China’s economy needs swift action to avert local government debt disaster
- Together with a forceful stimulus to revive growth, a smart approach to defuse China’s local government debt bomb could go a long way towards reducing systemic risks of the financial system, lessening the burden of the economy and restoring the confidence of investors
The first aspect is the debt pile’s rapid growth. Before the 2008 global financial crisis, local governments tended to run conservative budgets and had little debt, but this changed as they and their LGFVs played an important role in the post-crisis economic recovery. In 2015, the Ministry of Finance carried out a debt swap that replaced local government liabilities with more transparent and lower interest bonds.
Besides its rapid growth, the structure of China’s local government debt is also of concern. The average tenor of LGFV bonds is too short for financing infrastructure projects, which often take a longer time to yield any returns. This has created a significant maturity mismatch between assets and liabilities that exposes LGFVs to repayment risks.
In addition, the costs of these debts are excessively high. These punitive funding costs are untenable for most LGFVs as stand-alone commercial entities, considering the meagre returns they earn from operating public infrastructure outside major city hubs.
How is China defusing its debt bubble, and what’s the outlook?
First, the structure of the existing debt needs to be reshaped to align with economic reality. This means the funding costs of the entire LGFV debt stock need to fall, in line with the general decline in interest rates, to reduce borrowers’ financing burden. In addition, the maturity of debt should be extended to better match cash flows of assets to reduce duration mismatches.
Finally, successful debt restructuring cannot be achieved by considering only the liability side of the balance sheet. Instead, improving the cash-generating capability of assets has to be part of the solution. This means reviving the economy and stabilising the property market – with the goal of replenishing fiscal coffers – have to be a priority in the near term.
Triangular debt will hurt China’s growth if it is not addressed
Overall, the precarious state of China’s economy calls for swift and decisive action. Together with a forceful stimulus to revive growth, a smart approach to defuse the local government debt bomb could go a long way towards reducing systemic risks of the financial system, lessening the burden of the economy and restoring the confidence of investors.
Aidan Yao is a macroeconomist with more than 15 years of experience in both public- and private-sector organisations