Why LGFV debt is a growing risk for China’s economy

SHANGHAI – Cracks are showing in a pillar of China’s debt market: local-government financing vehicles (LGFVs).

Created to fund such things as roads, airports and power infrastructure, they rarely generate enough returns to cover their obligations. That means most rely on injections of municipal funds to stay solvent.

With many local authorities facing cash-flow problems due to a real estate crisis, there are growing concerns about this US$9 trillion (S$12.2 trillion) debt market – prompting the government to take steps to effectively bail out weaker issuers and avert a credit crunch.

Caixin on Saturday reported that Beijing plans to allow local governments to sell 1.5 trillion yuan (S$282.6 billion) of special financing bonds to help 12 regions repay their debt. 

The Chinese central bank may set up a special purpose vehicle with banks to provide low-cost and long-term liquidity to LGFVs, the report said.

How do LGFVs work?

LGFVs were originally established to skirt a ban on the municipal authorities borrowing from banks or selling bonds directly in the market.

The money they raise is spent directly on things such as infrastructure and state welfare projects that can take a long time to complete and often generate low returns.

While LGFVs are categorised as corporate debt, investors generally assume that local governments are held accountable for them.

How did they become so important?

LGFVs have been central to government efforts to ensure China’s infrastructure and public services expand fast enough to sustain outsized economic growth.

They took off after the 2008 financial crisis, when the government undertook a 4 trillion yuan national stimulus plan, and have grown rapidly ever since.

How significant are they to China’s economy?

The International Monetary Fund estimated that LGFV debts nearly doubled over the past five years to about 66 trillion yuan – equivalent to more than half of China’s annual economic output.

LGFVs had about 13.5 trillion yuan of outstanding onshore bonds at the end of 2022, according to data from S&P Global Ratings – representing about 40 per cent of China’s non-financial corporate bond market.

All types of financial institutions have exposure to them: commercial banks via their wealth management units, insurers, mutual funds, securities companies and hedge funds.

The overwhelming majority of their investors are local as foreigners consider LGFVs to be opaque and hard to analyse.

How did they become a major risk?

China’s property slump dealt a blow to local governments by depleting their income from land sales.

That, combined with a jump in public spending in response to the pandemic, left a majority of regional governments facing a serious funding squeeze.

Half of the cities experienced difficulty in managing debt interest payments in 2022, Rhodium Group said.

Meanwhile, LGFVs were paid average government subsidies of 392 million yuan in 2022, which was the most in nine years, according to a China International Capital Corp report.

Has any LGFV defaulted?

No. Even those local governments that are struggling the most appear to be prioritising timely bond payments, given the potentially catastrophic signal that it would send if they were unable to pay their way.

But some LGFVs have been making last-minute payments, indicating debt-servicing difficulties.

What is the government doing about it?

In a small but symbolically significant step, China will allow provincial-level governments to raise about 1 trillion yuan via bond sales to repay the debt of LGFVs and other off-balance sheet issuers, Bloomberg News reported in August.

The programme will in effect bail out weaker issuers, shifting the debt burden to provincial governments instead.

China’s biggest state banks have also started providing relief, Bloomberg News reported earlier.

Banks including Industrial and Commercial Bank of China and China Construction Bank were said to be offering loans that mature in 25 years, instead of the prevailing 10-year tenor for most corporate lending, to qualified LGFVs with high creditworthiness.

Some came with temporary interest relief. Past experience shows that a missed payment could trigger a surge in perceived risk that would inflate borrowing costs to unaffordable levels for some state entities and state-linked companies.

However, a sector bailout appears unlikely as the central government is trying to discourage reckless risk-taking driven by the assumption that the state will always come to the rescue when things go wrong.

What are the other risks besides a default?

The concern is that many local financing authorities are reaching a point where they will be forced to rein in their borrowing – potentially staunching the flood of cash that has been a steady source of stimulus for China’s economy.

If that happens, the timing could be unfortunate, with investors already worried that the country’s recovery from pandemic restrictions has lost momentum. BLOOMBERG