China is facing a serious debt problem that could threaten its economic stability and global influence. The country’s official government debt is already high, but there is another type of debt that is largely hidden from public view: the debt of local governments and their financing vehicles.
Local governments in China are responsible for providing public services and infrastructure projects, such as roads, bridges, airports, schools, hospitals, and more. However, they have limited fiscal autonomy and revenue sources, and they face strict borrowing limits from the central government. To circumvent these constraints, local governments have set up thousands of financing platforms, known as local government financing vehicles (LGFVs), to raise funds from banks and capital markets.
LGFVs are not officially recognized as part of the government, but they are implicitly backed by local authorities and their assets. They borrow money from various sources, such as bank loans, bonds, trust products, and shadow banking, and use it to finance local projects or repay existing debts. LGFVs have played a key role in supporting China’s economic growth and development, especially after the 2008 global financial crisis, when the central government launched a massive stimulus package that relied heavily on local spending.
However, LGFVs also pose significant risks to China’s financial system and fiscal sustainability. According to some estimates, the outstanding debt of LGFVs reached nearly $10 trillion by the end of 20221, equivalent to about 70% of China’s gross domestic product (GDP). This is in addition to the official government debt, which stood at about 45% of GDP2. The total government debt, including the hidden debt of LGFVs, could be as high as 115% of GDP3, far exceeding the international warning level of 60%.
The problem with LGFVs is that they operate in a murky and unregulated market, with little transparency and accountability. Many LGFVs are highly leveraged and have low profitability and solvency. They rely on rolling over their debts or borrowing new money to repay old debts. They also face increasing difficulties in accessing funding sources, as banks tighten their lending standards and regulators crack down on shadow banking activities. Moreover, many LGFVs have invested in unproductive or wasteful projects that generate low returns or even losses. These projects not only fail to generate enough cash flow to service the debts, but also create environmental and social problems.
The hidden debt of LGFVs could become a ticking time bomb for China’s economy, as well as a potential source of contagion for the global financial system. If LGFVs default on their debts or face liquidity crises, they could trigger a chain reaction of financial distress among their creditors, such as banks, bondholders, trust companies, and other investors. This could undermine the stability and confidence of China’s financial sector, which is already facing challenges from rising bad loans, shrinking profits, and growing competition.
Furthermore, if LGFVs fail to repay their debts or require bailouts from the central government, they could impose a heavy fiscal burden on China’s public finances. This could limit the government’s ability to implement effective fiscal policies to support economic growth and social welfare. It could also erode the government’s credibility and reputation among domestic and international investors.
Therefore, it is imperative for China to address its hidden debt problem before it becomes too late. The government needs to take measures to improve the transparency and regulation of LGFVs, such as disclosing their financial information, imposing stricter borrowing limits and supervision, and enhancing their governance and accountability. The government also needs to restructure or resolve the debts of LGFVs, such as by swapping them into bonds, writing them off, or transferring them to asset management companies. Moreover, the government needs to reform its fiscal system to enhance the revenue and expenditure management of local governments, such as by expanding their tax base, increasing their fiscal transfers from the central government, and rationalizing their spending priorities.
By tackling its hidden debt problem head-on, China can avoid a potential crisis that could derail its economic development and global ambitions. By doing so, China can also set an example for other countries that face similar challenges of managing their public debts in a transparent and sustainable manner.
