China's 8.3 trillion USD 'underground debt mountain'

The dismal real estate makes it difficult for local governments in China to repay their bonds, as the main source of revenue comes from land sales.

When authorities in the southern Chinese city of Liuzhou auctioned off public land lots in June, very few people came to buy. Only one in five plots of land put up for auction has an owner, while the rest are unsold. Like many cities across China, the downturn in the real estate market has reduced demand for land to develop apartment projects in Liuzhou.

This is bad news for local governments, which rely heavily on land sales for revenue. And this is also a worrying sign for holders of bonds issued by local government fund raising companies (LGFVs). These semi-public and semi-private companies have become the foundation for China's development in recent years.

Municipal land sales are often used to repay these bonds. After the failed auctions in Liuzhou, credit rating agencies downgraded two of the city's LGFVs, fearing the government would have trouble repaying the debt.

Men ride bicycles through construction sites near Evergrande's headquarters in Shenzhen, Guangdong province, China September 26. Photo: Reuters

The Economist commented, LGFV is one of China's "strange" financial innovations. In the mid-1990s, the government introduced budgetary laws to rein in local government debt. Therefore, localities have created LGFVs as an alternative. Thousands of LGFVs have become important engines of economic growth, helping to build bridges, houses and roads.

However, according to Goldman Sachs, it has also become one of China's largest debt categories, creating about 53 trillion yuan ($8.3 trillion, or 52% of GDP) in debt at home and abroad. Although the loan does not appear on the public balance sheet, the local government is still responsible for repaying it. These hidden debts also still threaten to plunge the financial system into disarray.

The Chinese government has spent years trying to reform the shadow financial system, but off-balance sheet debt has been slow to come to light. Many LGFVs earn meager income on the bridges, roads and water systems they build. Local governments used to cover the shortfall with land sales, but this is becoming more difficult.

In a land auction this year in China's 22 largest cities, the winning bid was only 4.7 percent higher than the government's starting price, very low from 16.7% at the beginning. years, according to research firm Enodo Economics. Evergrande's debt and the general instability of the real estate industry means demand for land is likely to continue to suffer.

No LGFV has ever defaulted on its bonds. But many observers, like Larry Hu at Macquarie bank, believe it's only a matter of time. Nomura Bank calculates that LGFVs will have to repay $32.2 billion in foreign bonds in 2022, up from $26.9 billion in 2021.

Most of these companies issue short-term bonds only to pay for other maturities. Guangxi Liuzhou Dongcheng, one of Liuzhou's LGFVs, was downgraded by S&P in October. They have 25.7 billion yuan ($4 billion) in short-term debt. On average, 60% of LGFV bonds are issued not for growth-generating projects, but to pay off debts maturing in 2020 and 2021.

Many local governments appear to be bracing themselves for a financial storm. Liuzhou used about 20 billion yuan in public funds to cover a shortfall at Dongtong Development and Investment Group, an LGFV that was downgraded by Fitch in August.

An LGFV in Chongqing city defaulted on its debt in March. A subsidiary of an LGFV in Guangxi also went bankrupt. The authorities of Jiangsu and Yunnan have issued guidance urging struggling LGFVs to comply with the official bankruptcy process instead of hiding their debt.

Such reforms will not be easy. In June, the total value of domestic LGFV bonds was 11,900 billion yuan in June. This is six times the value of bonds issued by real estate firms and one-tenth of the bond market. in the country of China.

Just a slight change in the government's implicit reassurance attitude towards LGFVs could make investors nervous. The caution was evident in "Document No. 15", an internal circular issued by the banking regulator in July, requiring lenders to reduce access to working capital for some LGFV.

If maintained, the new rules could trigger a cash crunch for LGFVs - similar to the funding squeeze with Evergrande. However, letting LGFVs fall is a line that the central government is not ready to cross.

This situation shows the risk of market wobble if reform policies are stopped or changed. Many other sectors, such as real estate, will immediately face difficulties when they are no longer supported by the government.

As for LGFV, because authorities are still not determined to end their implicit support for these companies, many asset management companies in China still consider them safe. So the funds are still pouring in. "They are becoming shelters," commented Larry Hu.

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