China is backsliding on a pledge to impose fiscal discipline on local governments by phasing out borrowing through special-purpose vehicles that allow provinces, cities and counties to skirt restrictions on local debt.
In landmark policy guidelines two years ago known as “Document 43”, China’s cabinet stated that borrowing by local government financing vehicles — investment companies owned by the government but ostensibly separate from the fiscal budget — “must not increase government debt”.
But after a dip in 2015, off-budget debt has returned this year. Net bond issuance by local government financing vehicles (LGFVs) hit Rmb1.07tn ($160bn) through late September, higher than the Rmb946bn issued for all of 2015, according to data from Wind Information.
The resurgence reflects Chinese policymakers’ efforts to boost the economy through quasi-fiscal spending on infrastructure by state-owned enterprises to buffer a slowdown in manufacturing investment by private groups. The International Monetary Fund estimates that China’s “augmented” fiscal deficit — a figure that includes LGFV borrowing alongside central and local government bonds — will reach 10.1 per cent of GDP in 2016, above the finance ministry’s official deficit target of 3 per cent for 2016.
“There was some compromise from day one. At the beginning they were talking about completely shutting down LGFVs. But in the official document there was no firm deadline,” said Zhu Haibin, chief China economist at JPMorgan in Hong Kong. “There will be a few years’ grandfathering period. Particularly when local governments are facing fundraising difficulties, (LGFV) bonds will pick up.”
Local government debt ballooned in the aftermath of the 2008 financial crisis, as Beijing gave local officials free rein to fund infrastructure projects with bank loans, bonds and shadow-bank credit. Most local borrowing occurred through LGFVs, whose legal status as corporations with an arms-length relationship to their government owners enabled them to skirt a legal ban on direct borrowing. Local-government debt totalled Rmb28.2tn at the end of 2015, equal to 41 per cent of gross domestic product, according to the International Monetary Fund.
In a paper published last week by the Brookings Institution, Bai Chong-en, economist at Tshinghua University in Beijing and a member of the Monetary Policy Committee at China’s central bank, found that LGFV spending worsens capital allocation and likely led to a “permanent decline in the growth rate of aggregate productivity and GDP”.
Realising that the debt surge threatened financial stability, the central government in 2014 moved to impose strict limits on local borrowing. Under the moniker of “open the front door, block the back door”, China’s parliament revised the budget to allow provincial governments to issue municipal bonds directly for the first time, subject to an annual quota approved by China’s legislature. Meanwhile, Document 43 appeared to forbid new debt issuance by LGFVs.
But signs of softening towards LGFV financing appeared within months. In March 2015, the cabinet directed banks to continue lending to LGFVs for projects already under way, a climbdown from the outright halt called for several months earlier.
Analysts now say that Document 43 was actually never intended to halt borrowing by LGFVs. Instead, the goal was to clarify that LGFVs would henceforth maintain a genuinely arms-length relationship to their government owners, meaning their obligations would no longer be “government” debt.
“LGFVs can still borrow from the markets, but investors should be aware that LGFVs are transforming, and their relationship with their owner-government is changing, such that the investors should not take implicit government support for granted,” said Ivan Chung, head of greater China credit research at Moody’s, the rating agency. “We see more differentiation in pricing for the hundreds of LGFVs in the onshore bond market. LGFVs belonging to cities, counties and districts from poorer or highly indebted regions are paying higher yields.”
As with other state-owned enterprises, the government was never been legally responsible for repaying LGFV debts. Yet market participants widely understood such loans and bonds as carrying an implicit government guarantee. That perception was bolstered by local governments’ frequent practice of providing cash subsidies or asset injections to keep their LGFVs solvent.
Document 43 was meant to mark a new era. Following an official audit to reveal the full extent of LGFV borrowing, the ministry of finance last year launched a debt-swap programme to transform LGFV bank loans into newly-legalised municipal bonds. In 2015, Rmb3.2tn worth of LGFV loans were swapped for bonds, and this year’s target is Rmb5tn.
Analysts say the swap amounts to a one-off amnesty in which implicitly guaranteed LGFV debt is transformed into municipal bonds that are explicit obligations of provincial governments. By around 2018, all LGFV bank loans in the latest audit, which covered the end of 2014, will have been transformed. For post-2014 debt, LGFVs are supposed to sink or swim on their own.
“The distinctive function of LGFVs versus governments are getting separated. The new principal is ‘Whoever uses, borrows; whoever borrows, repays’,” said Yan Liqiong, public utilities analyst at China Bond Rating, a local rating agency.
But the IMF remains unconvinced of LGFVs’ supposed independence. The fund estimates that when LGFV debt is included, China’s local government debt will grow by 4.2tn in 2016, far above the official Rmb1.2tn quota for provincial bond issuance this year.
Ms Yan believes compromise is inevitable as China seeks to wean itself from off-budget financing amid slowing growth. “With infrastructure construction as an important lever to stabilise the economy, investment demand is very heavy. Relying only on the official bond quota isn’t enough,” she said.
Additional reporting by Ma Nan