China’s Colossal Hidden-Debt Problem Is Coming to a Head

Pan Gongsheng, governor of China’s central bank, has promised financial support for indebted regions. PHOTO: TYRONE SIU/REUTERS
Pan Gongsheng, governor of China’s central bank, has promised financial support for indebted regions. PHOTO: TYRONE SIU/REUTERS


Cities and provinces across the country have accumulated a massive amount of hidden debt following years of unchecked borrowing and spending.

China is trying to defuse a financial time bomb that could severely damage its banking system.

Cities and provinces across the country have accumulated a massive amount of hidden debt following years of unchecked borrowing and spending. The International Monetary Fund and Wall Street banks estimate that the total outstanding off-balance-sheet government debt is around $7 trillion to $11 trillion. That includes corporate bonds issued by thousands of so-called local-government financing vehicles, which borrowed money to build roads, bridges and other infrastructure, or to fund other expenditures.

No one knows what the actual total is, but it has become abundantly clear over the past year that local governments’ debt levels have become unsustainable. China’s economic growth is slowing and the country is battling deflationary pressures that will make it harder for local governments to keep up with their interest and principal payments.

Economists say a significant chunk of the hidden debt—their estimates range from $400 billion to more than $800 billion—is particularly problematic and at high risk of default.

Chinese authorities have realized that the risks to the country’s financial stability and overall growth have become too large to ignore. They are trying to tackle the problem more systematically and are starting to swap out some hidden debt for new—and explicit—government debt.

The big worry is that a wave of defaults could spread losses far and wide. That could quickly snowball into a nationwide financial crisis if credit markets seize up and retail and corporate depositors start to get worried about the financial stability of banks that hold a lot of local-government bonds.

“Once a local-government financing vehicle defaults, the situation can easily get out of hand," said Yao Yu, founder of YY Rating, an independent Chinese credit-research firm. Bonds from local-government financing vehicles make up close to half of China’s domestic corporate bond market, according to Wind data, and defaults could choke off funding for other borrowers if many investors and bond buyers back away.

In early November, China’s central government said it places “great importance to the prevention and resolution of the risk of hidden debts of local governments." Bankers and local government officials were also warned that they would be held accountable for life if they raised new hidden debt.

Pan Gongsheng, the governor of the People’s Bank of China, said at a Beijing financial forum last month that the central bank would also provide emergency liquidity support to regions with relatively high debt burdens. He said China’s total government debt isn’t high by international standards and that the country is taking steps—including asset disposals and refinancing debt—to mitigate the risk posed by its local-government debt.

China has muddled through a yearslong property bust and dozens of real-estate developer debt defaults without massive losses to the country’s banks. That is largely because many property developers had raised money offshore by selling bonds to international investors and were less dependent on bank loans.

The situation is different for local-government financing vehicles. Most of their bonds are held by Chinese commercial banks, which also extended loans to them. A recent UBS report said domestic banks’ total exposure to local-government financing vehicles at the end of last year was equivalent to about $6.9 trillion—representing about 13% of the banking sector’s total assets.

For more than a decade, Chinese regulators have been trying to address the risks of the country’s hidden debt. The last round of major efforts occurred between 2015 and 2018. During that time, Chinese local governments also sold new public bonds to swap out their hidden debt, effectively giving the latter explicit government backing.

China’s Finance Ministry also told local governments to borrow more responsibly in the future. However, under pressure to stimulate growth, local governments went on another borrowing spree, and by the end of November, the outstanding bonds of their financing vehicles ballooned to more than twice what it was in 2018, according to Wind, a financial data provider.

Some cities and provinces are starting to show financial strains after a brutal property downturn caused local government income from land sales to plunge. Three years of heavy spending to contain the Covid-19 pandemic has also depleted their cash coffers.

In late 2022, Zunyi Road and Bridge Construction Group, a state-owned company that builds bridges and roads in debt-laden Guizhou province, extended the maturity of approximately $2.2 billion of bank loans by 20 years.

In May, a utility provider in the capital city of the financially weak Yunnan province repaid its domestic notes a day after their due date. And in October, a state-owned tourism group in Weifang, a city in China’s eastern Shandong province, missed $14 million in payments on nonpublic debt.

“In a lot of economically weaker regions and provinces, we’ve seen near misses and the last-minute scrambling to repay public bonds. It’s attracted more attention from the government to help alleviate these immediate liquidity problems," said Chris Yip, a credit analyst at S&P Global Ratings.

There has been an urgent push for local governments to issue so-called special refinancing bonds to replace some of their off-balance-sheet debt.

Since October, close to 30 Chinese provinces and cities have raised the equivalent of around $200 billion in such bonds. The fundraising was mostly in regions with high leverage including the provinces of Guizhou and Yunnan, and the city of Tianjin. The debt swaps have helped lower the risk of imminent local-government debt defaults, by giving local governments more time to come up with funds.

“It’s not enough, but I think this is just the beginning," said Robin Xing, Morgan Stanley’s chief China economist, of the debt exchanges that have been done so far. He reckons that there will need to be at least $700 billion worth of debt swaps to resolve the bulk of the troubled hidden debt.

“It is not really a restructuring plan but a refinancing plan. It leaves most of the problems with local government debt in place," said Logan Wright, director of China research at Rhodium Group, a research firm. A report that Wright co-wrote last month said the debt extensions or swaps will hurt China’s economic growth in the long run because more fiscal resources will be required for debt repayment.

“Markets should still be concerned about near-term default risk and resulting financial contagion from [local-government financing vehicles’] debt," Rhodium’s report said.

Most local-government financing vehicles currently depend on subsidies or capital injections from local governments and external funding. Most don’t generate enough cash from their operations to cover their interest payments, said Zhang Ning, a senior economist with UBS, after his team analyzed the financial statements of nearly 3,000 companies.

The longer-term solution, which could be hard to achieve, would involve restructuring some local-government financing vehicles’ debt and making them commercially viable enterprises. “The goal is not to come out debt free, but for them to become sufficiently profitable companies that don’t rely on governments for funding and support," said S&P’s Yip.

Serena Ng contributed to this article.


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