Borrowings by these entities exploded following the financial crisis, when Beijing encouraged LGFVs to play a key role in funding Chinese infrastructure projects, one of the big drivers of growth for the world’s second-largest economy.
But as China’s post-COVID-19 economic rebound sputters, investors are becoming increasingly worried that some cash-strained local governments might be tempted to allow some LGFVs to default on their borrowings.
Impact on confidence
These worries are already reflected in Chinese credit markets. Already more than 10 Chinese provinces have found themselves, in effect, locked out of the domestic bond market, which means they’re unable to issue enough new bonds to repay maturing debts.
Jitters over a looming debt crisis are also blamed for eroding confidence more broadly. After rallying strongly in the early months of the year, China’s CSI index has now had all its gains for this year wiped out. Meanwhile, the Chinese yuan has weakened to below the psychologically important level of 7 against the US dollar.
The finances of regional governments are under pressure as the country’s economic recovery falters, and the property sector’s continuing problems have caused land sales to collapse.
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China’s economy has failed to rebound as robustly as expected after the Draconian zero-COVID rules were loosened at the end of last year. The latest figures for industrial output, retail sales and credit growth came in well below expectations, suggesting that at best China’s growth this year will be in line with Beijing’s target of about 5 per cent.
Meanwhile, in the country’s embattled property market, sales are slowing after an initial rebound, and debt-laden local governments are pulling back on infrastructure spending.
Servicing the debt
Fears that China’s economic recovery is faltering are also reflected in declining commodity prices. The price of iron ore, a crucial ingredient for steelmaking, has fallen 23 per cent from its March high.
China’s flagging growth outlook is also exacerbating the country’s debt problem. In the past, the economy was able to rely on rapid economic growth to alleviate its debt strains.
But slower growth means it’s difficult for revenue to keep pace with the growth in total Chinese debt – including governments, companies and households – which has now ballooned to more than 300 per cent of GDP.
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Investors are particularly worried about the ability of LGFVs to continue servicing their debts, particularly since many of the infrastructure and property projects they backed are uneconomic and are delivering investment returns well below the cost of debt.
At the same time, Beijing is showing an increased resolve to impose financial discipline on local and regional governments. It wants to discourage them from using the off-balance sheet borrowings of their LGFVs, and instead rely on bonds backed by the central government.
But Beijing’s crackdown on local and regional government finances comes at a time when many are experiencing severe financial strains from slowing activity. Last year, local tax revenues fell almost 10 per cent and revenues from land sales plunged by more than 25 per cent.
Short-term solution
That leaves local and provincial governments with the problem of whether to use part of their dwindling revenues to repay the borrowings of their LGFVs.
Of course, the local authorities will be reluctant to default in the first instance. Instead, they are likely to lean on regional banks to provide financing to the LGFVs, allowing them to repay maturing bonds.
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But this strategy is only a short-term solution. It will lead to questions about the financial robustness of the regional banks, making it more difficult for them to raise funding from investors and depositors.
China’s economic rebound was already on shaky ground. The growing strains on local and provincial governments as they grapple with the massive $15.3 trillion of borrowings accumulated by their financing arms threatens to further derail the recovery of the world’s second-largest economy.
And that suggests that prices for Australia’s key commodity exports – such as iron ore and coal – have even further to fall.
The passage delves into the intricate web of China's economic landscape, focusing primarily on the challenges faced by Local Government Financing Vehicles (LGFVs) following the financial crisis. LGFVs became pivotal in funding China's infrastructure projects, fostering substantial economic growth post the financial crisis.
These entities encountered a surge in borrowing post-financial crisis, supported by Beijing's encouragement to aid infrastructure projects, a significant driver of China's economy. However, the post-COVID economic recovery in China has shown signs of struggle, raising concerns about potential defaults by cash-strapped local governments, impacting investor confidence.
Several factors contribute to these concerns, notably the inability of some provinces to issue new bonds for repaying debts, which has led to market restrictions for more than ten Chinese provinces. This restriction has triggered broader market apprehensions, reflected in the decline of China's CSI index and the weakening of the yuan against the US dollar.
The economic recovery's stuttering trajectory is evident in various sectors, including industrial output, retail sales, and credit growth, all falling below expectations. The property sector's ongoing problems have led to a collapse in land sales, further straining regional governments' finances.
Additionally, China's economic slowdown has led to a decline in commodity prices, particularly iron ore, which is crucial for steel production. The decelerating growth has exacerbated China's debt burden, reaching over 300% of GDP, challenging revenue growth to match the escalating debt.
Investor concerns specifically target LGFVs' ability to service their debts due to uneconomic infrastructure and property projects delivering returns below the cost of debt. Beijing aims to impose financial discipline on local governments, discouraging off-balance sheet borrowings and promoting reliance on central-government-backed bonds.
The current scenario leaves local governments with the quandary of repaying LGFV borrowings amid dwindling revenues. While default is an unappealing option, reliance on regional banks for financing LGFV repayments poses short-term solutions that may strain the banks' financial stability, complicating their funding acquisition from investors and depositors.
Ultimately, the fragility of China's economic rebound, compounded by the mounting debt amassed by LGFVs, threatens to derail the recovery of the world's second-largest economy. This predicament also forecasts further price declines for key Australian commodity exports like iron ore and coal, closely tethered to China's economic performance.
