China’s debt explosion has alarm bells ringing when leaders meet

(Bloomberg) — When China’s leaders convene for their annual parliament next week in Beijing, one of the biggest economic risks they face is rising provincial debt.

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A majority of regional governments – at least 17 out of 31 – face a serious funding squeeze as outstanding loans exceed 120% of revenue in 2022, according to Bloomberg calculations based on available official data. This is the threshold set by the Treasury Department to indicate disproportionately high debt risks.

Tianjin, a provincial-level city known for its port and massive overdevelopment, faces the greatest threat with debt nearly three times its income.

The financial crisis has several effects on the economy. Although a regional government is unlikely to fail, high levels of debt could force some to rein in spending and push the central government to spend more. It could also prompt the People’s Bank of China to keep interest rates low to keep the provinces’ repayment burden under control.

“Rising debt means higher debt repayment and servicing costs for local governments and limits their scope for fiscal stimulus as return on capital falls,” said Lisheng Wang, economist at Goldman Sachs Group Inc.

Wang said the PBOC is likely to keep interest rates unchanged this year, partly due to the rapid expansion of government debt, as well as other reasons such as uncertainty about the economic outlook and still mild inflationary pressures.

The country’s lawmakers and leaders are meeting starting this Sunday to approve key economic targets for 2023, including a new local borrowing quota, the budget and also the overall direction of monetary policy.

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A broader measure of government revenue fell last year for the first time since at least 2012 due to Covid disruptions, the housing slump and record tax breaks, while spending rose 3%. The budget deficit rose to a record high, forcing the government to sell a record number of new bonds to fund the deficit.

Most of the government debt raised in recent years has been in the form of special bonds primarily intended to pay for infrastructure investments. This has been a key government tool to create jobs and bolster the economy when other drivers of growth, such as exports and domestic consumption, are weakening.

The bonds are to be repaid with income from projects. In reality, the revenues generated are nowhere near enough to cover the interest payments owed on any province’s debt, and local governments are finding it increasingly difficult to find suitable projects to use the money.

The outstanding debt of local governments topped 35 trillion yuan ($5 trillion) late last year.

This total excludes off-balance sheet borrowing through local government funding vehicles that provinces use to fund their spending needs. According to Yang Yewei, an analyst at Guosheng Securities Co., this “hidden” debt could be more than double the official local debt.

As debt has increased, so has the repayment burden on local governments. They repaid 3.9 trillion yuan in bond principal and interest payments on their official debt alone last year, and many more on their unofficial loans.

stimulus limitations

China’s leaders have repeatedly stressed the importance of fiscal sustainability and controlling local debt risks. That means that while fiscal stimulus is needed to help the economy recover this year, there may be less support than before.

“Central government scrutiny is likely to gradually tighten as a local government nears the debt threshold,” said Susan Chu, senior director of S&P Global Ratings. “Financial support from local governments for related state-owned companies is becoming increasingly selective.”

Beijing is considering setting a special bond quota of 3.8 trillion yuan this year, Bloomberg News reported, less than the actual issuance in 2022. Chu said higher-debt regions could get a smaller quota.

Tax breaks could also be scaled back, with the finance minister warning earlier this month that tax revenue growth “won’t be too strong” despite a low year-on-year basis.

political alternatives

One way to close the funding gap would be for the central government to borrow more and increase its transfers to the regions, reducing the need for local governments to take on additional debt. Economists have been urging China to take this approach for years, given Beijing’s ability to borrow cheaper than local authorities and its balance sheet being much healthier.

The government could also ask state-owned banks like the China Development Bank to spend more, similar to a 740 billion yuan investment lenders made under one of their programs last year.

Lower interest rates could also reduce financing costs for local governments and improve their purchasing power, Zhang Bin, a researcher at the state think tank Chinese Academy of Social Sciences, wrote in a statement. Assuming that the debt of the entire government sector is 82 trillion yuan, each one percentage point cut in interest rates could reduce interest payments by 160 billion yuan, he wrote.

–With support from Adrian Leung and Jin Wu (News).

(Updates with local debt return on investment details in 9th and 10th paragraphs and chart.)

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