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China's hidden debt swells in scramble to finance public works

Off-books bond issuances on track to climb 50% in 2020

A man holding a face mask walks past a construction site in Beijing on July 16.   © Reuters

SHANGHAI -- On the outskirts of the coastal Chinese city of Ningbo, a construction crew busily adds new lanes to a highway to the neighboring city of Hangzhou. Clanging steel and roaring vehicles echo throughout the site.

"Construction resumed back in March, but we've picked up the pace recently," a worker said. "We're getting paid more overtime, too."

Zhejiang Communications Construction Group, the contractor handling the highway expansion, is one of China's local government financing vehicles -- companies that borrow from financial institutions and issue bonds to essentially raise funds for local governments off the books, money that is often used for infrastructure projects.

LGFVs have been instrumental in lifting the Chinese economy out of its coronavirus doldrums. But their mounting liabilities, widely understood to be at least partly backed by regional governments, loom large over the nation's recovery and financial markets.

"We will allocate more resources to this project," a Zhejiang Communications Construction executive said while touring the Ningbo site this month. The vehicle issued 800 million yuan ($114 million) in bonds in 2019 and is expected to continue tapping the market for additional funds.

A metal-processing facility in Ningbo, Zhejiang Province: Many of China's infrastructure projects are financed through off-the-books debt. (Photo by Yusho Cho)

Nationwide, China's local financing vehicles issued 3.3 trillion yuan in new bonds between January and mid-July, up 50% from the same period last year. The figure is already three-quarters of the full-year total from 2019, according to financial research company Shanghai DZH.

China has been among the first countries to escape from a coronavirus-induced economic slump, with gross domestic product increasing a real 3.2% on the year for the April-June quarter. Still, much of the recovery has been fueled by the real estate market and infrastructure projects funded by national, regional and LGFV bonds. Wages and consumer spending remain sluggish.

China's official stance is that regional bonds are the only legal way for regional governments to raise money. It has repeatedly stressed that neither the central nor regional governments are responsible for paying back LGFV bonds or for rescuing these vehicles.

But many still expect regional governments to help out with at least some of these bond repayments if necessary, given how closely they work together and the potential blow to the financial system from a large-scale bond failure.

"We have the government on our side, so we will have no problems or risks when it comes to repayment," a local financing vehicle in the city of Changzhou said, hinting that its bonds are essentially guaranteed by the government.

Chinese regional governments were estimated to have nearly 43 trillion yuan ($6.16 trillion) in hidden debt at the end of 2019, according to China Chengxin International Credit Rating. Combined with regular, on-the-books debt, these governments are believed to owe roughly 67 trillion yuan as of the end of June. The more hidden debt they accumulate, the greater the risks posed to China's financial market.

Some local financing vehicles are already running into trouble. A vehicle for Zunyi, a city in Guizhou Province, failed to make repayments on wealth management products in March. Wealth management products are often purchased by companies and wealthy investors and do not make it onto bank balance sheets, making them a common instrument for shadow banking. Other financing vehicles in Zunyi are also said to be in bad shape.

In May, a credit-rating agency issued a rare warning on bonds issued by a financing vehicle for Yingkou, Liaoning Province, that faced maturity for 500 million yuan in bonds with just 40 million yuan in cash and cash equivalents. The vehicle ended paying back the bonds on schedule, but where the money came from remains unclear.

Chinese President Xi Jinping is urging banks to boost financing to companies, allowing many LGFVs to raise funds even more easily of late. But some vehicles and regional governments are starting to buckle under the weight of their debts, exposing the limitations of an economic recovery led by public projects.

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