China’s rising leverage ratio has been the focal concern of both investors and policymakers for many years. Measured by the ratio of non-financial sectors’ debt to GDP, China’s macro leverage ratio in 2018 remained flat YoY for the first time since 2012. However, stringent policies imposed on off-balance-sheet financing and local government borrowing have led to excessive tightening of financial conditions which have impaired corporate cash flows, especially in the private sector. As a result, growth of both domestic investment and consumption has decelerated, dragging the Chinese economy to the brink of deflation again. However, thanks to adjustments to these excessive tightening policies year-to-date, we have seen signs of stabilization of economic activities and industrial product prices, supported by a rebound in debt issuance, particularly by local governments. Nevertheless, investors remain wary about policy measures to bolster growth through increasing infrastructure investment and adding leverage to the state-owned sector.
Should China re-set priorities regarding its multiple policy objectives such as a stable growth, deleveraging, and structural reforms? Is it wise to increase the leverage of the government and household sector again to stabilize growth? To answer these questions, we have conducted extensive in-depth research on China’s high leverage issue, and concluded that the root cause lies in China’s underdeveloped financial markets that are unable to allocate its exceedingly high savings efficiently into investment1.
In this report, we focus on local government financing vehicles (LGFVs), a special type of state-owned enterprise (SOE) in China. By analyzing their balance sheets disclosed upon bond issuance2, we try to assess LGFVs’ business performance and debt-servicing capabilities, and compare them with other non-financial corporations. Our analysis reveals that, between 2014 and 2018, LGFVs recorded the fastest debt growth, the lowest return on equity, and the worst debt-servicing ability.
1. As of end-2018, LGFVs’ interest-bearing liabilities topped Rmb30trn, or 34% of GDP.
2. The reported debt-to-GDP ratio of China’s non-financial sectors rose by 31ppt from 214% in 2014 to 245% in 2018. However, this ratio dropped 7ppt in the corporate sector, excluding LGFVs. In contrast, the debt-to-GDP ratio grew 17ppt in the household sector, 6ppt in LGFVs, and 15ppt in the government sector.
3. The ratio of LGFV debts to GDP has continued to rise even though Rmb16trn of local government bonds were issued to swap previously existing LGFV debts during this period. That is, LGFVs’ debt-to-GDP ratio would have risen by as much as 19ppt without the swap. This implies a more than 20% annualized growth of LGFV debts over the past five years, a much faster rate than those of bank lending and total social financing.
4. LGFVs’ ROE was 2.4% in 2017, far below other nonfinancial bond issuers’ 6.4% and LGFVs’ own borrowing cost.
5. The most worrisome data point is that LGFVs’ debt service coverage ratio is only 0.4x, suggesting that many LGFVs’ operating cash flows are unable to cover their maturing debt and interest payment for the current year. In other words, LGFVs could face severe liquidity risks if they cannot refinance.
6. LGFVs’ debt financing suffers from a severe maturity mismatch. While they, on behalf of local governments, invest mostly in infrastructure projects that may not generate any cash flows for a long period of time, the durations of their financing instruments are mostly less than three years. Many projects are financed at funding cost of above 6%, and some even at above 8%. Meanwhile, inventory-to-asset ratios in LGFVs are much higher than in other non-financial companies. We suspect that a substantial portion of LGFV inventories are land reserves. The positive feedback loop between LGFV debts and real estate prices exacerbates China’s macro vulnerability, as the government’s fiscal income relies heavily on revenue from land sales.
7. The sum of LGFV liabilities and explicit local government debts exceeds local GDP in eight provinces, but relative to local fiscal revenue, it exceeds 300% in 23 provinces, and 500% in 10 provinces. Our analysis suggests there may be significant debt risks in Guizhou, Yunnan, Tianjin and Jiangsu provinces.
To achieve a soft landing in the deleveraging process, China needs to tackle both the stock and flow of LGFV debts, and be careful about any side effects deleveraging may have on the corporate and the household sectors. China may need to embark on another round of debt swaps to take these LGTVs off bank balance sheets and “unblock” these bottlenecks in the monetary policy transmission mechanism. Such a swap can lower the cost of local government borrowing and extend their durations. It can also improve Chinese banks’ capital adequacy ratios, helping them cope better with the challenges amid further opening-up of the country’s financial sector.
To prevent LGFV debts from rising again, China needs to take further steps to advance fiscal reform, as the root cause of persistent LGFV borrowings lies in the imbalances between local government spending liabilities and their revenue. While excessive local government borrowings need to be brought under control, the central government should either increase revenue sharing with local governments, or take on more spending obligations.
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1.See CICC macro research Tackling the root cause of China's rising leverage, released on November 12, 2018, and Why is leverage rising faster in recent years? released on November 12, 2014.
2.The data are from the Wind database, which includes urban investment bonds identified against the criteria of Wind itself, CBIRC and CCDC. The CBIRC criteria are based on CBIRC’s quarterly LGFV list. The CCDC criteria are set when CCDC launched its urban investment bond yield curve on May 19, 2014. The Wind criteria have been the same as the CCDC criteria since December 29, 2014. The Wind database includes about 1,000 bond-issuing LGFVs under the CBIRC criteria, about 2,000 LGFVs under the CCDC criteria, and about 2,000 LGFVs under the Wind criteria (slightly more than those under the CCDC criteria). We use the Wind criteria.
For more information, please refer to our report The mounting LGFV debts – A “gray rhino” in China’s balance sheet published in March 2019.