It’s no secret that local governments in China have long been using "third-party" companies in order to fund their local maintenance and infrastructure projects – a practice referred to as Local Government Financing Vehicles (LGFV). But what has only recently become clear is that these LGFV’s have accumulated an estimated 10.7 trillion RMB (1.7 trillion USD) in debt… a sum equivalent to 56% of China’s GDP. This situation has been exacerbated by the lack of transparency and legality for many of the loans. If local governments end up defaulting on these debts, it could potentially derail the Chinese economy.

Problems on the horizon

In its annual report back in June, The Chinese National Audit Office warned about the impending doom of this mounting local government debt. One problem that it noted is that for a long time, provincial budgets were classified as "state secrets", and were thus completely unknown to all but a few officials. After the practice (and the implications of it) became known, the State Council warned local governments to stop using LGFVs, which relied solely on government income. This move was quite understandable: LGFVs are very risky investment platforms that aren’t real commercial organisations, and their existence diminishes overall debt accountability. Further, they lack a sufficient safety net for potential bankruptcy issues.

Because local governments are not permitted to sell bonds or take bank loans, they set up "third-party" companies as a method to finance infrastructure projects, such as constructing new roads and subways. However, these "companies" have little to no repayment capacity, and banks are consequently saddled with credit risk. Shockingly, many of the loans were issued backed only by land holdings and the promises of officials. The Bank of China, which issued many of these loans, has sought to calm fears about the mountain of debt. It has argued that because most of the debt went into infrastructure projects, they will automatically generate returns. The bank’s president Li Lihui has also said that 90% of these loans are covered by cash flow.

A Chinese debt crisis to resemble America’s?

If Chinese banks get saddled with bad loans that are not repaid, there’s a further risk that China’s credit rating may get downgraded by firms such as Standard & Poor, and Fitch. The crisis would then begin to mirror the US debt crisis, which saw the collapse and federal takeover of Fannie Mae and Freddie Mac, and more recently saw Standard & Poor downgrade America’s AAA credit rating. Another study has also shown that 28% of LGFVs are losing money and are therefore not sustainable. These fears are compounded by a report by the China Securities Journal, which explained that 43% of LGFV debt will reach maturity within two years.

Many critics of the Chinese banking system argue that added transparency in the system of loan allocation could potentially remedy the problem. Other proposals have included allowing local governments to issue bonds directly, or establishing an independent fund to absorb bad loans. Also, tighter regulation of local Government finances is absolutely crucial, in order to ensure that the central government isn’t forced to bail out local governments. These dilemmas are yet another consequence of China’s emergence as an economic powerhouse, and have the potential to heavily mirror the US’s economic rollercoaster of the past three years.
 

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Keywords: China Local Government debt Bank of China China Credit Rating Local Government Financial Vehicles