Will China Defuse Its $13 Trillion LGFV Debt Time Bomb?

The Chinese leaders' meeting later this month could be the perfect moment for policymakers to defuse the $13 trillion time bomb that is imperiling Asia's largest economy.

While China's real estate crisis is grabbing headlines, the debt problems plaguing municipalities across the country also require urgent action.

The problem is the explosion in recent years of local government financing vehicles (LGFVs). These debts, the vast majority of which are off-balance sheet, now almost rival China's annual gross domestic product (GDP).

Between the default drama surrounding giant real estate developers and the glut of LGFV, it's easy to see why global investors are concerned about China's economic fundamentals, especially at a time of extreme global uncertainty.

With U.S. bond yields remaining high, Japan teetering on the brink of recession and Europe lagging behind, the second half of 2024 isn't exactly fertile ground for China to generate an export surge.

The good news, however, is that Xi Jinping's Communist Party appears ready to tackle the LGFV time bomb. According to local press, a long-delayed economic strategy session is scheduled to be held from July 15-18 to hammer out a solution to the massive debt.

At the third plenum, Xi Jinping’s inner circle is expected to allow local governments to keep more of the tax revenues they generate that currently go to Beijing. The necessary reforms to China’s tax system could be a big step toward eliminating one of the most immediate threats to financial stability.

It could also be a key step to invest more in high-value manufacturing sectors while boosting currently flagging domestic consumption. The problem is the lack of social safety nets that push mainlanders to save more than they spend.

The increased revenue would give local governments more room to invest in innovation and productivity-enhancing industries and make municipalities less dependent on property and land sales to stay afloat. It would also make debt issues less attractive.

It is hard to overstate the impact such a shift could have. Fixing China’s financial vulnerabilities is only part of the process. The other is to strengthen China’s economic power and put it on a path to growth.betternot onlyfaster.

Since the Lehman Brothers crisis in 2008, Beijing has relied heavily on the 34 provincial-level administrative regions to fuel its economic growth. Even before that, regional leaders often attracted attention in Beijing by announcing GDP figures that were higher than the national average.

This explains the infrastructure race that is taking place across the country. Today, the bill for all those gigantic skyscrapers, six-lane highways, international airports and hotels, white elephant stadiums, sprawling shopping districts and amusement parks is coming up fast.

LGFVs have played a critical role in financing China's colossal infrastructure development, which has also helped drive up land prices in what was previously a virtuous growth cycle, notes Henry Storey, an economist at the Lowy Institute think tank. In the heady days before China's property sector collapsed, land revenues were a seemingly inexhaustible source of subsidy largesse.

This growth model is not without its drawbacks, Storey notes. After decades of overindebtedness, he says, local government debt accounts for more than half of China’s GDP, a dynamic that is completely unsustainable when median asset yields hover around 1%. Local governments now spend about 19% of their total budget resources on interest payments.

In the coming weeks, Xi Jinping has an opportunity to carry out a major reboot of the country. Since taking office in 2012 and 2013, he has pledged to recalibrate an economic model that he says has become unbalanced, uncoordinated and unsustainable.

But despite the capital importance economic change since many of the ambitions declared by governments remain the same, explains economist Diana Choyleva of Enodo Economics.

For this vision of high-quality development to be realized, Xi will need to be able to fully implement reforms, Choyleva says.

Of course, Choyleva adds, the success of these supply-side reforms will not be enough to put the economy on a sustainable growth path without the structural changes needed to create real consumer demand. Yet most of these changes are conspicuously absent from the debate.

The coming weeks could provide that missing link and mark one of the biggest changes to China’s fiscal system in the Xi era, if not in the past two decades. It would also be a major step toward fulfilling Xi’s promises to overhaul China’s $61 trillion financial sector.

According to Sherry Zhao, an analyst at Fitch Ratings, local and regional governments will still face challenges in supporting LGFVs due to declining revenues from land concessions. Economically stronger regions are likely to have greater resilience, as they are better equipped with public assets and stronger financial resources to resolve long-term debt.

More dynamic financial markets would help reduce volatile boom-bust cycles. Reforms would also give municipalities more room to implement policies to spread the benefits of economic growth.

Analysts agree that a major disruption is needed. economy The reactor is not melting down, but it is certainly operating well below its potential, and the government seems reluctant to do what it takes to get it back up to full capacity, says Arthur Kroeber, an analyst at Gavekal Dragonomics.

As always, much will depend on implementation. Over the past 13 years, Xi Jinping has sometimes proven himself better at talking about bold reforms than implementing them. But that may well change, and in a fundamental way.

Last week, the 24-member Politburo noted that a resolution on comprehensively deepening reforms and promoting China's modernization would be circulated among Beijing's elite. The priority is to transform the nation into a high-level state. socialist market economy by 2035.

One reason for the hope for reform is that, unlike in past times when major policy pivots were announced, the upcoming third plenum does not coincide with major changes among top leaders, said Haibin Zhu, an economist at Morgan Chase & Co. That is not the case this time, Zhu said.

According to economists, continuity could improve the chances of implementing reforms.

The plenum is likely to maintain the economic framework that has taken shape in recent years: prioritizing chokepoints in supply chain self-sufficiency and technological innovation, says Robin Xing, an economist at Morgan Stanley.

Shuang Ding, an analyst at Standard Chartered, believes this month will be a key moment for Xi Jinping's reform legacy. “We expect the plenum to reiterate the Party's support for private sector expansion as well as a stronger public sector and the decisive role of the market in allocating resources.”

“More importantly,” Ding adds, “we believe they will take steps to remove inter-regional barriers, encourage innovation and green transition, and improve income distribution. We also expect them to place greater emphasis on security, risk management in the housing and financial sectors, and increasing supply chain resilience. The market will likely pay close attention to potential tax reforms that are critical to long-term sustainability.”

This latest initiative could be a game-changer for local governments, although it is unlikely to boost GDP significantly in the short term. In fact, efforts to clean up local government finances would only worsen economic difficulties in the short term.

The focus on deleveraging the real estate sector and LGFVs continues to put downward pressure on growth and deflation continues, Xing says.

In recent months, LGFVs have found it much harder to issue bonds as regulators have stepped up efforts to reduce risks in one of China's most indebted sectors.

This indicates that regulatory tightening has been ongoing since the fourth quarter of last year and we have not yet seen signs of easing, says Laura Li, an analyst at Standard & Poors.

This suggests that it is increasingly difficult for low-quality and poorly rated LGFVs, including those in rich provinces such as Jiangsu and Zhejiang, to issue bonds in the future, Li added.

But allowing local governments to keep more tax revenue could dramatically change incentives. As economist Jonathon Sine, author of the newsletter Cogitations, explains, Beijing has in recent decades sought to channel revenue through its own coffers for control purposes, including over subordinate levels of government and redistribution.

This becomes clear when you realize that the central government simply transfers almost all the money, Sine explains. Indeed, once transfers are taken into account, the often-discussed budget gap between central and local governments disappears. Unfunded mandates did indeed materialize after the 1994 budget reform, but in a more nuanced way.

But the problem still lies in the nature of the intergovernmental transfer system, he said. Beijing bureaucrats distribute funds to provinces, which are responsible for distributing them to prefecture-level cities, which are responsible for distributing them to county-level units, which are responsible for distributing them to townships.

Sometimes, Sine notes, provinces send funds directly to counties, bypassing cities. Each level also needs its own funds. And it can take months for each level to pass on the funds it has received. By the time the funds get from the top down, it can take a year or more.

By ending this MC Escher-style financial system, China could increase the efficiency of the world's second-largest economy, disrupt distorted incentive structures, and bring Xi closer to delivering on his promises of high-quality growth.

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