It's now a year since China unveiled a "package of plans" to de-risk local government financing vehicles (LGFVs). Under the package of measures, local governments, financial institutions, and investors are all required to shoulder some of the costs to resolve this sector's outsized debt burdens. The overriding aim is to ensure economic stability and prevent systemic risks. So are the plans working?

The coordinated efforts have indeed alleviated the most pressing repayment needs of the weakest LGFVs and boosted market sentiment. Maturity extensions, cuts in funding costs, and settlement of a portion of hidden debt are underway, chipping away at entities' refinancing needs and lowering their interest burdens.

But S&P Global Ratings still sees uncertainties over the longer term. It's unclear that support from local governments and financial institutions could buy enough time for most LGFVs to transform themselves into self-sufficient state-owned enterprises (SOEs). This is particularly difficult for a large number of relatively small LGFVs linked to low-tier governments.

Investors are asking for more information on the challenges ahead.

Frequently Asked Questions

How big a problem is LGFV debt?

It remains a big problem. At least Chinese renminbi (RMB) 1 trillion in bonds alone will mature in each of the next couple of quarters; and bonds just represent no more than 20% of our estimated LGFV total outstanding debt. Measures have been prioritizing the debt servicing of LGFV bonds.

Refinancing pressure is acute. On average, about 25% LGFV debt matures over the next 12 months, but that rises to more than 30%-40% for many lower-tiered and weak entities.

It won't be easy to quickly reverse the debt momentum after years of fast growth. Last year LGFV debt growth dropped moderately--but was still a high single-digit. We think borrowings will likely grow at a mid-to-high single digit over the next couple of years.

This is not to say it's easy to borrow; conditions are challenging. The authorities' control over LGFV bond issuance has led to negative funding (i.e., net repayment) for three consecutive quarters in the domestic market--the first time this has happened in years. The weakest LGFVs have been hit the most. In our view, the recent resurgence of high-cost offshore bond issuances for refinancing or interest payment purposes possibly indicates liquidity crunches at a small number of LGFVs.

Will the package of plans resolve the debt risks?

So far, we see temporary fixes. The measures are more focused on "buying time," mainly through refinancing maturing bonds, replacing high-cost non-standard debt with loans, or banks rolling over loans to longer tenors for liquidity-weak LGFVs. These efforts could possibly continue until mid-2027, based on recent reports from reliable media sources.

We also note that some of these measures have been extended under existing policy directives, and question whether this "same for longer" approach will be enough. Because the fundamentals of the entities haven't improved for many such entities, i.e., their own cash flow from operations and investments remain sluggish (see "China Policy Patches Alone Won't Fix LGFVs' Fraying Liquidity," published on RatingsDirect on Sept. 7, 2023).

In our view, it's possible that some weak LGFV could become heavily reliant on these stop-gap support measures for a much longer period of time. We note that:

Tightening regulatory control is hampering debt growth for some weak LGFVs.  Some riskier borrowers can no longer obtain bond financing or even the usual alternative: high-cost, non-standard debt (such as trust loans, financial leasing, or direct financing registered at local asset exchanges). To some extent, this situation has increased cases of non-payment or discounted settlements on non-standard debt and commercial papers.

Defaults and haircuts have led to losses for lenders or investors, and this may improve market discipline.  These cases are generally bilateral in nature, in small amounts, and can be renegotiated without causing systemic impact to other funding channels. Still, they may fuel the push to deleverage some LGFVs and recalibrate market expectations to consider higher LGFV risks, i.e., non-standard debt lenders would become more cautious toward weak LGFVs.

At the end of the day, the issue is that many LGFVs are not operationally self-sufficient. The existing measures are unlikely to resolve the debt risks or serve as a more impactful and long-lasting solution until substantial transition can occur widely.

What's the most likely way out of the debt crisis for LGFVs over the long term?

Business transition to more commercial models. Some of this will occur via top-down consolidation of SOEs into larger entities. But in our view, consolidation won't guarantee better debt control or a smooth business transition unless there's better cash flow from operations and investment returns, and effective business integration. And that raises uncertainty about how soon or effective the governments can facilitate debt resolution at the LGFVs.

Business transition won't be easy, particularly for many lower-tiered LGFVs from small cities and districts/counties. Regulators' stringent control over debt growth will constrain new projects and financing options, making new investments to spur transition more difficult.

Lower-tiered entities and their government owners have limited resources to transition their business models. Existing policy directives ensure feasible transition channels are mostly related to land and property, as outlined under the "Three Major Projects" initiatives. These initiatives aren't new for most LGFVs; their past cash flow generation from land and property businesses has been sluggish even in many major cities. And given the prolonged property downturn, cash flow could be further constrained (See "China LGFVs' Bigger Housing Role: Risk Control Matters," March 27, 2024.)

Some entities have successfully transitioned toward more commercial models. They do this by choosing and structuring projects that can deliver more cash flow to cover obligations better than before.

In other cases, we've observed so-called "business transitions" are more style over substance. Hundreds of entities have recently announced their "delisting" as government financing arms, even though some of them haven't substantially reformed their business operations and financial management. In our view, some delistings are mainly to bypass certain financing restrictions placed on LGFVs. Such delistings or name changes won't fundamentally change their credit profiles or debt-servicing ability.

What is the role of local and regional governments (LRGs) in the resolution of local debt risks?

LGFV debt comprises: (1) LRG spending that is effectively undertaken by the LGFVs, or so-called "hidden debts"; (2) the LGFVs' own commercial debt and other debts that have not been declared as hidden debts. LRGs are responsible for repayment of hidden debts but not for other LGFV debts.

LRG Special Refinancing Bonds (SRBs) have helped to clear some hidden debt, a task that is scheduled to be completed by 2028. More typical means to clear hidden debt include fiscal revenues, monetizing assets, project returns, and restructuring some of the debt. LRGs have issued Chinese renminbi RMB1.5 trillion in SRBs over the past 10 months. This means the governments crystalized these hidden debts on their balance sheets and at a lower cost than LGFV borrowings.

But the SRBs can only do so much. The central government caps the future amount of SRBs that LRGs can issue (through the difference between the LRG debt ceiling and debt outstanding). As of end 2023, we estimate the cap at RMB1.43 trillion.

New hidden debt remains prohibited and closely scrutinized. The 2023 audit report of government budgets revealed illegal instances of LRG off-budget debt. But the scale is immaterial (RMB37 billion) compared with the total size of LRG debt (RMB41 trillion) as of end 2023.

LRG oversight for LGFVs' commercial debts is likely to mean more resource bridging.  That's because mismanaged credit events can induce systemic financial or social risks. Before LGFVs succeed with the long-term goals of commercialization and improved self-sufficiency, governments will focus on controlling the debt growth of these entities through guidance and coordinating financial resources for LGFVs they consider worthy enough to stay afloat.

LRGs may assume responsibility for bringing stakeholders to the table to work out a resolution, which can include other SOEs, banks, or investors. We think they are likely to allow low-impact risk events to happen, such as non-standard debt and commercial papers, which typically have a smaller number of creditors and less public attention.

We think LRGs will prioritize support toward LGFVs that carry out critical public functions on behalf of the governments. The prioritization comes amid a backdrop of weakened LRG capacity and health of the SOE sector in general. The prioritized LGFVs also tend to have a strong and durable association with their LRG through controls, and support policy and mechanisms, among others. The LRG coordinated support is most often provided by other SOEs, or at times financial institutions.

Have LRGs' special bonds been effective? Are more to come?

SRBs alleviate the considerable strain for selected high-debt provinces. In selected regions where debts are smaller in absolute terms, SRBs have played an impactful role. For example:

• Guizhou has issued the most to date at RMB289 billion, equivalent to 26% of total LGFV debts outstanding as of end 2023, according to Wind, a financial information provider.

• Tianjin is second with RMB175 billion (14% of LGFV debt). Then Yunnan with RMB126 billion (32%), Hunan with RMB112 billion (6%), and Inner Mongolia with RMB107 billion (563%).

• In some regions, such as Inner Mongolia and Liaoning, the SRBs also played an instrumental role in meeting LRG payables.

We expect China LRGs to issue lower amounts of SRBs in 2024.  So far this year, Tianjin and Guizhou have issued such special bonds of RMB109 billion in total, far short of the RMB1.4 trillion for 2023. This reflects our view that the bonds are aimed at offering short-term risk relief for selected regions, rather than being a long-term solution.

Aside from regular channels, LRGs may grapple for new means to tackle their hidden debt. Media reports suggest Henan has issued bonds for new investments. For RMB52 billion of these instruments, Henan cited the use of proceeds as "repayment of existing debt"--a common term for swapping out hidden debts. It soon replaced this statement with the more generic "various government-mandated projects." We think the switch reveals potential policy tweaks to accommodate LRGs' needs for debt resolution.

Henan is not one of the 12 high-debt provinces, and therefore tends to benefit less from the de-risking measures such as quotas for SRBs. Since the fourth quarter of 2023, we estimate Henan has issued RMB35 billion in LRG SRBs to swap out hidden debt.

Who can help LGFVs to refinance their debts?

We expect banks, local governments, LGFVs, and original lenders to share the pain and balance the risk between creating moral hazards and triggering a public confidence event.

In our view, policy banks will play an important role in assisting LGFVs to refinance part of their existing high-cost, non-standard debts and certain bank loans from local banks and megabanks will play an incremental role. Policy banks are likely to take a lead role in supporting LGFVs linked to regions with weaker credit profiles while megabanks will probably be involved selectively in a commercially viable manner.

Regional governments are likely to tap regional banks in their jurisdictions to provide some funding at times. That said, some regional banks, especially in regions with weak credit profiles, are likely to have limited capacity to help and won't take a lead role.

We estimate that the small regional banks that the central bank has designated in yellow and red zones (reflecting medium to high risk levels, respectively) account for a third of the total assets of city commercial banks and rural financial institutions (or about half in terms of numbers of entities). These weak banks and financial institutions have limited capacity to extend new loans to refinance a significant portion of LGFVs' high-cost non-standard debts. That's because of the constraints that these banks face over regulatory capital requirements.

Debt restructuring deals are likely to be a major tool used to help LGFVs avoid payment defaults. Having said that, we expect to see some LGFVs restructure their obligations after missing debt repayments, and a small number of LGFVs will be closed or consolidated into other platforms.

How will debt restructurings affect banks?

The impact on policy banks and participating commercial banks will be uneven, in our view, driven by the intensity of their participation and their existing expense and funding structure.

Original lenders, including banks, trust companies and other nonbank financial institutions, are likely to suffer haircuts on loan principals in a debt-restructuring scenario. Such concessions on the debt principal will have an immediate impact on the lenders' profit. As a recent example, a leasing company took a 15% haircut on debt principal of its loans to Guangxi Liuzhou Dongcheng Investment & Development Group Ltd. (unrated) in a debt restructuring deal.

We believe regional banks will suffer the most relative to their asset size since they have the highest exposure to lower-tier LGFVs, which are more likely to have weak cash flow and high non-payment risk. High geographic concentration would also exacerbate the pressure on regional banks operating in weaker regions, such as northeastern and southwestern China.

Lenders providing concessionary-rate funding to these restructured deals will see pressure on their net interest margins. Given the tenor of these restructuring deals are likely to be long (at 10-15 years or more), the impact on net interest margins will linger. Policy banks, and to a lesser degree, megabanks, are likely to shoulder a fair portion of pressure on net interest margins.

While loan restructuring would provide breathing room for borrowers, banks continue to bear the credit risk. A feasible loan restructuring plan with reasonable cash flow to service the debt is critical, in our view. Lenders and borrowers would just be kicking a can down the road if the plan is overly optimistic, and we expect to see some borrowers to run into distress again in three to five years.

If borrowers fail to service restructured loans, they could be reclassified as nonperforming loans, which would attract significant additional provision requirements for banks at a later stage.

Related Research

• China's Local Governments: Capacity To Support SOEs Will Be Tighter For Longer, July 8, 2024
• Your Three Minutes In China LGFV Bonds: Weaker Entities Go Long, June 27, 2024
• China Local Governments: The Slow Road To Stabilization, June 13, 2024
• Record Bond Rejections To Squeeze China's Lower-Tier LGFVs, April 11, 2024
• Credit FAQ: What Are The Credit Implications Of China's Various Programs To Support Growth?, March 28, 2024
• China LRGs: Recouping Revenue Is Key To Fiscal Sustainability, March 27, 2024
• China LGFVs' Bigger Housing Role: Risk Control Matters, March 27, 2024
• Credit FAQ: Policy Implications Of China's 2024 "Two Sessions", March 18, 2024
• Same Game, Different Name: China LGFV Issues To Repay The Debt Of A Peer, Feb. 29, 2024
• China Policy Shift May Saddle LGFVs With A Fresh Problem: Stranded Assets, Jan. 25, 2024
• China LGFVs Face Higher Liquidity Risks As Funding Channels Tighten, Jan. 11, 2024
• Can China's 'Basket Of Measures' Defuse LGFV Debt Risks?, Nov. 20, 2023
• "China's Fiscal Bid To Stanch Local SOE Debt Risk, Nov. 2, 2023
• LGFV Strains May Inflict A RMB2 Trillion Hit On China Regional Banks, Oct. 18, 2023
• China Policy Patches Alone Won't Fix LGFVs' Fraying Liquidity, Sept. 7, 2023
• What Are China's Options To Resolve Local-Government SOE Debt Risk?, Aug. 2, 2023
• China's Local Governments Are Shedding Their Ties To Struggling SOEs, March 1, 2023