China’s Local Government Debt Doesn’t Seem Ruinous to Us

It is back! Chinese debt alarm, that is, with commentators we follow focussing on local government debts ... which many think are large—and could trigger a deep economic downturn. We think this has likely added to near-term uncertainty for Chinese stocks. But in our view and from a global perspective, the issue appears isolated, a widely known extension of China’s real-estate issues, and the economic effects are likely much smaller than most allege—particularly because the central government has plenty of firepower to step in with fiscal aid if needed, as we will explain. This doesn’t seem like a global risk to us.

The current concern centres on local government financing vehicles (LGFVs), which are off-balance sheet obligations China’s local governments use to skirt the central government’s restrictions on debt issuance and fund infrastructure and real estate projects.^[i] Because LGFVs are off-balance sheet, they aren’t officially accounted for, so their size is opaque.^[ii] Public estimates vary from £7 trillion to £10 trillion, which would be around half China’s 2022 gross domestic product (GDP, a government-produced measure of economic output).^[iii]

Ballooning LGFVs are an outgrowth of real estate weakness.^[iv] Before real estate’s downturn, when China’s local governments were short of tax revenue—like they were after 2020’s lockdowns crushed economic activity—they turned to selling long-term leases for land to property developers, seemingly buoyed by insatiable appetite for housing (and investment homes).^[v] But after 2021’s Chinese property developers’ travails, not so much.^[vi] In their place, LGFVs—which traditionally sold debt to fund public infrastructure projects—stepped in last year, going on a land (lease) buying spree.^[vii] China’s government then sought to crack down, which caused net issuance to dry up.^[viii] Many commentators we follow say this potentially hurts local governments’ ability to roll over existing debt, leading to current calls for a reckoning. A record level of LGFVs are coming due just as China’s ailing property markets and rolling lockdowns have drained local government coffers the last couple years.^[ix] This has them warning they may not be able to meet their LGFV obligations and spurred calls for financial assistance from Beijing.

In our view, the uncertainty over the problem’s size—and the response—could weigh on Chinese stocks for a spell, but a major spill over into global financial markets is likely limited. Whilst headlines we read suggest this is the next financial problem perking, with local defaults causing an economic downturn, we think how the government defused property developers’ debt bomb is instructive. Though selective defaults (on offshore bonds) were allowed, officials directed state-run banks to otherwise prop up the sector.^[x] Instead of a deep downturn, GDP grew 8.1% y/y in 2021 and 3.3% last year.^[xi] Whilst not great, we think it is a far cry from sharp contraction.

A similar situation appears to be developing now, in our view. Besides supporting real estate, China’s biggest banks have started offering 25-year loans to LGFVs, with some waiving interest and principal payments for their first four years.^[xii] Analysts we follow say this just shifts problems to banks, which could face ballooning non-performing loans as a result. However, we think it is important to keep in mind that state-run Chinese banks are, well, state run. Profitability may be nice, but they have a long history of being a government mechanism used to backstop, bail out and write off bad debts—in an orderly way, taking years if needed to unwind them—which we think markets reflect.^[xiii] Chinese banks are currently trading at a low, low price-to-book ratio of 0.4 compared to the All Country World Index’s 1.0, which is quite the discount.^[xiv] This implies markets see some major reason to force Chinese banks to trade at a discount—like their role in a potential bailout. That isn’t great for shareholders, perhaps. But the banks are backed by implicit state guarantees and have been recapitalized in the past when needed.^[xv]

Exhibit 1: Chinese Banks’ Discount to the All-Country World’s

Source: FactSet, as of 14/7/2023. MSCI China Banks and All Country World Index (ACWI) Banks trailing 12-month price-to-book ratio, January 2013 – June 2023.

Conversely, it appears Chinese banks’ (potential loan) loss could be LGFVs’ gain. LGFV credit spreads—a measure of the market’s perceived default risk—have narrowed this year.^[xvi] Whilst this could change, it is also worth noting that no LGFV has defaulted on its public bonds so far, though some have restructured their terms.^[xvii]

In the meantime, property developers and, now, local governments may have trouble borrowing, but the central government apparently doesn’t. The yield on 10-year China government bonds is 2.7%, whilst yields on equivalent maturity offshore bonds—traded globally—hover just above that.^[xviii] This isn’t too high a price to avoid a deep economic contraction—and help maintain social harmony—in our view.

We think this also points to how debt problems in China (and everywhere else, for that matter) generally resolve: Losses weaker hands can’t absorb are—sooner or later—borne by institutions strong enough to withstand them. Sometimes there are a lot of intermediate steps in between to help sort it all out. Besides bank support, an additional step being considered is simply loosening the restrictions on local government debt issuance that seemingly caused the LGFV mess in the first place.^[xix] In any case, since China’s banking system is largely walled off from global markets, we don’t see much of a transmission mechanism to the rest of the world.^[xx]

Although the central government appears reluctant to pull out the fiscal stops—e.g., massive public works’ spending—there is seemingly more recognition greater household consumption is necessary to drive sustainable growth.^[xxi] In China, consumer spending makes up less than 40% of GDP compared to over 60% in most of the developed world.^[xxii] This has been a long-running government goal: transitioning from investment and export-led growth to consumption and services-driven growth.^[xxiii] In that vein, the government has announced plans to take targeted measures to boost household consumption.^[xxiv] Whilst as yet unspecified, with the ability and intention to support growth, we don’t think it holds much water to argue a deep downturn is imminent. In our view, spending will likely still continue and local government investment alone wasn’t propping up GDP. So, despite some fears, this doesn’t look like a Chinese economic calamity in the making to us, but one more false fear in the wall of worry global stocks are climbing.