November 23, 2016 1:00 pm JST

China again grappling with 'hidden' local debt

YUSHO CHO, Nikkei staff writer

Railroad construction funded by a local government financing vehicle.

SHANGHAI -- China's local governments have issued more debt through investment funds designed to skirt financing restrictions so far this year than in all of 2015, leading the central government to crack down on what could potentially lead to an explosion of credit risk.

Local government financing vehicles are used to raise government funds with bond floats and bank loans. They are also involved in building and running sizable infrastructure projects. Issuance of LGFV bonds, also known as chengtou notes, from January to November totaled 1.7 trillion yuan ($246 billion), compared to the 1.3 trillion yuan or so for the entirety of 2015.

Money raised by LGFVs goes both to refinance old debts and to fund new investments. One vehicle created by Zhejiang Province has issued 4 billion yuan in bonds this year to fund parking lot construction. Proceeds from the sale of the facilities will help pay down that debt. Another fund has floated 1 billion yuan in bonds to finance a railroad.

Local governments turn to these vehicles out of a chronic lack of cash. The real estate bubble in certain areas has yet to reach the interior, where government revenues from the sale of land are stagnant. Meanwhile, tight regulation makes it difficult to issue provincial bonds directly. Local governments also face pressure to invest in public works to stimulate the economy, leaving few options other than LGFV bond floats.

Beijing ordered local governments to rein in such issuance in 2014 as LGFVs disrupted fiscal discipline. But the central government reversed course the following year, letting shadow financing slide as the risk of slowing economic growth rose. This year, LGFVs have floated between 400 billion yuan and 500 billion yuan in debt each quarter.

Local government debt is seen totaling more than 17 trillion yuan at the end of 2016, posing an increasingly obvious risk to public finances. LGFV bond issuance, meanwhile, is likely not entirely accounted for on local government books, creating transparency issues.

Were a sizable share of that debt to go bad, China's credit rating could take a hit. Beijing has therefore stepped in once again. The Ministry of Finance asserted in early November that LGFV bonds should not count as local government debt, implying that such debt may not be subject to the tacit guarantee given by the central government to local bonds. This aims to curb investors' appetite for the instruments, reducing further issuance.

The State Council said Nov. 14 that local governments are in principle responsible for paying back their own debts. Four types of debt risk and emergency responses for each have been laid out, sending the message that local governments will be held accountable for such events as defaults and should shape up accordingly. But tightening belts too far could have a chilling effect on China's overall economic growth -- an equally pressing problem for Beijing.

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