On paper, the Chinese government appears to owe very manageable debt for a country that has relied so much on investment for its growth. By official definition, general government debt, which includes central and local government debt, is about 55 per cent of GDP, a level comparable to Asia Pacific peers such as Australia and Korea, which are much richer in GDP per capita terms. This implies that Beijing has plenty of headroom to help the many provinces in debt trouble. Last November, policymakers announced the issuance of RMB 1tn (USD $140bn) of special government bonds to support local governments, which raised the 2023 budget deficit by 0.8 percentage points to 3.8 per cent.

But that is a drop in the ocean for an economy the size of China’s. Investors have been scratching their heads over the lacklustre stimulus deployed by the government for its struggling economy. A look at the broader general government debt, which also includes government related funds, offers a slightly better explanation of China’s fiscal conservatism. That figure is estimated to stand close to 70 per cent of GDP at the end of 2023, which makes China more vulnerable than other, lower rated emerging markets such as Indonesia and the Philippines, and closer to peers such as India [1], judging just from this single indicator.

But even that figure fails to capture the enormity of the risks in local government financing vehicles, or LGFVs. These shadow financing tools helped the provinces prosper during the decades of China’s debt-fuelled growth. They enabled the construction of impressive roads and railways, while shelving liabilities off the government’s balance sheet. But they relied on land sales and began to unravel as the real estate sector tumbled in 2021. With RMB 60tn worth of debt, LGFVs cannot be completely disregarded when investors assess the government’s fiscal burden. Although we consider any scenario where all LGFV debt would need to be recognised as a liability of the central government highly unlikely, when it is included it brings China’s government debt ratio to roughly 130 per cent - elevated among emerging markets and comparable with developed markets that resorted to quantitative easing, including Eurozone countries (France, Italy), the UK, the US and Canada.

If growth slows further, LGFVs won’t be the only ones seeking support. Corporate debt adds another 123 per cent of GDP worth of liabilities, a large chunk of which is owed by state-owned enterprises (SOEs) [2]. In addition, household debt - mostly mortgages - is 61 per cent of GDP. Altogether, China’s gross national debt is over 300 percent of GDP. A high debt burden constrains the government’s fiscal firepower, preventing it from unleashing bolder stimulus and weakening its effectiveness when implementing support measures.

This explains why a central government with apparently manageable debt seems to be playing for time with so-called ‘extend and pretend’ debt management strategies. Beijing has directed local governments to embark on a RMB 1.5tn debt swap with LGFVs. It will cover only half the average interest cost of outstanding LGFV debt, but with the additional bond issuance these actions will shore up liquidity and, crucially, investor confidence. Banks have also been told to go on ‘national service’ by refinancing LGFV loans. An infrastructure LGFV in Zunyi, a remote city in the less affluent Guizhou province, received a 20-year extension on its LGFV’s debt and will only pay interest for the first 10 years, according to local media reports.

Acknowledging the urgency of the debt challenge, the government also accelerated spending last year that was already approved, for instance by frontloading a portion of the RMB 4.3tn local government bond issuance ahead of schedule. With an additional refinancing bond issuance of about RMB 1.4tn in 2023, total local government bond issuance reached 4.5 per cent of GDP for the full year. Incremental new spending is likely to focus on strategic national priorities, such as high-end manufacturing and more commercially viable infrastructure projects. 

Housing headaches

The underlying problem is structural. China has raised too much debt for the amount of demand there is in its economy - an imbalance that could get worse before it gets better.

The housing market has been the linchpin of Chinese growth. Its success drove local government revenues. As the property sector cooled, apartment sales dipped to just 9.6m flats last year — the lowest since 2012, and way below the high of almost 14m flats in 2021. But the debt structure of property developers is built to support the sort of demand seen in the decade before the recent correction. There aren’t many choices for a country in this situation: either drive up demand, or reduce supply.

Homebuyers in China do not just represent demand, they are the developers’ ultimate creditor. For years, the housing industry ran on a presales model: customers committed cash upfront, sometimes years in advance, before projects even began. The machine ran fine with the high demand of previous decades. But today, the population is peaking, consumer confidence is low, and a lot of demand has already been met after a decades-long building spree. We don’t believe a recovery in homebuyer demand could bail out developers this time around. 

The other option is to fix the blockage on the supply side. Industry estimates indicate that the majority of real estate assets in China are inventory - projects that are sold, but not yet built. Government aid for developers to complete unfinished projects would help stabilise prices, and in turn put more pressure on developers’ debt service capability in the near-term. These dilemmas have put policymakers in a tough spot and resulted in less decisive policy support, which in turn dampens investors’ expectation on China’s long-term growth. Indeed, these challenges have been severe enough to alarm at least one international credit rating agency: Moody’s replaced China’s stable outlook with a negative view in December.

Pain for gain

In an ideal world, LGFVs should look more like commercial companies. The winners would employ a managerial mindset to get debt down, and the losers would be allowed to fail. Capital and revenue streams would be redirected to productive industries. The housing market should correct itself at the cost of wealth destruction and real estate industry consolidation to rebalance supply-demand. Painful as it is for households to see their net worth dwindle in line with falling home prices, they may end up with more balanced asset allocation that includes more of other financial assets, such as equities and bonds.

But with the debt pile high and demand sluggish, undertaking market-driven reforms for LGFVs is less a priority for China than getting them to stabilise their finances, fast. “Safeguarding against systemic risks” remains China’s paramount concern today. This is in contrast with the last big debt crisis of the 1990s, when the country was still in the early phases of reform and opening up to the world. Officials doubled down on cleaning up bad debt and privatising state-owned enterprises.

Some LGFV bonds could even enjoy a bit of a rebound in the short term thanks to more soft bailouts. High yield LGFVs were among the best performing onshore credits in August as policy shifted to a more accommodative stance. Likewise in the broader government bond market, policy tweaks are reshaping the landscape for investors. The Chinese leadership’s recent commitment “to keep liquidity reasonable and adequate and financing costs constantly decreasing” signals lower long-term rates, and makes bond investments more attractive in the medium-term. Counterintuitive as it may sound, China’s debt market that has been the cause of so much concern for investors could also be where investors find cherished assets. 

[1] Unless otherwise specified, all debt-to-GDP numbers in this article are based on the International Monetary Fund’s calculations.

[2] A report by the credit rating agency S&P Global in 2022 estimated that 79 per cent of corporate debt in China was owed by SOEs (the IMF does not break down the proportion of debt owed by SOEs).