In today’s Finshots, we tell you why China’s gargantuan debt rescue package might not be enough to wipe out its hidden debts.

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The Story

India’s stock markets have been in a bit of a slump lately. And sure, there are several reasons behind it — foreign investors selling off shares and Donald Trump’s surprise win as the next US president. But there’s also another culprit stirring up trouble — China’s massive 10 trillion yuan ($1.4 trillion) debt package.¹

This is China’s way of rescuing its local governments from a mountain of debt that’s spiralling out of control. And it’s no wonder that investors are pulling money out of Indian equity markets and shifting to China. They probably see this as a smart move for the Chinese government to prevent a financial crisis and kick-start its economy yet again. But… they could be wrong.

Why, you ask?

Well, let’s take it from the top.

Back in 1994, China overhauled its tax system.² It changed how tax revenues were split between the central government and local governments like municipalities, prefectures, townships and villages. The reform gave the central government a much bigger slice of the tax pie, while local governments were left scrambling. Over time, this shift meant that local governments saw their share of tax revenues drop below 40%, even as their national spending obligations soared past 60%. And to make up for the shortfall, they started leaning heavily on land-related revenue.

Luckily, China’s land system made this easy. Although all land is technically owned by the state, local governments have the authority to manage and lease land within their regions. So, they began leasing out “land use rights” to companies, developers and individuals.

But that strategy hit a wall when the 2008 global financial crisis rolled in. The economy was slowing, and the central government needed a way to stimulate growth without taking on all the debt itself. So, it came up with a workaround ― Local Government Financing Vehicles (LGFVs).

These LGFVs were entities separate from local governments but closely linked to them. Since local governments weren’t allowed to issue bonds or raise money directly back then, LGFVs did it for them. They borrowed mainly from banks to fund big infrastructure projects like roads, bridges and railways — basically, all the things that could boost their local regional economies.

And banks were more than willing to lend to LGFVs, thanks to two big reasons.

One, LGFVs had a lot of land which they bought cheaply from local governments and sold to developers at a profit. This land stash also boosted their balance sheets and made them look financially stable to banks. And two, the loans were essentially backed by local governments, so if an LGFV struggled, the government was expected to step in.

But here’s the catch. LGFVs weren’t regulated the same way as local governments. They were like shadow extensions, borrowing heavily and buying land. And unlike local governments, they could run budget deficits. So naturally, local governments pushed them to borrow more for infrastructure in hopes of higher land revenue.

And over time, this borrowing spiralled out of control.

Besides, since LGFVs didn’t have to report finances like local governments did, much of this debt was hidden or “off the books”.

By 2011, local government debt reached 10.7 trillion yuan ($1.7 trillion), nearly a quarter of China’s GDP at the time. So yeah, if LGFVs couldn’t repay their debts, the banks that lent to them would face massive losses. And that could trigger a financial crisis across China.

That likely spooked the government too. So, in 2015, they stepped in and changed the rules, letting local governments raise debt directly. They could now issue bonds and borrow from banks, pension funds, insurance companies and even regular investors.

The goal? Use these funds to pay off some of the LGFVs’ hidden debt.

And that’s exactly what China is doing again now. It announced another massive debt swap package of 10 trillion yuan.

This simply means that local governments will take on new debt to pay off old LGFV debt through a debt swap program. It’ll convert a lot of the risky LGFV debt into safer, government-backed municipal bonds. In other words, more LGFV hidden debt will come out of the shadows and onto the books, making it easier to track, manage and control.

The plan is to reduce hidden debt as much as possible over the coming years.³

But here’s the thing. This isn’t the first time China has tried this. Between 2015 and 2022, China issued over 10 trillion yuan in similar “swap bonds” to convert hidden debt into official debt.⁴ And while there isn’t any official data on the full scale of the current hidden debt, research from the National School of Development at Peking University found LGFV debt surging to 54.6 trillion yuan ($7.8 trillion) by the end of 2022. This was up from 32.6 trillion yuan in 2018. And that’s a massive two-thirds increase, despite the central government’s efforts to rein it in.

This time around may not be any different.

Because while swapping debt and bringing it out into the open might look like a solution, it doesn’t address the core issue: How will this debt actually get repaid once it’s on the books?

Think about it. Local governments have already drained their budgets after spending heavily on COVID lockdowns to maintain China’s zero-COVID policy. Now, they need more revenue to avoid defaulting on these debts. But that’s not easy because their main source of revenue — land leasing — has dried up. After the Evergrande crisis shook up the real estate market, property sales and land revenue have slowed significantly. So even though some of this debt is now officially on the books, there’s still not enough money coming in to pay it off.

The real problem? The funds needed to repay this debt are closely tied to real estate. And that’s why swapping the debt may not actually help.

So what will?

Maybe it’s time for China to do a full audit of its local governments to understand exactly how much hidden debt they’ve taken on. It could then rebalance the revenue sharing between the central and local governments, giving local governments a bigger slice of the pie to help avoid a financial crisis. Or perhaps they need to explore new forms of taxation to boost local revenue.

We don’t know for sure. All we know is that China needs to tackle the root of the problem instead of just kicking the can down the road by letting local governments take on new debt to delay existing debt repayments.

Will they be able to do it? Only time will tell.

Until then…

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Sources: The New York Times [1], Understanding local government debt financing of infrastructure projects in China [2], CNN [3], Nikkei Asia [4]

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