China to defuse its $13 trillion LGFV debt time bomb?
Local reports indicate policymakers may finally get serious about a solution to dangerous debt pile at upcoming Third Plenum
China’s leadership gathering later this month could be the moment policymakers devise to defuse the US$13 trillion time bomb imperiling Asia’s biggest economy.
Though China’s property crisis gets the headlines, debt troubles plaguing municipalities across the nation also require urgent action.
At issue is the explosion of local government financing vehicles (LGFVs) in recent years. Such debt, the vast majority of it the off-balance-sheet kind, now almost rivals China’s annual gross domestic product (GDP).
Between the default drama surrounding giant property developers and the glut of LGFVs, it’s easy to see why global investors worry about China’s economic foundations – particularly at a moment of extreme global uncertainty.
With US bond yields staying elevated, Japan skirting recession and Europe walking in place, the second half of 2024 isn’t exactly fertile ground for China to manufacture an export surge.
The good news, however, is Xi Jinping’s Communist Party seems ready to tackle the ticking LGFV time bomb. Local press reports indicate that a long-delayed economic strategy session to be held July 15-18 will aim to craft a solution to the massive debt pile.
At the upcoming Third Plenum, Xi’s inner circle is expected to allow local governments to keep more of the fiscal revenues they generate that currently go to Beijing. The required reforms to China’s tax system could be a big step toward removing one of the most immediate threats to financial stability.
It could also be a vital step toward investing more in high-value manufacturing sectors while stimulating now languid domestic consumption. At issue is a lack of social safety nets that causes mainlanders to save more than they spend.
Increased revenues would give local governments greater scope to invest in innovation and productivity-enhancing industries and make municipalities less reliant on property and land sales to stay afloat. They also would diminish the allure of debt issuances.
It’s hard to exaggerate the game-changer such a pivot could be. Fixing China’s financial cracks is only one part of the process. The other is building economic muscle that puts China on a path toward growing better, not just faster.
Since the 2008 Lehman Brothers crisis, Beijing has relied heavily on China’s 34 province-level administrative areas to fuel economic growth. Even before that, regional leaders often got attention in Beijing by reporting higher GDP figures than the national average.
This explains the infrastructure arms race across the nation. Now, the bill for all those ginormous skyscrapers, six-lane highways, international airports and hotels, white-elephant stadiums, sprawling shopping districts and amusement parks is coming due.
“LGFVs played an essential role in funding China’s colossal infrastructure buildout, which has also helped drive up land prices in what was previously a virtuous growth cycle,” notes Henry Storey, an economist at the Lowy Institute think tank. “In the heady days before China’s real estate collapse, land revenue provided an ostensibly inexhaustible source of largesse for subsidies.
This growth model was not without its drawbacks, Storey notes. “After decades of bingeing, he says, “LGFV debt comprises well over half of China’s GDP – a totally unsustainable dynamic when median return on assets has hovered around 1%. Local governments are now spending around 19% of total fiscal resources on interest payments.”
Over the next few weeks, Xi has a chance for a major reboot. Since taking the reins in 2012 and 2013, Xi pledged to recalibrate an economic model that he said had become “unbalanced, uncoordinated and unsustainable.”
But “despite momentous economic change since, many of the government’s stated ambitions remain the same,” says economist Diana Choyleva at Enodo Economics.
For this “vision of high-quality development” to ultimately be achieved, it will depend on “whether Xi can fully implement” reforms, Choyleva says,
To be sure, Choyleva adds, “success with these supply-side reforms will not be enough to place the economy on a sustainable growth path without the structural changes needed to create genuine consumer demand. Yet the majority of those are conspicuously missing from the discussion.”
The weeks ahead could provide this missing link and mark one of the biggest changes to China’s fiscal system of the Xi era — if not the last couple of decades. It would also be a major down payment on Xi’s pledges to revamp China’s $61 trillion financial sector.
“We believe local and regional governments will still face challenges in their support for LGFVs due to falling land concession revenue,” says Sherry Zhao, an analyst at Fitch Ratings. “Economically stronger regions are likely to have higher resilience, as they are better equipped with stronger state-owned assets and financial resources for long-term debt resolution.”
More vibrant capital markets would reduce volatile boom-bust cycles. Reforms also would leave municipalities more room to implement policies to spread the benefits of economic growth.
Analysts agree major disruption is needed. “China’s economy is not cratering, but it is definitely running at well below potential, and the government seems reluctant to do what it takes to get it up to full speed again,” says Arthur Kroeber, an analyst at Gavekal Dragonomics.
As ever, it will all come down to implementation. Over the last 13-plus years, Xi has at times proven to be better at talking about bold reforms than implementing them. That may be about to change, though, in foundational ways.
Last week, the party’s 24-member Politburo noted that a “resolution on comprehensively deepening reform and advancing Chinese modernization” will be circulated among the Beijing elite. The priority is to transform the nation into a “high-level socialist market economy” by 2035.
One reason for reform hope is that, unlike past moments when big policy pivots were announced, the coming Third Plenum does not coincide with major changes among top leaders, says Haibin Zhu, an economist at Morgan Chase & Co. “This is not the case this time,” Zhu says.
Continuity, economists say, could improve the odds that reforms are implemented.
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