China’s Local Government Debt Still Isn’t Ruinous

They are back! Chinese debt fears, that is, with most attention lately centered on local government debts ... which many fear are large—and could trigger a hard landing. This has likely added to near-term uncertainty for Chinese stocks. But from a global perspective the issue is isolated, a widely known extension of China’s real-estate issues, and the economic effects are likely much smaller than most fear—particularly because the central government has plenty of firepower to step in with fiscal aid if needed. This doesn’t seem like a global risk to us. Let us explain.

The current concern centers on local government financing vehicles (LGFVs), off-balance sheet obligations China’s local governments use to skirt debt issuance restrictions and fund infrastructure and real estate projects. Because LGFVs are off-balance sheet, their size is opaque. Public estimates vary from $9 to $13 trillion, which would be around half China’s 2022 GDP.^[i]

Ballooning LGFVs are an outgrowth of real estate weakness. Before its 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). But after 2021’s Chinese property developers’ travails, not so much. In their place, LGFVs—which traditionally sold debt to fund public infrastructure projects—stepped in last year, going on a land (lease) buying spree. China’s government then sought to crack down, which caused net issuance to dry up. Many fear this potentially hurting 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. 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 spillover into global financial markets is likely limited. While frantic headlines suggest another (made-in-China) shoe is about to drop, with local defaults causing an economic downturn, 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. Instead of the long-feared hard landing, GDP grew 8.1% y/y in 2021 and 3.3% last year.^[ii] While not great, we consider this a relatively soft—if still bumpy—landing.

Like then, a similar situation appears to be developing now. 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. Analysts say this just shifts problems to banks, which now face ballooning non-performing loans. However, keep in mind that state-run Chinese banks are, well, state run. Profitability may be nice, but they are also meant to backstop, bailout and write off bad debts—in an orderly way, taking years if needed to unwind them—which markets reflect. 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.^[iii] Not great for shareholders, perhaps. But the banks are backed by implicit state guarantees and have been recapitalized in the past when needed.

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

Source: FactSet, as of 7/14/2023. 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 market’s perceived default risk—have narrowed this year.^[iv] While 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.

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

It 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 restrictions on local government debt issuance that caused the LGFV mess in the first place. 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.

Although Beijing 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. In China, consumer spending makes up less than 40% of GDP compared to over 60% in most of the developed world.^[vi] This has been a long-running government goal: transitioning from investment and export-led growth to consumption and services-driven expansion. In that vein, the government has announced plans to take targeted measures to boost household consumption.^[vii] While as yet unspecified, with the ability and intention to support growth, we don’t think it holds much water to argue hard landing is imminent. In our view, spending will 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, it is one more false fear in the wall of worry global stocks are climbing.