Local Government Financing Vehicles: A Growing Risk for China’s Economy?

We believe idiosyncratic credit events may occur over the next 12 months, but systemic bank risk is remote.

Local governments have been instrumental in driving China’s remarkable economic growth over the last 30 years, in particular by providing massive public investments in critical physical and social infrastructure. Yet, amid a slowing economy and an ailing property market, debt-laden municipalities now pose a potential risk to China’s economic growth and financial stability.

Market concerns have resurfaced over local governments' off-balance-sheet debt, which amount to 55-60 trillion yuan (U.S. $7.5-8.2 trillion) by our estimates. These off-balance-sheet entities, known as local government financing vehicles (LGFVs), were set up to fund infrastructure projects. According to Bloomberg, a record number of LGFVs failed to make payments on short-term debt in July, amounting to 1.86 billion yuan (U.S. $258 million), up from 780 million yuan in June.

Chinese leaders at the July Politburo meeting pledged to formulate "a basket of plans" to resolve risks stemming from local government debt. In August, Chinese media reported that local governments (LGs) will be allowed to sell about 1.5 trillion yuan (U.S. $210 billion) of special financing bonds to help 12 regions repay debt.

We do not believe LGFVs pose a systemic risk to the banking system. However, idiosyncratic credit events could occur over the next 6 to 12 months – and, in the long run, banks will likely have to bear some of the cost of debt resolution. In the worst-case scenario, which we see as unlikely, a collapse of the LGFV bond market could drag down China’s GDP growth by about 1 percentage point over one year.