Abstract: On June 15th, the China Finance 40 Forum (CF40) organized a seminar addressing "The Risk Situation of LGFV Debt and Strategies for Mitigation." The seminar focused on the increasing debt risk faced by local government financing vehicles (LGFVs), driven by factors such as declining infrastructure returns, the impact of the Covid-19 pandemic, and a downturn in the real estate market. Experts emphasized vigilance and immediate actions to ensure timely bond repayment. For the long-term, recommendations included promoting the market-oriented transformation of urban investment companies and enhancing government credit support for quasi-public infrastructure projects. Additionally, the authors call for the central government's assistance and a better alignment of expenditure responsibilities between central and local governments for sustainable debt management.
I. THREE MAJOR REASONS FOR THE ESCALATING DEBT RISK OF LGFVS
As significant vehicles for infrastructure construction, local government financing vehicles (LGFVs) have played a crucial role in local economic development. However, they have also accumulated substantial debt. It is estimated that the total interest-bearing debt of LGFVs nationwide is nearly 60 trillion, with approximately 25% in bond form and the remaining 75% in non-bond form. In recent years, the debt risk of these companies has increased due to three primary factors:
First, low and declining investment returns on infrastructure construction: LGFVs primarily undertake infrastructure projects with quasi-public goods characteristics, resulting in inherently low investment returns. Moreover, as infrastructure investment increasingly shifts towards the public service sector and certain areas become saturated, the returns on infrastructure investment continue to decline.
According to statistics, the median return on capital (ROC) for LGFVs has decreased from 3.1% in 2011 to 1.3% in 2022. Additionally, the financing costs of these companies have not significantly decreased despite the decline in investment returns, leading to tightening capital inflow, persistent outflow pressure, and ongoing liquidity constraints.
Second, the traditional financing model of LGFVs, which relies on land value, has become unsustainable due to the downturn in the real estate market. Over the past two decades, local governments have often funded LGFVs through land use rights and related revenues, enabling them to utilize land value and have unique financing capabilities, which has become the most important basis for these companies’ debt expansion. However, since the second half of 2021, land revenue and stock land value have been negatively affected by the real estate market downturn, rendering the reliance on land value an inadequate financing model for LGFVs.
Third, the combination of the pandemic and the real estate market downturn has decreased local government revenue and weakened the ability to coordinate and alleviate the debt pressure of LGFVs. In recent years, due to the pandemic, large-scale tax reductions and price cuts, and the real estate downturn, the fiscal gap for local government is widening. In 2020, national land transfer revenues declined by nearly 30% year on year, with a further drop of almost 20% in the first five months of 2023. Consequently, the ability of local governments to coordinate regional financial and state-owned asset resources for alleviating the debt pressure of LGFVs has weakened.
II. THE DEBT RISK OF LGFVS SHOWS DIFFERENTIATION IN MULTIPLE ASPECTS
First, regional differentiation: There is a differentiation in debt risk between LGFVs in different regions. Experts suggested that LGFVs in some metropolitan areas and southeastern coastal provinces have relatively higher debt-servicing capacity and lower refinancing costs. Conversely, in certain western and northeastern provinces, local financial strength and land markets have faced more substantial negative impacts in recent years, and refinancing channels for LGFVs are narrower, costs higher, and debt risks more prominent.
Second, differentiation between different levels of LGFVs: from the perspective of stock urban investment bonds, provincial and municipal LGFVs issue approximately 45% of the total urban investment bonds, and most of these companies are able to finance themselves. However, according to some experts, approximately 55% of urban investment bonds are issued by county-level or industrial park-level LGFVs, some of which, face greater repayment pressure due to their lower hierarchy and limited market recognition.
Third, differentiation between standardized and non-standardized debt: some experts pointed out that the default risk of non-standardized debt, such as credit channel financing and directed financing of LGFVs, has increased. In the first four months of 2023, there were 73 default cases on non-standardized debt of LGFVs, reaching the highest level since 2018. However, no defaults on standardized debt have been reported, especially on bonds issued in the open market.
III. POLICY RECOMMENDATIONS
The debt risk of LGFVs, if not properly handled, could result in risk proliferation and cause, among other things, operational risks for non-bank financial institutions and financial market volatility.
Experts at the seminar advised that it is imperative to safeguard the payment of bonds in the open market so that there will be no substantial risk for urban investment bonds in the short term. Measures such as extending bank loan terms and reducing refinancing costs should be considered to "exchange time for space". Specifically speaking:
First, it is recommended that the LGFVs and local governments should attach great importance to jointly making succession arrangements in advance for the debt maturity repayment funds.
Second, utilize accounts receivable for credit enhancement. LGFVs can issue bonds based on their accounts receivable from the government, thereby reducing refinancing costs. By using a certain ratio of these accounts receivable as credit enhancement measures, the possibility of successful issuance can be increased, and the cost of the interest payment can be lowered.
Third, local governments can employ channels such as local government bonds, bank loans, and direct financing to replace stock non-standardized and high-cost financing of LGFVs, thereby reducing interest expenses and extending the repayment period. The example of Jiangsu province is worthwhile for other regions to learn from. Thanks to its economic and financial strength, debt management and coordination capacity, and the advantages of regional financial resources, the provincial government promoted the collaboration between LGFVs and financial institutions in Zhenjiang city and supported the city in relieving its debt pressure through debt quota, which improves the regional financing environment and achieve smooth market-oriented financing.
In the medium and long term, three key recommendations are proposed: First, promote market-oriented transformation of LGFVs. This involves clarifying the government’s and enterprises’ responsibilities and rights to enable LGFVs engaged in market-oriented activities to operate as local state-owned enterprises in line with contemporary corporate governance principles. Second, for LGFVs involved in quasi-public projects, their financing should rely partially or entirely on government credit. Third, the central government should provide greater support for local infrastructure financing, ensuring a better alignment of expenditure responsibilities and financial resources between the central and local governments.
The article is one of CF40’s briefings. It is translated by CF40 and has not been reviewed by the authors. The views expressed herewith are the authors’ own and do not represent those of CF40 or other organizations.
