New Delhi: The debt of China’s local-government financing vehicles (LGFVs) has almost doubled since 2017, reaching an estimated 56.671 trillion renminbi (RMB), or roughly $7.8 trillion, in 2022, according to the latest International Monetary Fund (IMF) report on China’s economy.
The rapid increase in debt has raised concerns about the financial stability of China’s local governments, which could add further pressure to the Chinese economy.
According to the IMF report, released in February this year, China’s LGFV debt stood at only 30.7 trillion RMB in 2017.
The report was based on a consultation with the People’s Republic of China (PRC) that was conducted in 2022 under Article IV of the IMF’s Articles of Agreement. Under Article IV, the IMF holds discussions with its member countries, usually every year, to assess their economic conditions.
Essentially, LGFVs are companies created by local governments to borrow from banks, trust companies, or the bond market, according to a 2014 IMF working paper. They were created as a way for municipal authorities to circumvent a ban on borrowing from banks or selling bonds directly in the market.
These vehicles raise funds — categorised as corporate debt — for infrastructure, such as roads and bridges, or “state welfare” projects that have low returns and take a long time to complete, according to a 9 June Bloomberg report.
Jabin T. Jacob, an associate professor at the Department of International Relations and Governance Studies at the Shiv Nadar Institution of Eminence, explained that the 1994 taxation reforms in China centralised revenue collection in Beijing while offloading infrastructure and social expenditure to the provinces.
“Local governments did what they could for money, which is to monetise land and get into real estate bubbles,” Jacob told ThePrint. “Across China, local government debt is a huge issue.”
Notably, Beijing’s share of total fiscal revenue grew from less than 30 per cent in 1994 to around 50 per cent in 2012, according to the 2014 IMF working paper cited earlier. Meanwhile, local governments were responsible for most infrastructure investment, service delivery, and social spending — amounting to about 85 per cent of total expenditure, per the IMF report.
Given that they were prohibited from borrowing for the most part, local governments began setting up LGFVs to bridge the gap between the state budget and infrastructure investment.
ThePrint traces how the substantial growth of LGFVs, fuelled by the aftermath of the 2008 global financial crisis, has contributed to China’s “augmented debt” and also played into the existing east-west economic divide in the country.
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Soaring ‘augmented debt’
China witnessed a significant increase in investment spending after the 2008 global financial crisis, with the government swiftly implementing a massive stimulus package of $586 billion to bolster its economy.
Unveiled on 9 November 2008, Beijing’s package was worth roughly 12.5 per cent of China’s Gross Domestic Product (GDP) at the time, and about three times the size of the economic stimulus package announced by the US, as reported by the Organisation for Economic Co-operation and Development (OECD), a Paris-based intergovernmental organisation.
The 2008-2009 Chinese stimulus programme was implemented largely by local governments, employing two primary approaches.
The first was a conventional process, where local governments submitted project proposals to the National Development and Reform Commission (NDRC). Selected projects were then incorporated into the national investment plan and received funding, as reported by the OECD.
The second approach was more radical, entailing investments made through LGFVs.
On 24 March, 2009, the People’s Bank of China and the China Banking Regulatory Commission issued a document that called for “supporting localities with appropriate conditions to organise and build financial platforms,” as highlighted by the OECD paper.
As a result of the fiscal stimulus, local government debt increased through LGFVs.
Although this “off-budget” financing was not classified as debt on the accounts of the local governments, it was still considered a component of China’s overall “augmented debt”— which includes the debt raised by LGFVs, along with official reported government debt and a few other sources of debt financing.
In 2014, the IMF reported that China’s total augmented debt accounted for approximately 45 per cent of its GDP in 2012.
By 2022, China’s augmented debt had soared to 110 percent of its GDP, according to the IMF’s latest report.
Furthermore, the IMF estimates that by the end of 2023, China’s augmented debt could potentially grow to 122 per cent of its GDP.
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East-west development gap
The 1994 taxation reforms, and the subsequent growth of LGFVs and other non-budgetary financing had a disproportionate impact on the western provinces of China.
“The western and interior provinces of China have the handicap of starting later in their reform journey and lack some of the economic advantages of the coastal provinces,” explained Jacob.
In an effort to bridge this development gap, the western provinces embarked on large-scale infrastructure investment projects, contributing to the current debt situation.
Ritu Agarwal, an associate professor at the Centre for East Asian Studies, Jawaharlal Nehru University, explained to ThePrint that the western provinces relied heavily on centrally allocated funds before the tax reforms. After the reforms, they raised funds through debt and other non-budgetary means for financing investments.
“The tax reforms added budgetary and non-budgetary funds. Budgetary funds were allocated to provinces by Beijing, while non-budgetary funds were raised by provincial governments through attractive investment policies, sale of land, and focusing on cash crops like tobacco,” added Agarwal.
With the advancement of urbanisation across the country, sale of land became a lucrative revenue stream for local governments. According to the 2014 IMF working paper, the share in the proceeds of land sales increased from 40 per cent to 95 per cent for local governments after the 1994 tax reforms.
Reasons for skewed development
During China’s opening up in the late 1970s, the focus was primarily on the eastern coastal provinces.
Gunjan Singh, an assistant professor at O.P. Jindal Global University and an expert on Chinese domestic policies, explained some of the reasons for this.
“The western provinces like Xinjiang and Tibet, for example, are not majority Han (ethnic Chinese). The coastal provinces were easier for the CCP (Chinese Communist Party) to implement new development policies given the Han majority in those regions,” Singh told ThePrint.
As a result, the coastal cities developed faster than the inland provinces. The west came into focus only later.
“One way to understand regional inequality is to look at when China opened under Deng Xiaoping, the focus was on the coastal development model. It was only in 1999, when the Chinese government announced the Xibu da kaifa [Go West] strategy,” explained Agarwal.
She pointed out that the maritime regions not only had advantages for export but also a historic connection with the world. “Shanghai was globally connected in the 1930s and 1940s,” she added.
After the liberalisation of China’s ‘household responsibility system’, which gave households in rural areas the responsibility of managing agricultural land and production, cheap labour from western provinces like Sichuan started migrating eastward.
Furthermore, the availability of water resources in the west became a valuable source of cheap hydroelectric power for the eastern provinces.
“Due to the growth of the idea of self-reliance along with Xi Jinping’s poverty alleviation schemes in the western provinces, there has been a shift back towards the west,” added Agarwal.
But the cost of economic modernisation across China has been steep, especially in the western provinces that were originally promoted as cultural tourism hotspots.
The Chinese growth model relied on urbanisation and big-ticket infrastructure projects. This meant rebuilding cities and thereby demolishing older buildings that could have added cultural value. Further, in this race to urbanise, local provincial governments focused on raising funds through LGFVs and non-budgetary means.
The singular focus on urbanisation and growth in the ethnically and culturally diverse west led to a top-down approach to changing the social fabric of the western provinces, explained Singh.
“The government’s focus has also been on promoting the use of Mandarin across the country, which faces difficulty in the more diverse provinces of the west. Despite the best efforts of Beijing in building roads and huge infrastructure in the west, the change in lifestyles from agrarian to urban has been slow in these [western] provinces,” she added.
Agarwal, too, observed that the focus on urbanisation and modernisation across China “made cities look similar”, which was “counterproductive to the promotion of western cities as cultural hotspots”.
LGFVs — China’s growth paradox
The property market is critical for the fiscal health of provincial governments, as reported earlier by ThePrint. With the current slowdown in the real estate market, provincial governments have found it difficult to service interest payments.
Land sales revenue was RMB 2.0 trillion lower in 2022 than the year before, according to a June 2023 report by the Rhodium Group, an independent research firm. It is estimated to further decline in 2023 given the one-year lag on payments made for land purchases, the report adds.
To artificially inflate land sales revenue, local governments have directed LGFVs to purchase considerable volumes of land, the report further says. LGFVs contributed to almost half of the total land purchases in 2022, in comparison to 33 per cent in 2021 and 17 per cent in 2020, it adds.
In the annual reports of LGFVs, land is normally categorised as inventory, property investment, and intangible assets. An analysis of the LGFVs annual reports by Rhodium Group showed that these vehicles’ inventories accelerated to 11.4 per cent by the end of 2022— increasing for the first time since 2018.
However, the purchase of land by LGFVs to stimulate land markets has resulted in a decline in the overall cash position of LGFVs.
From RMB 8.7 trillion in 2021, the total cash position of LGFVs decreased to RMB 7.8 trillion in 2022. Interest paid out by LGFVs increased to RMB 2.9 trillion in 2022 from RMB 2.7 trillion in the year before, despite the decline in interest rates and monetary easing by the People’s Bank of China, the report by Rhodium Group adds.
“One advantage in China in the case of local government debt is that Beijing is the ultimate guarantor of debt. We do not know what the money supply is, so it can be managed by diktat up to a point. But there is the problem of a moral hazard, so the central government has a difficult task on its hands,” Jacob pointed out. “Authoritarian states with poor feedback mechanisms sometimes have no option but to keep throwing good money after bad.”
(Edited by Asavari Singh)
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