In depth: Local governments give up funding to discharge hidden debt

China is running a campaign to reduce hidden borrowing from local government financing vehicles (LGFV) to ease its debt burden. This initiative aims to turn heavily indebted local authority LGFVs into market-oriented entities, aiming to reduce debt levels and ease central government borrowing constraints. [para. 1][para. 2]. However, analysts warn that this strategy may not solve the financial risks and may lead to new hidden debts. These market-oriented LGFVs can still invest in non-profit infrastructure projects [para. 3].

In Chongqing, a municipality of 30 million people, four LGFVs were recently restructured to operate independently, keeping the local government only partially responsible for liabilities. This approach has been adopted by 239 LGFVs in 24 provincial-level regions, and another report highlights 454 LGFVs now operating as market units or without government debt [para. 4][para. 5]. This change follows directives from the State Council to address hidden local government debt, an effort highlighted after a Politburo meeting in July [para. 9].

Local governments are facing heavy debt and are having difficulty balancing debt settlement with economic needs. LGFVs have historically financed infrastructure to meet GDP growth targets, resulting in significant hidden debt. The International Monetary Fund estimates LGFV debt at about 60 trillion yuan ($8.5 trillion) compared to 40.7 trillion yuan of official local government debt at the end of 2023 [para. 10]. The current debt settlement strategy involves issuing special refinancing bonds and directing banks to extend credit terms and lower interest rates. [para. 11].

Local governments are looking for innovative ways to offload liabilities and access new funding, although this approach is still experimental and has not been formally endorsed by central government. [para. 12]. A national database was created to check hidden debt, restricting nearly 18,000 LGFVs from borrowing for anything other than “three big projects” [para. 13]. This step aims to prevent the accumulation of hidden debt, but it significantly cuts the financing of local economic development [para. 14].

Chongqing’s decision to allocate some LGFV from the local government’s balance sheet aims to reduce the debt-to-GDP ratio and lift project investment restrictions. The strategy involves a three-step approach: paying off hidden government debt, declaring LGFV independent status, and transferring liabilities to other companies. However, the third step, which involves negotiating with creditors, is particularly challenging [para. 17][para. 18]. Even with these steps, there is no guarantee that the restructured LGFVs will provide new financing for local infrastructure projects [para. 19].

Being on the list of heavily indebted regions limits Chongqing’s ability to invest in new projects, which significantly affects local GDP growth alongside other struggles such as the prolonged slump in the property market and weak consumer confidence. Over half of China’s provincial-level regions missed their 2023 GDP growth targets, increasing pressure to meet new targets [para. 25]. To regain investment capabilities, Chongqing aims to reduce its debt-to-GDP ratio by offloading some LGFVs. However, simply transforming LGFVs into market-oriented entities may not be enough to remove them from high-risk lists. [para. 26][para. 27]. The main challenge remains the repayment of the LGFV debt, as the restructuring does not eliminate liabilities or guarantee refinancing [para. 28].

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