Recent media reports on China’s debt-ridden Guizhou province pleading for Beijing to bail it out  have raised market concerns about billions of dollars in local government debt which has been seen as ‘the canary in the coalmine’. The issue with impoverished Guizhou’s sizeable debt burden is illustrative of problems at China’s local government financing vehicles (LGFVs). 
While we believe the size of the LGFV debt is unlikely to become a systemic risk,  the singular risk posed by LGFVs could be a source of volatility in China’s financial system over the medium term as Beijing continues to retreat from its implicit guarantee policy.
The LGFVs’ debt repayment issues relate to a sharp drop in land sale revenues and caps on their ability to tap alternative sources of funding.
What of LGFV risk?
Assessing the outlook and implications of LGFV-related risk requires an understanding of the different types of LGFVs and Beijing’s attitude towards them.
Firstly, size matters. In winding down its implicit guarantee policy, Beijing has in recent years allowed large state and non-state companies to fail. They include Evergrande, Huarong Asset Management and the HNA group. By implication, Beijing could also let go of any of the thousands of LGFVs that it deems to be non-systemic.
Secondly, there are two types of LGFV: quintessential and hybrid. Although both are local government-owned entities, the latter have more diversified holdings and behave like state-owned enterprises (SOEs). For example, a hybrid LGFV may finance public housing as a local government would do, but it can also invest in commercial property, just as a private company can.
Beijing has been pushing many LGFVs to diversify, hoping they could generate more revenues and depend less on local government coffers. However, since this process began in 2015, these LGFVs have become more fragile due to excessive risk-taking and poor risk management. It means that the risk of LGFV default is concentrated in these hybrid LGFVs.
Thirdly, Beijing views hybrid LGFVs as more dispensable than quintessential ones. The commercially diversified nature of hybrid LGFVs means they function like (local) SOEs. As Beijing retreats from its implicit guarantee policy, which has resulted in rising defaults in recent years (Exhibit 1), it has allowed (local) SOEs to fail in the hopes of imposing market discipline on the state sector to reduce moral hazard.
Hybrid LGFVs are thus not on the bailout priority list and will have to deal with their debt obligations on their own rather than count on the local or central government.
Limited resources mean tough choices
The bottom line is that faced with tight budgets, local governments must make tough choices on where to spend their limited resources. Since tackling the debt problem is likely to be prohibitively expensive, if push comes to shove, they will likely let the less important hybrid LGFVs fail.
As long as systemic risk is contained, the central government cannot be expected to intervene. Beijing sees a controlled default process as a way to weed out bad assets and reduce debt in the system by allowing the bad companies to fail or default.
Nevertheless, depending on the scale of hybrid LGFV failures, Beijing may have to erect a firewall before regional financial instability becomes systemic instability. Striking a balance between invoking market discipline and preventing systemic instability is difficult, requiring accurate judgment of the risks and the timing of intervention on Beijing’s part.
Beijing could be at risk of a policy miscalculation, creating a Black Swan event. Also, it cannot – nor does it want to – save every hybrid LGFV. In short, there are likely to be more LGFV defaults in the coming years as China’s debt reduction and restructuring processes move ahead.
Given the central role of LGFVs in funding infrastructure projects, which play a key part as one of the main drivers of growth for the world’s second-largest economy, dealing with their financing and spending issues will be an important test for China’s modest economic growth target of around 5% this year.
1 For example, see “China Province Steps Up Its Plead for State Aid on Debt Woes”, Bloomberg, April 24, 2023, or “China May Have to bail Out One of Its Poorest Provinces”, CNN Business, April 27, 2023 (here), or “One of China’s Most Debt-Ridden Provinces Asks Beijing for Help in Now-Deleted Online Post”, South China Morning Post, 12 April 2023 (here).
2 “Chi on China: China’s Systemic Risk (II/II): Local Government Debt”, 14 May 2014 (here).
3 See reference in footnote 2.