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Prevailing Winds

China’s Hidden Government Debt

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

Measuring China’s government debt is a complex task because so much of the borrowing occurs through off-balance sheet channels. Distortions within China’s fiscal system mean that local governments are chronically short on funds yet also face hard limits on the amounts they are permitted to borrow. To circumvent these limits, local governments utilize special off-balance sheet financing vehicles to borrow. This debt exists in a legal gray zone where there is no direct government liability, but an implicit guarantee of government support is widely anticipated by the market. The impact on China’s economy from local government off-balance sheet borrowing is enormous. The financing vehicles are both one of the key conduits for economic stimulus and a source of acute financial risks.

China’s official levels of government debt are modest, as shown in Figure 1. At around 17%, China’s central government debt relative to GDP is among the lowest for any major economy and has been stable for many years. Added to this amount is local government debt guaranteed by the central government, which began to be recognized in large numbers in 2014. Even with the inclusion of local government debt, China’s total levels of government debt are relatively low at around 38%, as of the end of 2017. This compares with an average of 84% for the world’s major economies.1

Figure 1. China’s (Official) Government Debt As a Percentage of GDP
Sources: International Monetary Fund, Seafarer.

However, the statistics in Figure 1 account for only part of the picture. China’s government, primarily the various local governments, engage in a significant amount of off-balance sheet borrowing. To understand how and why this borrowing occurs, it is important to first understand how China’s fiscal system works.

China’s Distorted Fiscal System

Establishing a balanced and sustainable fiscal system is a long-standing policy challenge for China. Much of the problem stems from the split in revenues between local governments and the central government. At a high level, local governments are responsible for around 85% of government spending but receive just over 50% of total revenue (before transfers).2 Until very recently, local governments have been prohibited from borrowing directly. Faced with these restrictions, local governments have utilized a variety of off-balance sheet financing channels to raise funds.

The most common tactic for off-balance sheet borrowing has been the creation of local government financing vehicles (LGFVs). These companies are set up by local governments with a bit of capital (often in the form of land) and then proceed to leverage up by borrowing from banks and other financial institutions. LGFVs then finance projects, usually infrastructure-related, on behalf of the local government.

In response to the 2008 global financial crisis, China undertook a massive economic stimulus. At 4 trillion renminbi (RMB), the stimulus was amongst the largest initiated by any country during the crisis. Most of the stimulus spending came not from the central government, but from LGFVs that borrowed heavily from the banking system. According to one estimate, three-quarters of China’s RMB 4 trillion stimulus was carried out by these vehicles.3 This off-balance sheet borrowing provided a tremendous boost to growth during a period of economic shock. However, it also created a wave of new financial risks as LGFVs began to rapidly accumulate debt. In addition to bank loans, these financing vehicles began issuing bonds and borrowing via shadow banking channels. Many LGFVs grew beyond their original infrastructure mandate, with subsidiary companies across a variety of different industries.

Audits conducted by the central government in 2010 and 2013 revealed rapidly growing amounts of LGFV debt: around RMB 18 trillion (2.7 trillion U.S. dollar (USD) equivalent) in debt guarantees and contingent liabilities.4 Analysts and policymakers began to fear that this debt was large enough to be a systemic risk to the financial system. Not only was debt growing more quickly than local government revenues, it was also being financed via short-term bank loans at high interest rates.

As a result, the central government stepped in and began to regulate LGFV activity more tightly. In 2014, the State Council issued new rules which prohibited local governments from guaranteeing the debts of LGFVs, and restrictions were put in place on new borrowing by the entities. In 2015, a new budget law allowed local governments to directly issue their own bonds, subject to quotas imposed by the central government. The combination of these policies was described as “opening the front door, closing the back door,” or shutting down the off-balance sheet channels of borrowing and creating regulated new on-balance sheet channels. As part of this process, a large amount of existing LGFV debt could now be “swapped” for local government bonds.

Nearly five years after the initial crackdown, LGFVs continue to exist and borrow large amounts. China’s Finance Minister Liu Kun recently admitted that hidden debts incurred by local governments are an ongoing concern. Another senior Chinese official confirmed that some localities have off-balance sheet debts larger than their quotas for official debt. Despite the fiscal reforms of the past few years, local governments continue to utilize LGFVs because they are still frequently short of funds. Local officials are extremely creative in finding ways to circumvent rules from the central government that are designed to prevent off-balance sheet borrowing. The central government sometimes turns a blind eye to these activities because LGFVs are a useful tool for local governments to boost economic growth and support central policy initiatives, such as the promotion of strategic industries and urban redevelopment projects.

Debating China’s “True” Government Debt Level

The overall level of government borrowing in China is a matter of intense debate. From the perspective of Chinese officials, the only debts that should be included are those where there is direct promise of repayment, such as central government debt and local government debt that has been officially recognized. All other borrowing activity is not to be included because the government does not bear a direct liability.

Organizations like the International Monetary Fund (IMF) argue that this definition is overly narrow and excludes the quasi-fiscal borrowing done by entities like LGFVs.5 A more complete assessment of the government’s fiscal stance should include the activity of these financing vehicles. Despite claims by Chinese officials to the contrary, the debts of LGFVs represent contingent liabilities for the government. Frequent intervention by local governments to bail out troubled LGFVs on the verge of default help to prove this point.

The IMF has gone so far as to create an alternative estimate of China’s total government debt levels over the past several years – the “augmented debt” series.5 As shown in Figure 2, China’s augmented debt can be classified into the following components:

Central Government Debt:
Debt issued by the Ministry of Finance.
Local Government Debt (Official):
Debts from local governments that are officially recognized and on-balance sheet.
Local Government Financing Vehicle Debt:
Debts incurred by LGFVs. Some of these debts are related to quasi-fiscal activity and therefore may be recognized at a later point in time. Other debts are unlikely to be officially recognized but serve as a contingent liability upon the government.
Government Fund Debt:
The contingent liabilities faced by the government as a result of its creation of special policy funds. These funds include government-guided funds, such as those used to promote China’s current technology campaign, and special construction funds that finance infrastructure and urban redevelopment projects.
Figure 2. China's (Augmented) Government Debt As a Percentage of GDP
Sources: International Monetary Fund, Seafarer.

Even the augmented debt numbers are not inclusive of all the items that could be considered government liabilities. Some estimates of China’s debt also include the borrowing activities of China’s three policy banks, public-private partnerships (PPPs) between local governments and companies, and China Railway Corporation (CRC). China Development Bank (CDB), the largest of the policy banks, is an enormous financial institution with total assets in excess of RMB 16 trillion (2.4 trillion USD-equivalent) at the end of 2017.6 The bank primarily finances infrastructure and urban renewal projects across the country with corporate lending and project financing. However, CDB’s borrowing activities cannot be added to China’s government debt without some degree of double-counting. Much of the bank’s lending flows to local governments and LGFVs, meaning that it is already included in the augmented debt numbers. Nonetheless, there is still quasi-fiscal borrowing by state-owned enterprises (SOEs) that does not register as official government debt.

The same is true of PPPs, in which companies, often SOEs, front the costs of joint projects with local governments under the promise of repayment at a later date. As of January 2019, there are more than 12,000 PPPs across the country in various states of implementation, with a total of RMB 17.6 trillion invested (2.6 trillion USD-equivalent).7 As with the development banks, there is likely to be some double-counting between PPP activities and borrowing by local governments and LGFVs.

CRC, the state-owned rail operator, is trillions of renminbi in debt.8 Indeed, the company’s interest payments on its debt have exceeded its operating profits since 2015.9 In order to remain in business, CRC continues to take on additional debt. CRC’s borrowing can be considered a form of contingent liability because the central government is ultimately responsible for this debt.

China’s Fiscal Stance

As the data in Figure 2 reveals, the cumulative scale of government borrowing over the past several years has been enormous. China’s official annual budget deficit has been between 2-3% of GDP for the last several years, a modest amount for a country whose economy is growing at more than twice that pace each year. However, when borrowing from LGFVs and government funds is included, the budget deficit becomes much larger. In 2017, borrowing from these entities was RMB 5.6 trillion (835 billion USD-equivalent), equal to 6.8% of GDP.

Like the “augmented debt” estimate, the IMF also produces an “augmented deficit” estimate in order to better gauge the true fiscal stance of the government in a given year. In addition to the off-balance sheet borrowing activity of LGFVs and government funds, the IMF also adds the proceeds from government land sales.10 The inclusion of land sales increases the budget deficit by another RMB 2 trillion (310 billion USD-equivalent). As shown in Figure 3, when all these items are added up, China’s 2017 augmented deficit was a startling RMB 8.8 trillion (1.3 trillion USD-equivalent), equal to 10.8% of GDP.

Figure 3. China's (Augmented) Budget Deficit As a Percentage of GDP
2015 2016 2017 2018 est.
Official Deficit 2.3% 2.9% 2.9% 2.7%
Deficit Including Land Financing 2.8% 3.7% 3.9% 4.1%
Deficit Including Land Financing, LGFVs, and Government Funds 8.4% 10.4% 10.8% 10.7%
Source: International Monetary Fund.

Once again, these high deficits underestimate the total scale of spending as the activities of the policy banks, PPPs and CRC are not explicitly included.11 For comparison, during the global financial crisis, the U.S. federal budget deficit peaked at -9.8% in 2009.12

Economic Impact and Financial Risks

The scale of government expenditures, whether financed by off-balance sheet debt, the sale of land, or other means make clear the large role that the government (particularly local governments) has played in supporting economic growth in recent years. It’s no wonder that a renewed crackdown on local government debt in 2018 coincided with an economic slowdown.

Faced with economic headwinds, China is once again turning to local governments to stimulate the economy. This time around, local governments are being encouraged to issue more bonds directly in order to finance infrastructure projects and boost growth. However, despite the reforms over the past few years, it seems unlikely that LGFVs will disappear. Even with higher official borrowing quotas, the expenditures of local governments are likely to outstrip their revenues and therefore require the use of LGFVs. As a result, the financial risks from these contingent liabilities will remain a vexing challenge.

Nicholas Borst,
The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
As of March 31, 2019 the Seafarer Funds owned no shares in the entities referenced in this commentary.
  1. Defined as the G20 economies. See “Credit to the Non-Financial Sector,” Bank for International Settlements, 5 March 2019.
  2. Wind Information. Accessed 11 March 2019.
  3. Chong-En Bai, Chang-Tai Hsieh, Zheng Song, “The Long Shadow of China’s Fiscal Expansion,” The Brookings Institution, February 2017.
  4. Aileen Wang, Koh Gui Qing, “China $3 trillion local government debt stirs alarm,” Reuters, 30 December 2013.
  5. Rui Mano and Phil Stokoe, “Reassessing the Perimeter of Government Accounts in China,” International Monetary Fund, 8 December 2017.
  6. 2017 Annual Report,” China Development Bank.
  7. Wind Information. Accessed 28 March 2019.
  8. Zhao Jian, “What’s Not Great About China’s High-Speed Rail? The Debt,” Caixin, 29 January 2019.
  9. Nicholas Lardy, The State Strikes Back: The End of Economic Reform in China (Washington, D.C.: The Peterson Institute for International Economics, 2019).
  10. Though not a debt, the sale of land is treated as a financing item equivalent to privatization. See Yuanyan Sophia Zhang and Steven Barnett, “Fiscal Vulnerabilities and Risks from Local Government Finance in China,” International Monetary Fund, January 2014.
  11. As described above, some of their activities may be captured indirectly via borrowing by local governments and LGFVs.
  12. Kimberly Amadeo, “US Budget Deficit by Year, Compared to GDP, Debt Increase, and Events. Is the U.S. Deficit Really That Bad?,” The Balance, 28 March 2019.