3.03  China’s Local Government Debts

16 September 2018

Rise of Local Government Debts after the 1994 Fiscal and Tax Reforms


There are five levels of government in China: central, provincial, prefectural/municipal, county, and township/village. Governments at all levels in China rely to a greater or lesser extent on debt financing. Here, “local government debt” refers collectively to obligations of the lower four levels.


By all accounts, local government debts really began after the 1994 fiscal and tax reforms.


Through the 1980s and the early 1990s, the central government implemented a series of reforms to decentralize its fiscal system in order to provide more incentives for local government to promote economic growth. However, this fiscal decentralization led to widening fiscal disparity and shrinking central government revenues. The introduction of tax-sharing reform in 1994 was therefore meant to boost the central government revenues and enhance intergovernmental transfers.


As a result of the reforms, local governments receive only around 50% of all tax revenue in China, but are responsible for around 80% of total fiscal expenditures. The gap has to be filled mostly by borrowing. By the end of 2004, a decade after the fiscal and tax reforms, it was estimated that Chinese local government debts were close to 2.5 trillion yuan.[1]


Global Financial Crisis in 2008 and Rise of Shadow Banking


Local government debts grew rapidly particularly after 2008 when the Hu-Wen government implemented the “RMB 4 trillion” fiscal stimulus plan to counteract the negative impact of the Global Financial Crisis (GFC) on the Chinese economy. The fiscal plan emphasized infrastructure investment, large-scale engineering projects, and social welfare housing construction. Over 60% of funding for those projects came from local governments, which issued additional debt to pay for them. In one year alone, between 2008 and 2009, debt totals almost doubled. By the end of 2009, it was estimated that Chinese local government debts were about 10.0 trillion yuan.[2]


At that time, Chinese law forbade most local government agencies from directly issuing bonds in the capital market or borrowing from banks. Those who are eligible for issuing bonds must go through the strict approval procedure of the Ministry of Finance and the size of the quota is small. Hence, to finance the gap between desired expenditures and revenues, the central government encouraged local governments to establish more local government financing vehicles (LGFVs). The debt issued by LGFVs is backed by the sponsoring local government, either directly or indirectly. Many local government agencies shift land resources to LGFVs to serve as collateral, or pledge future government fiscal revenues when LGFVs borrow from capital markets. Local government agencies are also big borrowers.[3]

Notably, local governments were borrowing not only to fight the crisis. Rather, most increased investments so as to compete with each other for best short-term economic performance which is the central's evaluation criteria of local officials for promotion. To finance the investments, local governments can borrow in a variety of opaque ways including through the shadow banking system, which began to expand rapidly.


The most important lenders to local governments then were the banks—both commercial banks and government-run policy banks (primarily the China Development Bank). To avoid the tightening regulations that restrict bank loans to local governments and other out-of-favour industries, banks began to establish a parallel shadow banking which are complex off-balance-sheet structures to discreetly finance local government projects. For example, banks sell wealth management products to the public and then lend the money to local governments. Banks can also lend to trust companies, which then make loans to local governments. Those assets appear as investments in corporate securities rather than as loans on the banks’ balance sheets. Through the working of the shadow banking system, the actual percentage of financing for local governments coming from the banking system exceeds the percentage reported. Apparently, the banks believed that local governments would find a way to make good on their obligations despite the very high debt levels and limited revenue sources.


In the years that followed, to combat the economic slowdown brought on by the GFC, local governments continued to borrow heavily. The figure soon reached 17.9 trillion yuan (including 7.0 trillion yuan of contingent liabilities) by June 2013, increasing by 67% from 2011.[4] The speed at which the local government debt level was rising was alarming but China was not on a verge of fiscal crisis. The total government debt was hovering around 58% of GDP, a level that is less than half the debt burdens in Japan and Greece where public finances were strained.


Still, investors were increasingly worried about the ability of local government to repay the debt since most of the money borrowed had been used on non-lucrative public infrastructure projects with uncertain revenue streams. A report from National Audit Office, China’s state auditor, also revealed that local governments were using new loans to repay more than a fifth of their debt.[5] 


At the same time, there were also concerns over sustainability of local governments’ heavy reliance on land sales revenue to service the debts. Generally, local governments own large areas of land and can lease it (i.e. not sale) to the private sector. Land is also used as collateral for bank loans. In recent years, with the pressure to finance investments and repay debt, growth rate of land sales was as high as 60%. Based on data from 23 provinces, it was found that, on average, they promise their creditors to repay 40.31% of debt using land sales. Some provinces rely on land sales to repay more than 60% of local debt. There were even reports that when real estate sales slumped and demand for land from commercial developers evaporated, local officials used their financing vehicles to purchase land from themselves using credit from both state-owned and shadow banks.[6] Unlike tax revenue, however, land supply is not renewable. In a research done in 2013, it was estimated that at the prevailing selling speed, local governments would run out of land resources within ten years. The exhaustion of land resources and a cooling property market could end in fiscal distress if alternative revenue streams are not developed.[7]

In 2014, amid growing concerns local governments’ abilities to service the debts, a new national audit revealed another spike in local government debts which rose to 15.4 trillion yuan (US$2.42 trillion), along with 8.6 trillion yuan of contingent liabilities. Calls for China to accelerate financial reforms grew louder.


Rule No. 43 in 2014 - New Guidelines for the Supervision of Local Government Debt


In response to mounting concerns over local government debts, the central government instituted a number of policies of which the most significant is Rule No. 43 issued by the State Council issued on October 2, 2014. The document was seen by the market as a meaningful blueprint for reforms laying out new guidelines for the supervision of local government debts. Through those guidelines, policymakers hoped to create a standard procedure for local governments to raise debt, to clarify the responsibilities of debtors and creditors, to incorporate local debt into the overall management of fiscal budgets, and to put local debt growth on a sustainable path that avoids systemic risk.[8]


Specifically, Rule No. 43 calls for:

  • Strictly supervising the financing channels of local governments. With the approval of the State Council, qualified provincial governments will be allowed to issue government bonds to finance their investment projects. Prefectural and lower levels of governments, if in need of financing, can ask provincial governments to issue bonds on their behalf but they cannot issue government bonds independently.

  • Shutting down non-standardized financing channels. Local governments are no longer allowed to borrow from firms. (A supplementary document from the Ministry of Finance stipulates that beginning in 2016, LGFVs are forbidden to issue bonds, and LGFVs will be shut down gradually.)

  • Local governments should issue general-purpose bonds (普通债) to finance social welfare projects that generate little revenue, to be repaid from budgetary fiscal revenue. For projects that generate adequate cash flows, like some municipal infrastructure projects, local governments are to issue specific-purpose bonds (专项债) and repay with revenue or profits from the projects. 

  • Local governments cannot provide guarantees for firms, private institutions, or persons without legal authorization. Except for guarantee for foreign (transferred) loans, which is permitted by Guarantee Law of the People’s Republic of China enacted in 1995, all other kinds of guarantees will no longer be legally permitted.

  • A major overhaul of the infrastructure for local government debt. That includes the local government bond market, the credit rating system, policy measures to cope with default, the local fiscal transparency regime, stricter supervision of local government officials, etc.


Issuance of Local Government Bonds and Debt Swaps in 2015

Besides the Rule No. 43, the Budget Law of the People’s Republic of China was amended and enacted on January 1, 2015 to allow all provincial governments to issue local government bonds in the capital market. The issuing size of local government bonds must be permitted by the National People’s Congress of China and must be included in the local fiscal budget. This is considered a significant legal step to open a more standardized and transparent financing channel for local governments.


In addition, under the guarantee of the Ministry of Finance, debt-swap deals were launched to help local governments replace their short-term, high interest rate bonds with long-term, low interest rate bonds. In total, about 3.2 trillion yuan of such liabilities were swapped into bonds in 2015.[9] By the end of 2016, that figure went up to 8.1 trillion yuan.[10] Besides easing the stress of local governments, these measures served to improve bank asset quality.


One way central government sought to increase fixed asset investments while restraining growth of local government debts was to encourage public-private partnership (PPP) in infrastructure projects. Since mid-2015, the National Development and Reform Commission, the nation’s economic planner, had released PPP proposals worth 6.4 trillion yuan. The government also simplified approval processes and offered incentives for private investment in infrastructure.


Raising Government’s Debt Ratio to Reduce Corporate Sector’s Leverage Ratio in 2016


In May 2016, the Chinese government further announced that it would increase its leverage ratio to support a gradual reduction in the corporate sector’s leverage ratio which was believed to be around 120% to 160% of GDP. According to the Ministry of Finance, the government could do so because its debt levels were still low compared with other major economies. As of the end of 2015, the government debt ratio – including direct and contingent debt – was just 41.5% of GDP. Comparatively, this was much lower than Japan’s 200%, France and the US’ 120%, Brazil’s 100% and Germany’s 80%. Moreover, the local government debts were backed by “a great number of high-quality assets” and were generally under control. Hence, the Chinese government asserted that its debts were “different from those countries facing debt crises”. [11] In effect, the announcement pointed to the possibility, and perhaps the likelihood, of a more major central government bailout should debt levels become unmanageable for some provincial governments. By this time, analysts projected that the combined debt in government, corporate and household sectors, estimated to be between 250% and 280%, was on track to hit 300% of GDP by 2020. [12]


Meanwhile, because of government clamp down on borrowings, local government has become more and more inventive in securing financing for their infrastructure projects. As a result, the problem of implicit or “hidden debt” – including credit guarantees for borrowings by local government financing vehicles, local state-owned enterprise debt and public-private investment schemes – has become more pronounced in recent years.  In 2016, for example, UBS estimated that government debt, including explicit and quasi-government debt, rose to 68% of GDP from 62% in 2015.[13] In early 2017, as part of wider efforts to keep borrowing in check and avoid widespread defaults, China’s Finance Ministry began to name and shame a handful of local governments.

Beside the issue of implicit debt, another emerging worrying trend is the unequal regional distribution of debts. The more affluent eastern provinces have the most local debt in absolute terms, but the smallest amount as a share of local GDP. The poorer western provinces actually have the highest debt burden as a share of GDP. Based only on budgetary revenue, some western provinces like Guizhou, Gansu, and Qinghai have debt-to-fiscal revenue ratios higher than 500%. Overall, however, assets exceed liabilities for all provinces. Because assets do not include capitalized tax revenues, the ratios would be further improved taking it into account. However, the debt-to-asset ratios are considerably higher in the poorer western regions, in part because of the lower land values in those areas.


2018: Year of Rising LGFV Defaults and Sino-US Trade War


Meanwhile, fears that 2018 might turn out to be "a year of defaults" phase for off-balance sheet local government borrowings came true when, in January, Yunnan State-owned Capital Operation Co, which is fully owned by the State asset regulator of the government of Southwest China's Yunnan Province, missed payments amounting to more than 900 million yuan. This was followed, in May, by the default by Tianjin-based municipal government-owned real estate company on two trust loans collectively worth 500 million yuan ($78.69 million).[14]


In May 2018, to help local government ease debt repayment pressure, Beijing has for the first time allowed provincial and municipal governments to issue 15- and 20-year bonds – previously the longest maturity was 10 year. The move was announced as market interest rates was edging up while the supply of fresh funds drying up, adding to the pressure on heavily indebted local authorities. [15]  A longer maturity could stave off an outbreak of financial risk, leaving more room for Beijing to manoeuvre and work out how to tackle the national debt mountain. But since the overall size of that debt pile remains high, it also raises the question of whether Beijing is simply kicking the can down the road. Chinese investors are also more focused on safety than in the past.[16] To ease market concerns, the Finance Ministry said it would control the size of long-term bonds – those with a maturity of more than seven years will be capped at 60% of their total, based on a quota for the province. Issuers will also be forced to disclose more financial information, and buyers will be allowed to use the local bonds as collateral for interbank trading and repurchases. [17]


By the end of June 2018, official state data revealed that China’s explicit local government debt, including bonds approved by Beijing, totalled at 16.8 trillion yuan while the size of “implicit” local government debt could be at least 20 trillion yuan. With the “implicit” debt factored in, the national ratio of government debt to GDP could surge from the 36.7% past the red line of 60% set by the Bank for International Settlements.[18]


The danger for China with regard to local government debt is that when economy slows in the coming months as its trade war with Washington escalates, control over borrowings would become increasingly complex. Depending on how severe the adverse impacts on the economy will be, it may be even impossible to put a lid on local governments’ borrowing as the latter struggle to keep their local economy afloat.


At the central, Beijing has already started, on July 23, to ease off on debt control to give the economy a push. The State Council announced it would increase bond issuances to 1.3 trillion yuan to support infrastructure investment. The cabinet also encouraged bank lending to financing vehicles under “market rules” to ensure continuity of construction projects.[19]


In other words, policymakers are easing their control on transparent local debts but are still reining in rising systemic risks associated with “hidden debt”, particularly at a time when the economy was becoming increasingly vulnerable as a result of the trade war with the US. On 29 August, 2018, the Finance Ministry announced that it would further tighten control on local government debt by curbing local government hidden debt and off-budget fundraising activities while speeding up the development of a "long-term supervision mechanism" on local government debt. The Finance Minister Liu Kun also reported that, henceforth, the central government would hold provincial-level governments responsible for debts incurred by local governments within their jurisdictions.[20]


Meanwhile, state-owned banks, securities brokers and insurers who were major investors of local government bonds were beginning to shift towards treasury bonds. They were big on local debts because these debts were deemed to come with an implicit government guarantee. However, with the spectre of rising defaults of local government financing vehicles (LGFVs), local government debts are no more deemed as risk-free investments.


Factors Impeding China’s Local Government Debt Reforms


Clearly, despite reforms launched by Xi and Li after their ascension to the highest office, the central government’s efforts failed to stop local government debts from rising rapidly. The unstoppable trend of growing debts can be attributed to several factors.

(a)         Misaligned Incentives between the Central and Local Governments

To begin with, even though the reforms might help reduce irregularities, they could “hardly get rid of the root problem”, which is that central and local governments had “misaligned incentives”. The performance of local officials are still judged based on a system of short-term performance criteria which are in conflict with longer term objective of sustainable and quality growth. Local government officials compete with each other on economic performance, motivated by concerns over promotions and political pressures from higher levels of government. Cadres are therefore under constant pressures to outperform and this has led to unachievable goals and probably to over-investment. When making the second “Five-Year Plan” (2011-2015), for example, the Chinese central government targeted a 7% national GDP growth rate, but all the provinces set higher GDP growth rate targets, ranging from 8% to 13%. More recently, in 2017, sixteen provinces sought to increase the size of their investments compared to previous year. The combined investment target of 23 of the nation’s 31 provinces hit 40 trillion yuan compared to the national total of 49 trillion yuan the year before.[21] Moreover, pressures to outperform also appear to have resulted in inflated provincial statistics. Aggregating provincial GDP in all the 31 provinces, the sum exceeds China’s national GDP in each of the past ten years by a percentage of about 7%.[22]


While competition between local governments has helped China achieve economic success and encouraged local innovation over the past several decades, many observers believe that its excesses, including the massive debt buildup, have become a net negative force on the Chinese economy.[23]

(b)        Local Governments’ Structural Imbalances between Revenues and Expenditures

Secondly, the debt market reforms do not address the underlying fiscal pressures that exacerbated the debt buildup. The structural imbalance between local government spending and access to tax revenues remains a fundamental tension. Ultimately the ability of local governments to pay for their expenditures depends on fiscal revenues. Under the current Chinese fiscal and tax system, the total fiscal revenue of local government consists of three parts: budgetary fiscal revenue, central government transfers, and government managed funds (GMFs). Local tax revenue accounts for most of budgetary fiscal revenues. After the 1994 fiscal regime reform, local governments receive only around 50% of all tax revenue in China, but are responsible for around 80% of total fiscal expenditures. The gap has to be filled from other sources. One such source is the transfers from central government but they are assigned for specific local projects and cannot be used for other purposes. Local governments have more discretion over GMFs, funds that were previously off-budget but that are now reported. In recent years, approximately 80% of GMF revenues were raised from local government land sales, a situation that is not sustainable in the long run. The rest of GMF revenues come from fees charged by local governments for supporting public services like education and cultural activities, providing housing for government employees, maintenance of public transportation system, etc. [24] In short, because of the existing imbalanced fiscal and tax system, the ability of local governments to issue debt (and to sell land) has played an important role in the development of the Chinese economy over the last decade. A successful reform will therefore require more stable and transparent financing channels for local governments. Suppressing debt issuance without supplying an alternative funding source or transferring more government functions to the private sector could have adverse consequences for economic growth.


(c)          Importance of Debt-Financed Investment as a Countercyclical Policy Tool

Next, in the case of China, infrastructure investments and property market-related activities account for the majority of spending financed by the local government debts. There is now a negative correlation not only between local debt growth and GDP growth but also between local infrastructure growth and GDP growth. Those relationships appear more significant after 2008 when the economy was on the verge of drastic slowdown as a result of the Global Financial Crisis (GFC). Infrastructure and housing investments are the most common ways local governments seek to stimulate the economy. And because the ability of local governments to raise revenue is limited, debt issues became the primary source of funds to finance those investments. The negative correlations thus suggest that local governments were increasingly using debt-financed investment as a countercyclical policy tool. This is true not only in the immediate aftermath of the GFC but also in following years when Chinese economic development hit bottleneck and was beginning to slow down. Infrastructure investing became the convenient and most direct discretionary fiscal tools local governments could use to stimulate the economy in the short run. [25]

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[1] See Zhang Mengzhong & Qi Youwei. (2017). “Grand Strategies for Dealing With Chinese Local Government Debts.” Management Studies, Mar.-Apr. 2017, Vol. 5, No. 2, 91-107

[2] See Zhao, Y. (2011). “Research on local government debts.” Economic Research Reference (Chinese), 38, 2-22.

[3] See Xun Wu. (2015). “An Introduction to Chinese Local Government Debt.” 1 October. 2015.

[4] See Aileen Wang & Koh Gui Qing. (2013). “China $3 trillion local government debt stirs alarm.” Reuters. 30 December, 2013.

[5] See Aileen Wang & Koh Gui Qing. (2013). “China $3 trillion local government debt stirs alarm.” Reuters. 30 December, 2013.

[6] See Jamil Anderlini. (2015). “China: Overborrowed and overbuilt.” FT. 30 January, 2015.

[7] See Lu, Yinqiu, and Tao Sun. (2013). “Local Government Financing Platforms in China: A Fortune or Misfortune?” IMF Working Paper WP/13/243.

[8] See Xun Wu. (2015). “An Introduction to Chinese Local Government Debt.” 1 October. 2015.

[9] See Frank Tang. (2018). “China’s new way to kick the can down the road on government debt: longer-term bonds.” SCMP. 12 May, 2018.

[10] See Xun Wu. (2015). “An Introduction to Chinese Local Government Debt.” 1 October. 2015.

[11] See Zhou Xin. (2016). “China plans rise in government debt to prune corporate red ink.” SCMP. 27 May, 2016.

[12] See Zhou Xin. (2016). “China plans rise in government debt to prune corporate red ink.” SCMP. 27 May, 2016.

[13] Reuters. (2017). “China ‘to keep 3 per cent budget deficit in 2017 as debt risks grow’.” 26 January, 2017.

[14] See Global Times. (2018). “Tianjin govt-owned firm defaults on two trust loans.”

[15] See Frank Tang. (2018). “China’s new way to kick the can down the road on government debt: longer-term bonds.” SCMP. 12 May, 2018.

[16] See Frank Tang. (2018). “China’s new way to kick the can down the road on government debt: longer-term bonds.” SCMP. 12 May, 2018.

[17] See Frank Tang. (2018). “China’s new way to kick the can down the road on government debt: longer-term bonds.” SCMP. 12 May, 2018.

[18] See Frank Tang. (2018). “Just how big is China’s ‘hidden’ debt pile? Beijing orders local cadres to find out.” SCMP. 17 August, 2018.

[19] See Frank Tang. (2018). “Low-hanging fruit and a mountain of debt – how China’s credit binge is playing out.” SCMP. 15 August, 2018.

[20][20] See Chen Jia. (2018). “Finance minister outlines plans for control of local debt.” China Daily. 29 August, 2018.

[21] See Frank Tang. (2017). “China moves to defuse local government debt bomb.” SCMP. 27 February, 2017.

[22] See Xun Wu. (2015). “An Introduction to Chinese Local Government Debt.” 1 October. 2015.

[23] See Xun Wu. (2015). “An Introduction to Chinese Local Government Debt.” 1 October. 2015.

[24] See Xun Wu. (2015). “An Introduction to Chinese Local Government Debt.” 1 October. 2015.

[25] See Xun Wu. (2015). “An Introduction to Chinese Local Government Debt.” 1 October. 2015.