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

Cracks are visible in a pillar of China’s debt market: local-government financing vehicles (LGFVs). Created to fund things like roads, airports and power infrastructure, they rarely generate enough revenue to cover their obligations. That means most rely on injections of municipal funds to stay solvent. With many local authorities facing liquidity problems due to the real estate crisis, concerns are growing about this $9 trillion debt market – prompting the government to take action to effectively bail out weak issuers and avoid a credit crunch.

LGFVs were originally established around a ban on municipal authorities borrowing from banks or selling bonds directly on the market. The money they raise is spent directly on infrastructure and state welfare schemes, which take longer to complete and often generate less revenue. Although LGFVs are classified as corporate loans, investors generally assume that local governments are responsible for them.

2. How did they become so important?

LGFVs are central to government efforts to ensure China’s infrastructure and public services. It grew rapidly after the 2008 financial crisis, when the government embarked on a 4 trillion yuan ($562 billion) national stimulus package.

3. How important are they to China’s economy?

The International Monetary Fund estimates that LGFV loans have nearly doubled to 66 trillion yuan ($9 trillion) in the past five years — more than half of China’s annual economic output. LGFVs had about 13.5 trillion yuan of outstanding offshore bonds at the end of 2022, according to S&P Global Ratings data — about 40% of China’s non-financial corporate bond market. Financial institutions of all kinds exhibit them: commercial banks through their wealth management units, insurers, mutual funds, bond firms and hedge funds. Most of their investors are locals as foreigners find LGFVs opaque and difficult to analyze.

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4. How did they become such a big risk?

China’s property collapse was a blow to local governments by reducing their income from land sales. This, combined with an increase in public spending in response to the pandemic, has left the majority of regional governments facing a severe financial crisis. Rhodium Group reported that half of the cities faced difficulties in paying their debt interest last year. Meanwhile, LGFVs received an average of 392 million yuan in government subsidies in 2022, the most in nine years, according to a report by China International Capital Corp.

5. Is there any LGFV default?

No. Even the most struggling local governments seem to prioritize paying bonds on time, given the dire signal it sends if they can’t pay their way. But some LGFVs are making last-minute payments, indicating debt-servicing difficulties.

6. What is the government doing about it?

In a small but symbolic step, China will allow provincial-level governments to raise about 1 trillion yuan through bond sales to repay the debt of LGFVs and other off-balance sheet issuers, Bloomberg News reported in August. The scheme would bail out weak providers, instead shifting the debt burden to provincial governments. Bloomberg News previously reported that China’s largest state-owned banks have also begun providing relief. Industrial & Commercial Bank of China Ltd. and China Construction Bank Corp. Banks included are said to offer loans maturing in 25 years instead of the prevailing 10-year tenure for most corporate loans to qualified LGFVs with high creditworthiness. Some came with temporary interest relief. Past experience suggests that missed payments may increase the risk of raising borrowing costs to unaffordable levels for some government agencies and state-owned enterprises. However, a sectoral bailout is unlikely as the central government tries to discourage reckless risk-taking driven by the assumption that the state will always come to the rescue when things go wrong.

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7. What are the risks other than default?

The worry is that many local fiscal authorities will be forced to limit their borrowing — preventing the flood of money that has been a constant stimulus to China’s economy. If that happens, the timing could be unfortunate, as investors already worry that the country’s recovery from pandemic restrictions has lost momentum.

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