Local Debts: a Top-Level Design

How China's central and local governments have jointly ushered in a debt-based economic model in the past decade.

By Hubert Xue

Quick Takes:

Local debt explosion in China results from a joint effort by central and local governments rather than a localized issue.
China's debt-driven model has undergone three major rounds of fiscal and monetary expansion initiated by the central government: Stimulus after the 2008 Financial Crisis, monetized shanty-town resettlement in 2015, and the pandemic-induced expansion since 2020.
In 2009, China's central bank promoted local government financing vehicles (LGFVs) for debt financing, enabling local governments to bypass legal restrictions on debt raising.
Local governments' heavy reliance on land revenue, coupled with lax judicial supervision and rent-seeking, has led to real estate speculation and unsustainable debt growth.
Given the central government's incompetence to regulate the finance market and reduce dependency on the real estate sector, the local debt crisis will continue to affect China's economy.

Since 2008, the Chinese central government has designed three major fiscal and monetary expansion rounds, which spawned a debt-based economic model driven by government borrowing and investment. Local government financial vehicles (LGFVs) were set up in cities nationwide to carry out financing, large-scale land sales, new zone development, and infrastructure and real estate projects. This apparent ‘economic miracle’ drew plaudits; however, due to laxity regarding fiscal discipline, bank credit, corruption, and rent-seeking, the results have also included excessive local government borrowing, meager project yields, and huge LGFV debt risks. China’s post-coronavirus recovery in the first half of 2023 has been halting, with CPI inflation plummeting to near zero, policy interest rates unchanged, real market interest rates tracking upwards, real debt service costs up, and a looming ‘debt-deflationary spiral.’ The following is the first of a two-part reflection, which will identify the factors behind the hidden local debt explosion, China’s options for responding to the debt crisis, and its far-reaching macroeconomic effects.

World-Leading: China’s Local Government Leverage Ratio

China’s government has an overall leverage ratio due to have reached around 100% by the end of 2022, lower than the US (145%) and Japan (260%). Whereas public debt in Western countries is structurally dominated by sovereign debt, Chinese government debt is mainly made up of local government debt, which amounts to 74% of GDP, the highest such level in any major economy; local government debt in the US and Germany makes up under 30%, in France and the UK below 10%.

There are principally three types of Chinese local government debt: ‘General bonds’, ‘Special bonds’, and LGFV debt. ‘General bonds’ refers to bonds included in the general budget for public services. ‘Special bonds’ refers to bonds that are part of a government fund budget, which are earmarked for certain revenue-generating public amenities. General and special bonds are explicit liabilities and are mainly issued on the open market by provincial governments and those of "sub-provincial cities .” As of the end of 2022, outstanding explicit local government debt totaled ¥35 trillion, equivalent to 28.9% of GDP; general bonds made up ¥14.38 trillion, and special bonds ¥20.67 trillion.

LGFV debts, on the other hand, are a kind of implicit debt since a major share of them is not issued on the open market. They consist of bond issues by state-owned LGFVs, credit issued by banks and financial institutions, and other so-called “non-standard debt” (for example, in the shadow banking system). According to the data aggregator Wind, there were 3,027 ‘urban investment companies’ (LGFVs) nationwide as of July 24, 2023, and these had 19,633 LGFV bond issues outstanding.

Local governments use credit guarantees and implicit credit lines to arrange debt financing for LGFVs, and the latter then invest in infrastructure, develop urban land, operate real estate, and invest in for-profit projects such as tourist sites and industrial parks. Since the function of LGFVs is to finance, invest and generate revenues for local governments, LGFV debt is highly bound up with local government interests and usually recognized as (implicit) local government debt.

If we take the case of a new high-speed railway, the general central budget finances the railway itself, local special bonds raise funds for the station in the city in question, and LGFV finances highways, parks, industrial zones, wholesale markets, and condominium developments, forming an economic cluster around the new high-speed rail station.

An essential financial ‘weapon’ in local governments’ arsenals, LGFVs have contributed to local GDP and infrastructure, but their real economic benefits are the crux of much debate. Local governments and LGFVs have overinvested and taken on heavy debt over the past decade or so, and in recent years local government revenues and LGFV debt-servicing capacities have deteriorated rapidly.

LGFV debt is rather concealed: besides close to ¥14 trillion publicly issued on bond markets, significant amounts of the debt are not recorded or accounted for. According to Zhongtai Securities, total outstanding interest-bearing LGFV debt stood at ¥54 trillion by the end of 2022, equal to 44.6% of GDP. However, based on broad measures, LGFV debt may total as much as ¥70 trillion.

Let us take the example of Dushan County, Guizhou Province. The county has poor economic fundamentals: fiscal revenue of only ¥1 billion in 2018 and government debt as high as ¥40 billion. The Dushan County government borrowed and built aggressively since 2010, its projects including a megalomaniac building referred to as ‘world number one’ at the cost of ¥200 million, a 1,000-hectare university city at the cost of ¥2 billion, a ¥1.35 billion racecourse, a ¥1.52 billion ‘old town’ project, and a ¥1 billion big data center, more or less all of which ended up with construction suspended due to cash flow problems. This plunged the county's finances into a morass of debt. From 2018 onwards, Dushan County’s party secretary, county head, and many other officials were arrested for corruption.

Screenshot of a report by CCTV.com about Dushan County and the ‘world number one’ building.

Local Debts: a Top-Level Design

The hidden Chinese local government debt crisis is often chalked up to corruption by local officials in the eyes of both Chinese and Western reports. But how can it be that for so many years, officials around China have been able to borrow recklessly? Is local debt just a local-level phenomenon? Understanding the mechanisms behind China's hidden debt problem requires an overview of China's political and economic system and the calculus that central and local government decisions follow.

In an attempt to redress central government fiscal shortfalls, a tax-sharing reform took place in 1994. From then on, revenues from customs duties, consumption taxes, and corporate income taxes on central enterprises and banks went to the central government. As for the most significant tax in China, the VAT, 75% of the revenue went to the central government and 25% to local authorities. In 1994, the transfer of the bulk of VAT and Consumption Tax revenues to central coffers boosted the central government’s share from 22% of total revenues to 55.7% of GDP.

While tax-raising and spending powers have been progressively concentrated in the central government’s hands, responsibilities for provision (e.g., primary education, health care) have been continually devolved, leading to a system for basic public services where ‘central government orders the food, local government pays the bill.’

To compensate for this, the central government gave local city and county governments the power to make money from land. The 1982 version of the Chinese Constitution stipulates that urban land is state-owned, while rural land is collectively owned by villagers. In the wake of China's rapid urbanization, municipal and county governments have been able to reap lucrative revenues by selling state-owned urban land use rights to developers and expropriating rural land in the exurbs for resale to developers.

To maximize land revenues, local governments often use this power to the extreme, creating supply-demand contradictions by monopolizing and throttling the supply of land, which pushes land and house prices (and thus revenues from selling land use rights) to one high after another. In 2019, nationwide revenue from the sale of state-owned land use rights was ¥7791 billion, equivalent to 40% of general national budgetary revenue.

Since the tax-sharing reforms, the central government and local governments now have a strong joint interest in constant fiscal expansion.

Some scholars have commented that since the tax-sharing reforms, "the central government and local governments now have a strong joint interest in constant fiscal expansion.”

The Chinese government has immense administrative, judicial, fiscal, and financial powers, controls key resources such as energy, steel, electricity, telecommunications, and banking, and is in a powerful position to intervene in the economy. During a recession, the government must step in to rescue the market. However, China's macroeconomic adjustment policies differ somewhat from Keynesianism and the countercyclical adjustments, as the Chinese state is strongly incentivized towards fiscal and monetary expansion and public investment.

From the central government’s point of view, state-owned enterprises (SOEs) control upstream raw material sectors such as oil, coal and steel, as well as basic downstream service sectors such as electricity, telecommunications and banking; each round of stimulus and debt-fueled investment has rapidly boosted these respective sectors’ assets, revenues and profitability. For example, the 2015 monetized shanty-town resettlement program (further details below) aimed to stimulate real estate through monetization and help upstream raw materials sectors reduce inventory, capacity, and leverage levels.

In 2022, SOEs and state-controlled enterprises posted total operating revenue of ¥82 trillion, up 8.3% year-on-year, a much higher growth rate than the 3% GDP growth. Massive borrowing also has supercharged banks' assets, revenues, and profits. Commercial banks realized a cumulative net profit of ¥2.3 trillion in 2022, up 5.4% year-on-year.

Local Governments’ Motivations for Heavy Borrowing

From a local government perspective, there are strong incentives to earn land sales and tax revenue.

As part of the economic transition, the central government has developed a set of ‘competitive’ models to incentivize and keep tabs on local officials. Under these models, local officials are keen to maximize their promotion opportunities by posting high local GDP and revenue growth during their time in office. Results from a 2019 empirical study show that due to promotion pressures, local-level cities whose party secretaries are in a specific age group (55-58) are more inclined to issue LGFV bonds and expand LGFV debt; promotion pressure has a tremendous stimulus effect on the scale of LGFV debt in economically less-developed and less urbanized cities.

Local governments’ modus operandi is to set up state-owned LGFVs, which raise finance through bank loans and LGFV bonds, and then purchase large tracts of state-owned land from authorities and invest in infrastructure such as highways, real estate, and certain for-profit projects. This method has brought in huge revenues for local governments in short timeframes, mainly of land-related fiscal revenue (state-owned land use proper sale proceeds, land, and real estate-related tax revenues), real estate sales revenues, and business revenues from for-profit projects.

Today, local government coffers are highly dependent on revenue from land. The share of land-related fiscal revenues in broad fiscal revenues (general budgetary revenues + government fund budget revenues) nationwide is expected to have reached 32% in 2022, rising to over 50% of broad fiscal revenues in the case of many local governments.

In addition, lax judicial supervision leads to strong rent-seeking incentives for local officials. LGFV projects are subcontracted to chains of companies in which the latter have vested interests. In this process, it is difficult to scrutinize and detect enrichment and rent-seeking corruption; the amount of funds reaching the projects can be much less than expected.

Some foreign analysts have argued that "most LGFV spending and investment aims to provide affordable public services rather than generate significant financial profits." It is undeniable that many LGFV bonds have supported actions in the public service sector. However, public benefit is only a superficial motive; it covers local governments bidding up the price of state-owned land, then selling the latter to earn land-related fiscal revenue. This is where local government interests lie in practice. Their internal political calculus calls for large debt-fueled investments to pump-prime officials’ short-term political scoresheets, earn promotion opportunities, and broaden rent-seeking opportunities. In addition, local governments use LGFVs to conduct large-scale, for-profit investments in tourism, expressway, and real estate projects in anticipation of business income.

In the early phases of (the post-1978) Reform and Opening-Up, local governments generally grew their economies and tax takes by attracting investment, bringing in foreign capital and technology, and fostering free markets. Following the 2008 financial crisis, economic growth rates declined, as did governments' patience in nurturing the market; this gave way to an urgent push to boost revenue. The fastest short-term way to create nominal GDP, tax revenues, and political brownie points has been for them to borrow and invest on a massive scale.

A ‘Four Trillion’ Stimulus and the Rise of LGFVs

As Shanghai Volkswagen celebrated its fifth anniversary on 18 April 1990, then-Premier Li Peng announced a new central government policy to develop the Pudong area of Shanghai. Shanghai Urban Construction Investment and Development Corporation was set up soon after, and China’s first LGFV bond came out in 1992: the Pudong New Area Construction Bond.