(Bloomberg) — China’s property market crisis is making it difficult for local governments to cut an estimated $6 trillion in hidden debt even as Beijing shows more determination in cracking down on the problem.
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Beijing, Shanghai and Guangdong Province are planning experiments to eliminate off-balance sheet borrowing that local authorities use to raise money for spending. Although no details are available, it is likely that the pilots will eventually be rolled out to more than 31 other regions of the country.
The central government is getting more serious about tackling the financial risks associated with debt, which it called a “national security” issue earlier this year. Authorities must balance the push to fix the problem with efforts to keep standard bond defaults and a slowing economy from spiraling out of control.
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The downturn in the real estate market will not make it an easy task. Land sales, which account for about 40% of local government revenue, have fallen since August, putting pressure on public finances. Moody’s Investors Service is warning that land sales income may fall and local governments will likely take on more, not less, debt to fund infrastructure.
Here’s a look at what government-linked economists say are the challenges in trying to cancel debt.
What is hidden debt?
Local governments, under pressure to support growth in the wake of the 2008 global financial crisis, have set off a voracious borrowing frenzy to fund infrastructure projects as part of China’s 4 trillion yuan ($626 billion) stimulus package.
Before the new budget law was passed in 2015, regional authorities were not allowed to borrow directly. Instead, Beijing encouraged them to use state-owned enterprises now known as local government financing mechanisms, or LGFVs, to raise money through bank loans, and later issue bonds.
Debt does not appear on the balance sheets of local governments, but it carries an implicit guarantee of its repayment with public money. Most of the debt is owned by local banks, so the rise over the years has led to moral hazards and risks to the financial system.
In a way, hidden debt is emblematic of China’s old growth model, one that relies heavily on investment and debt-fueled urbanization.
How big is the problem?
A large part of the problem lies precisely in the fact that there is no way to be sure exactly how much debt local governments have accumulated.
The International Monetary Fund estimates that LGFV’s debt amounted to 39 trillion yuan ($6 trillion) in 2020. Goldman Sachs Group estimates it at 53 trillion yuan. Using a narrower definition, the state-run National Corporation for Finance and Development estimates 15 trillion yuan.
The problem is compounded by the stagnation of real estate. On the other hand, LGFV bonds have become popular among investors looking for a haven in state-backed assets, following the sale of private developer bonds. On the other hand, many LGFVs consider land as their main asset and reduced land sales may harm their ability to pay off debt.
Beijing is also likely to rely on state firms to help ease pressures in the real estate market, which could make it more difficult to reduce hidden debt. Local state-owned enterprises and LGFVs could be called in to help, for example, by buying more land or bailing out businesses if needed.
said Mao Jie, a professor at the University of International Business and Economics who advises the Ministry of Finance.
“It’s a systemic challenge,” he said, to settle hidden debts. “Both local governments and the market need to make massive changes in the way they operate.”
How can counties handle it?
Several options are available, according to experts.
Paying off debts from financial income
Some cities in Guangdong province have repaid LGFV debts from public income, and this remains one of the manufacturing center options during its trial, said Wen Laicheng, a professor at the Central University of Finance and Economics. Mao said Guangdong may cancel its hidden debt within two years.
Pay off debt by selling LGFV, assets or government stock
This can help local governments use assets more efficiently, although their resources will be less, said Cui Zhiguan, a professor at the Beijing National Institute of Accountancy, under the Ministry of Finance.
Pay off debt with project returns and LGFVs profits
Wen said this could only be viable in a few places like Shanghai, because most LGFVs are public welfare projects and have limited returns.
Convert LGFVs into real market entities
This would turn hidden debt into corporate debt, as LGFVs take on more profit-driven businesses, such as utilities and construction, rather than public welfare projects.
Replace hidden debts with refinancing bonds
A total of 688 billion yuan of these bonds had been sold as of the end of October with the goal of paying off existing debt, according to GF Securities Co. Ltd. Place in Beijing, Shanghai and Jiangsu Province mainly, according to China Industrial Securities Co. Ltd.
Restructuring or bankruptcy of LGFVs
While none of the LGFVs have yet to default, provinces including Jiangsu and Yunnan have said they will restructure or liquidate LGFVs that have lost repayment capabilities. Cui said bankruptcies may be a necessary cost to pay to fix some LGFVs, while at the same time China needs to be protected from any “malicious evasion” of debt repayment by local authorities.
What is happening so far?
China has tried to control hidden debt over the past decade. Here are some examples of success in different areas:
Shanxi Province merged about thirty highway construction companies into one entity, which signed new loan arrangements with banks and reduced interest payments
Shanghai SMI Holding Co., Ltd. Ltd. One of the earliest examples of successful LGFV repair, according to Mao
Liaozhong District of Shenyang City, northeast of the country, repaid 15 million yuan of debt with assets in 2019
Duolun County in Inner Mongolia has paid off 600 million yuan of hidden debt with the real estate they own
Authorities set up a domestic bond market in 2015 to move funding away from the more obscure LGFV debt.
Going forward, trials next year are likely to expand to more cities in less developed regions, such as western provinces, according to Zhang Yichun, a member of the China Public Finance Association. Despite the challenges, he said, the country is likely to reduce all hidden debt by 2035, and regions with better financial resources may be able to achieve this by 2025.
“About half of the debt will be repaid, and the other will turn into balance sheet debt,” Zhang said.
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