Is local government debt a serious threat to the Chinese state?

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Vanessa Yau's picture

It all started in late 2008, when Beijing unveiled an Rmb4trn stimulus program in an attempt to bolster national income amid the global economic slowdown1. The package spans over a period of two years, with over Rmb1.5trn to be poured into public infrastructure. With the central government only providing Rmb1.8trn, the rest was to be provided by local governments and private sectors 2, which in effect meant many of the funds had to come from extensive borrowing.

Under the Budget Law, local governments are not allowed to borrow from banks or the capital markets.3 After the stimulus program was announced, the number of LGFVs (Local Government Financing Vehicles) rocketed from an estimated 360 in 2007 to 8,821 at the end of 2009.4 These shell companies are set up to bypass the restrictions by channeling money into local government projects through bond issuance and bank loans.  A national audit by Beijing discovered that these companies racked up Rmb5trn of debt, which equals to 47% of the full Rmb10.1trn amount owed by local governments. 5 Victor Shih, celebrated political economics analyst at Northwestern University, estimates the NPLs associated with LGFV-related loans amount to Rmb2.3tn, a whopping 20.2% of the entire portion. 6

However, analysts are in agreement that the official data are severely understated. Local debt is estimated to fall in the range of Rmb15.4bn to Rmb20.1bn, in a study based entirely on official numbers by the CBRC and PBOC. 7 Coupled with central government debt, this puts China’s public debt at a dangerous level of 89% of GDP.

This essay attempts to assess the risks that underlie these debts and discuss what can be done to curb reckless borrowing in the future.

The key risk of insolvency comes from the maturity cycle mismatch of the debt structures in the large-scale infrastructure projects started after 2008, most of which are long-term investments that take years to build and do not bring enough revenues in the short term to service debt payments. For example, expressway construction LGFV Gansu Provincial Highway Aviation Tourism Investment Group Co. has bank borrowing amounting to Rmb55.9bn at Sept 2010, while its operational cash flow for the whole year 2010 was Rmb3.04bn, hardly enough to cover its interest payments at 6.56%, leaving no resources to pay down principal. 8 Worse cases, like Yunnan Highway Investment Limited, also an LGFV specializing in highways, attempted to default on its debts by sending a letter to its bankers in April 2011, announcing, “from today onwards, we will only be paying interest on our loans, and not principals”. 9

Another important factor adding to the risk of defaults is that local governments pay for 80-90% of their debts (and through explicit responsibilities or guarantees, debts of their LGFVs) using revenue from land sales, or use land as collateral when borrowing10. The first problem with this is that land is limited and cannot be sold off to generate revenues to repay debts forever. Also, some of the land used as collateral is actually protected land, like the Guanyinxia forest in Chongqing11, which effectively gives banks no safeguard from defaults. But the most significant issue is that the property sector is slumping, which brings land sale revenues down as well. Centaline found that 900 land auctions failed last year, up 300% from 201012, while the Ministry of Land and Resources shows that revenue from land sales fell 11% year-on-year.13 With land sales forming up to 74% of their revenue base, local governments are going to have a hard time in paying the loans maturing this year, which is an estimated amount of 53% of the total local government debt. 14

However, while these risks are real and reflect structural problems underneath, China’s public debt as whole should not be a cause for concern. Although local government loans are growing at a fast pace indeed, the Economist reports that through falling national debt and bank-restructuring bills, the level of total public debt has not changed much since 2004.15 Furthermore, with national GDP growing at a nominal rate of 15% last year16, China’s debt burden can be easily inflated away. Thus it seems that the PRC central government, armed with Usd3trn in reserves, is unlikely to be insolvent and it will most probably continue to bail out banks and financial institutions that need to be just like in the 1990s. Of course, bail-outs do cost precious resources that can be used elsewhere, especially for areas like healthcare, education, and pensions, services essential for continued urbanization in rural areas, but analysts are confident that no banking crisis will happen at this stage yet.

So what can China do to encourage better lending practices in the future? An efficient regulatory framework must be established to reap the benefits from subnational borrowing while minimizing its risks. Detailed restrictions should be written, governing the purposes of local government borrowing (eg. long-term borrowing must be used for capital investment, and not servicing debt incurred previously, with a legal trustee responsible for overseeing that the money is not diverted to other unauthorized purposes), the types of debt allowed, and procedures of issuing debt. Fiscal targets like debt service ratios, a balanced operating budget (the “golden rule” in western countries), and guarantee limits can also give local government officials different goals to pursue other than blind infrastructure expansion to achieve GDP growth.

The State of Ohio in the US has introduced a Fiscal Watch Program in its state government, as an early warning system to warn the Office of Auditor of State if local governmental entities are experiencing financial stress. 17  For China, it can use specific financial indicators to assess fiscal management, and alert local governments to start reducing expenditure and increase cash reserves.

The control mechanism used by France also has merits. Following the “golden rule”, non-balanced budgets or the incurrence of non-budgeted mandatory expenses would be referred to the Regional Chamber of Accounts, which would issue a statement giving recommendations. If the local government does not follow it, the Chamber has the power to implement a new budget. This type of strong supervision will allow China to filter substandard projects from a local government’s budget at an early stage.

Furthermore, fiscal transparency is a must for local governments to issue bonds. Current official figures often attract dispute from analysts, which does not instill enough confidence in investors. The Electronic Municipal Market Access (EMMA) website is set up in the US to provide free public access to official disclosure documents of municipal bonds, along with real-time trade data. With some richer cities as pioneers to start issuing their own government bonds, China should aim to have a similar website for local government bonds to facilitate the making of investment decisions for individual investors. Since bonds compete with each other for capital from investors, the enhanced availability of information will make it easier to compare across bonds, thus eliminating inefficient or weak profit-yield projects by market competition.

To conclude, China’s local government debt problem does not pose a major threat to the national economy at its size now. With better regulatory measures to encourage prudent borrowing and instill confidence into investors, China’s large domestic savings and the local governments’ fiscal autonomy make it well positioned to reform the landscape of local government borrowing.

  1.  David Barboza, The New York Times, China unveils $586 billion stimulus plan, Nov 11, 2008,
  2. Economic Observer News, China's Stimulus Package: A Breakdown of Spending, Mar 7, 2009,
  3. National People’s Congress, Budget Law of the People’s Republic of China, 1994,
  4. World Bank, The Urban Development Investment Corporation (UDICs) in Chongqing, China, 2009, Washington DC
  5. National Audit Office of the People’s Republic of China, No.35 of 2011 (General Serial No. 104) Audit Findings on China’s Local Government Debts, 2011,
  6. Victor Shih, Local Government Debt: Big Rock-candy Mountain, China Economic Quarterly, June 2010
  7. Victor Shih, The Financial Times, Guest post: China’s local debt problem is bigger than it looks, June 28, 2011, News, China Debts Dwarf Official Data With Too-Big-to-Finish Alarm, Dec 18, 2011,
  9. 温秀, 張宇哲, 于宁, 鄭斐, 云南高速公路建融資平台近千億貸款違約, June 27, 2011,
  10. Lili Liu, Strengthening Subnational Debt Financing and Managing Risks, Aug 16 2010,
  11. Geoff Dyer, China warned of growing ‘land loan’ threat, Mar 28 2010,
  12.  Simon Rabinovitch, The Global and Mail, Debt worries grow as China land sales slump, Jan 5, 2012,
  13. Tom Orlik, The Wall Street Journal, China Tallies Local Debt, Jun 28, 2011,
  14. Simon Rabinovitch, The Global and Mail, Debt worries grow as China land sales slump, Jan 5, 2012,
  15. The Economist, How manageable is China’s red ink?, Jun 28, 2011,
  16. Jamil Anderlini, The Financial Times, Behind its lectures, China is a sinner,too, Aug 11, 2011,
  17.  Lili Liu, The World Bank, Strengthening Subnational Debt Financing and Managing Risks, Aug 16, 2010,