As liquidity concerns continue to mount among China’s real estate developers, the world has cast a wary eye on Chinese markets. Back in September, disgruntled investors stormed Evergrande’s lobby in Shenzhen demanding that their money be returned; since, the over-leveraged real estate giant has continued to steal headlines with a string of close calls on payment deadlines.
China’s US$52 trillion real estate sector produces as much as 29% of China’s annual GDP growth and has significant influence over other sectors of the economy. This close interconnectedness suggests the need for stable property markets; should real estate developers begin to fail, the consequences would be dire. As a result, with China’s major developers currently in the spotlight, some serious ripple effect risks have flown under the radar.
Local government financing vehicles (“LGFVs”) have gone overlooked for far too long. LGFVs have expanded off-balance sheet borrowing over recent years – a trend accelerated during the pandemic – and have accumulated high levels of hidden debt. Now, with slowing real estate weighing on land sales and limiting access to funding, LGFVs are highly exposed to potential defaults in the real estate sector. Authorities in Beijing are keen on managing debt amongst LGFVs; however, policymakers must carefully balance the need to front-run debt issues while preventing a liquidity crisis in the LGFV sector.
The Moral Hazard of LGFVs
What Are LGFVs?
Local government financing vehicles, or “LGFVs,” are local government-owned special purpose vehicles (SPVs) that raise money through loans and debt securities for municipal construction and infrastructure projects. They emerged during the global financial crisis in 2008. Due to a lapse in law, regional governments were unable to borrow directly from debt markets until 2015, and therefore LGFV borrowing became a go-to stop-gap solution to supplement Beijing’s stimulus. Even after the crisis, LGFVs were widely used for bolstering local infrastructure development and urbanization efforts.
Because LGFVs are government-owned, when they fail to service their debts, the local government is on the hook to bail them out. While this prevents defaults, it creates a compounded issue of moral hazard. First, government support for LGFVs reduces their incentive to prioritize infrastructure projects with higher returns. In fact, with average returns on investment at less than 2%, LGFVs are notorious for choosing unprofitable investments. Second, in cases in which an LGFV does fail and is bailed out by regional governments, the broader economy is left picking up the tab through lagged economic growth. Despite Beijing’s best efforts to crack down on these financing solutions, “hidden” LGFV debt has continued to drag on local economies, outpacing GDP growth by over 30% since 2008.
LGFVs Come Back Into Favor During Pandemic
The pandemic has echoed the economic conditions faced by China in 2008. After implementing a wide array of indirect stimulus through VAT tax rebates, social security contribution deferments, and more, fiscal revenues slowed to a trickle. In the first quarter of 2020 alone, national general budget revenues decreased by 14.3% year-over-year. For local governments, the decline ticked slightly lower at 12.3%.
Given local governments were still expected to spur local economic activity, many officials turned to LGFVs more heavily to hit the short-term growth targets assigned by Beijing at the expense of long-term economic health. In May 2020, Premier Li Keqiang announced that provincial and local governments would raise CN¥1.6 trillion through special bond issuances to be earmarked for infrastructural development. LGFVs have since roared back to life and raised record-high funds for traditional infrastructure projects during the course of the pandemic.
The Rising Debt Risk of LGFVs
The Risk of Off-Balance Sheet LGFV Debt
LGFV debt risk is not readily apparent. At the end of April 2021, outstanding local government debt reportedly amounted to CN¥26.6 trillion, which returns a debt-to-GDP ratio of 24.7%. While this figure may appear quite rosy when compared with China’s 160% debt-to-GDP ratio among non-financial corporations, LGFVs’ off-balance sheet borrowing paints a murkier picture.
Local government financing vehicles borrow money through a variety of means. LGFV debt primarily includes publicly listed debt securities, direct bond offerings, and loans from banks. While LGFV debt from publicly listed bonds is typically well-recorded, financing through shadow banking channels and direct bond offerings are notorious for poor transparency. In fact, estimates from economists place LGFVs’ hidden debts at CN¥45 trillion, or nearly double on-balance sheet borrowing figures.
Reduced Borrowing Amid Looming Debt Maturities
As the pandemic stretched local governments’ finances in 2020, LGFVs ramped up borrowing to support regional economic activity. Chinese financial markets have undergone strict tightening since. Although there is no past instance in which an LGFV defaulted on a publicly listed bond, the SPVs have defaulted on a variety of private bonds and other shadow banking instruments. Chongqing Energy Investment Group Co. LTD is a recent example that stole headlines earlier this year when it shook investor confidence in local government support for SOEs by defaulting on a letter of credit of CN¥915 million.
The weight of LGFV debt obligations on regional economies will become increasingly cumbersome over coming years. LGFVs introduced just shy of US$20 billion worth of bonds set to mature in 2021, with significantly more primed to mature in 2022. In addition, due to the government’s tightening on leverage, LGFV net bond issuance turned negative in May 2021. This is an extremely rare phenomenon for LGFVs and implies that the value of bond redemptions has outpaced the value of bond issuances. With near-term maturities gaining steam at the same time as bond market funding dries up, many financing vehicles could find themselves facing a severe liquidity crunch as they lack the funds to pay off their debt.
The Unholy Matrimony Between China’s Real Estate and LGFVs
Local government financing vehicles go hand-in-hand with the real estate sector, particularly as upwards of 40% of LGFV revenues are driven from land sales to real estate developers. In the wake of the current liquidity crisis, China’s housing market continues to cool. Private developers have halted land buying activity, and state-owned developers have been compelled to purchase more land at public auctions than ever before. According to the Financial Times, state developers have stepped in to purchase 75% of land sold at auctions in 22 of China’s largest cities, which is well beyond the historical average of 45%. While state developer support will provide short-term relief to LGFVs that are dependent upon land sales to pay off debts, the underlying issue of persistent negative or ultra-low LGFV project ROIs leave state developers on the hook for failing local and regional investments.
Looking Forward
Beijing is well aware of the risks that local government financing vehicles pose after years of unchecked debt growth and have already begun restricting financing channels to LGFVs. For example, banks are beginning to connect on a platform released by the Ministry of Finance that monitors LGFV finances and aims to shore up the provision of liquidity to over-leveraged LGFVs. It is also possible that governments will become more selective in bailing out LGFVs in the future, particularly given a recent shift in mentality by the central government that has allowed SOEs to default, such as the US$200 million default of Tsinghua Unigroup in late 2020. Beijing’s top policymakers have shown a new determination to improve the efficient allocation of market capital, which has let weak companies fall by the wayside.
There are additional measures that local governments are taking to reduce or alleviate the burden of hidden LGFV debt. Regions such as Shanghai and Guangdong, among others, have launched debt pilot programs in which governments work to clean up off-budget lending through a variety of measures, such as repaying debt with fiscal revenues, liquidating LGFV assets, replacing hidden debts with refinancing bonds, or even restructuring LGFVs.
These pilot programs are likely to spread to other regions as significant debt risks are exposed by a slowing real estate sector. Nonetheless, these long-term efforts will do little to address the current threat presented by the growing default risk in China’s real estate sector to China’s failing LGFVs. Regardless, while LGFVs could soon see their first official bond default given Beijing’s recent inclination to pave the way for more efficient capital markets, hidden LGFV debt still poses substantial systemic risk to the economy via lending institutions and policymakers are likely to provide support to zombie firms in the short-term to buy enough time for long-term fixes.