China To Defuse Its $13 Trillion LGFV Debt Time Bomb?

“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.

“The Plenum will likely sustain the economic framework that has taken shape in recent years: prioritizing chokepoints in supply chain self-sufficiency and tech innovation,” says Robin Xing, an economist at Morgan Stanley.

Shuang Ding, an analyst at Standard Chartered, expects this month to be a key moment for Xi's legacy as a reformer.“We expect the Plenum to reiterate the party's support of private-sector expansion as well as a stronger state sector and the decisive role of the market in resource allocation.”

More importantly, Ding adds,“we think they'll take steps to remove cross-region barriers, encourage innovation and green transition, and improve income distribution. We also expect them to attach greater importance to security, addressing risks in the housing and financial sectors and increasing the resilience of the supply chain. The market will likely pay close attention to potential fiscal/tax reforms that are essential for long-term sustainability.”

This latter push could be a game-changer for local governments, though it might not enliven GDP significantly in the short run. In fact, efforts to repair local government finances would increase economic headwinds in the short term.

The“focus on deleveraging the housing sector and LGFVs continues to exert downward pressure on growth and deflation continues,” Xing says.

In recent months, LGFVs have found it much harder to issue bonds as regulators have intensified efforts to reduce risks in one of China's most debt-plagued sectors.

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That“points to the continued regulatory tightening since the fourth quarter last year and we haven't yet seen any signs of relaxation,” says Laura Li, an analyst at Standard & Poor's.

“This suggests that it's increasingly difficult for low-quality, low-rated LGFVs, including those from affluent provinces such as Jiangsu and Zhejiang, to issue bonds in future,” Li added.

But allowing local governments to retain more tax revenues could alter incentives in powerful ways. As economist Jonathon Sine, author of the Cogitations newsletter, explains, Beijing in decades past wanted revenues routed through its own coffers for purposes of control, most importantly over subordinate levels of government and redistribution.

“That becomes evident once you realize the central government simply transfers back just about all the money,” Sine explains.“Indeed, once transfers are accounted for the oft-cited central-local fiscal gap disappears. Unfunded mandates did materialize following the 1994 budget reform, but in a more nuanced way.”

Locally generated revenues are often shipped from the provinces to Beijing and back again. Photo: Asia Times Files / AFP

Yet the“problem was – and still is – in the nature of the intergovernmental transfer system,” he says.“Beijing bureaucrats apportion funds to the provinces, who are in charge of apportioning funds to prefectural cities, who are in charge of apportioning among county-level units, who are in charge of apportioning among townships.”

Sometimes, Sine notes,“the provinces send funds directly to the counties, by-passing the cities. Each level also needs their own funds. And each level can take months before passing on the funds it received. By the time funds get from top to bottom, a year or more can pass.”

By ending this M C Escher-like financial system , China could increase the efficiency of the globe's second-biggest economy, disrupt distorted incentive structures and get Xi closer to fulfilling his high-quality growth promises.

Follow William Pesek on X at @WilliamPesek

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