issued bonds worth about 12 trillion yuan between 2015 and 2018.
Beijing may also request that specific localities sell assets or borrow money in order to raise money.
“Extension of local government and LGFV debt and de facto restructuring, especially with banks, will likely be encouraged, while local governments may also be pushed to sell or mortgage some assets,” said Tao Wang, chief China economist at UBS.
Next is thrifty Beijing, which has the most leeway and a central government debt that is only 21% of GDP.
Beijing issued 270 billion yuan in special bonds in 1998 to recapitalize the "big four" state banks, 1 trillion yuan in special bonds in 2020 to deal with the epidemic, and 1.55 trillion in 2007.
“The central government can issue low-cost bonds to replace local debt," a second policy adviser said.
Chinese 10- to 30-year government bonds have a yield of 2.7% to 3.0%. Some LGFVs and cities charge 7–10% interest.
The professor Guo claimed that for such swaps to have an impact this year, they must total more than 1 trillion yuan.
Analysts believe that more generous direct fiscal transfers might also be included in the mix to pay for essential public services. The finance ministry anticipates a record 10 trillion yuan in such payments this year, up 3.6% from 2022, showing that this is a well-traveled path.
Policymakers must make significant adjustments to the way the economy functions if they want the local debt issue to stop recurring.
The growth performance criteria for ranking local government officials should be relaxed, according to BBVA analysts.
After four decades of astounding growth, Beijing and Chinese society may eventually have to accept slower growth.
"Whether Beijing will be able to accept a significant slowdown in local government investment, and therefore economic growth, will be one of the most important questions in any restructuring," Rhodium's Wright said.