Much of the spending burden of China's local public services and infrastructure will continue to fall on the shoulders of tier-two and tier-three local and regional governments.

S&P Global Ratings believes some of these credit risks may find ways to migrate upwards. That's amid the reform of "hidden debt" (or LRGs' off-balance sheet debt) and revenue challenges faced by lower-tier LRGs in China.

Tier-three LRGs have seen the greatest fiscal deterioration in recent years; these are mostly district, county, and county-level city governments. Upper-tiers have been much more immune or even, in some cases, seen improved fiscal performances. Tier-one governments include provinces and nine municipalities while tier-two LRGs are typically prefecture-level cities (see appendix map).

Chart 1a

Chart 1b

Rising Debt Burdens Is Core To The Migration Risk

Repayment risk rises for lower-tier LRGs as their direct debt loads expand, posing contingent risks to their upper-tiers.   Furthermore, repayment risks at local state-owned enterprises (SOEs) can, in rare cases, require upper-level LRGs to provide support via upper-level SOEs or financial institutions.

Tier-three LRGs are fiscally weaker by design.  While they have been loading up on debt for much of China's local public investments, they are also the most affected by a prolonged decline in land sales– a key component of their fiscal revenue. They also have the most limited revenue flexibility, as the ultimate receivers of orders and funds cascaded from the upper rungs. This is in keeping with an institutional framework in China that is ultimately top-down, and prioritizes fiscal discipline for governments higher up in hierarchy.

Potential cracks in risk migration.   In the base case at the sector level, risk segregation is still effective among different tiers of LRGs. There are, however, channels where fiscal or SOE risks from lower-tier LRGs could permeate into upper-tiers in some regions or situations--constituting downside risks for selected LRGs.

Even as we view the upper-levels to generally have options and mechanisms in place to limit the materiality of risk transfer, they do have incentives to extend support to lower-tiers when a serious situation calls for it. But these would be used sparingly and in a measured way so as to not risk dragging themselves into a murky situation.

Chart 2a

Chart 2b

Limited budgetary impact to upper-level LRGs, but upper tiers may need to assume temporary debt repayment if their lower-tiers struggle

The rules for fiscal revenue sharing and expenditure responsibilities among Chinese local governments favor provincial-level governments.  Hence most of China's 36 tier-one LRGs are fiscally resilient with modest deficits. We don't view them as willing to structurally alter the existing favorable revenue and expenditure distribution to help lower-tier LRGs to fill their gaps on capital spending. Furthermore, they are unlikely to use transfers to support lower-tier capital programs. Such transfers (or subsidies) from upper to lower-tier LRGs are mainly for operating fiscal duties, not for capital purposes. If we were to see large increases in transfers or an alternative fiscal setup, that would hinge on central government policies.

Absent structural changes in fiscal rules, it is unlikely that lower-tier LRGs could shift their burden to tier-one through budgets.  That's because they already collect majority of the fiscal revenues in China. Tier-two and tier-three collect almost all land sales, 80% of the province's tax and fee collections, and about 93% of central government transfer that their tier-ones receive, all goes to support local expenditures. These revenues are rarely enough to plug the imbalances in capital spending, as such they retain a growing portion of new borrowing proceeds (82% in 2020 to 87% in 2023) to fund the wide gaps.

Because of the vagueness between tier-two and tier-three LRG responsibilities in certain spending overlaps, tier-two LRGs may have to pick up the slack if tier-three LRGs struggle.   Cities and districts are generally responsible for local capital-intensive jobs like local transportation, urban and rural construction and development, as they have the local expertise and knowledge.

Additional support to lower-tiers' capital programs through fiscal transfers are likely dominated by central government policies and funds, and unlikely to come from upper-tier LRGs.

Tier-two and tier-three governments receive little capital transfers on a regular basis. Capital transfers from the provincial level accounted for less than 4% of lower tiers' capital expenditures in 2023. Any spike in capital transfer (such as a one-off seen in 2020) would likely be due to special central government funds targeting local capital spending.

Provincial governments are retaining a stable portion of central government transfers at the provincial-level government, to sustain their financial capacity despite lower-tiers faced with increasing revenue challenges.  Rather, in response to revenue challenges, the LRG sector has been scaling back spending plans through fiscal consolidation, including cuts for discretionary uses and on infrastructure investments. Upper-level LRGs like provinces also have the fiscal power to redistribute fiscal resources from one lower-tier LRG to another, so as to support weaker lower tiers without hurting their own fiscal positions.

Chart 3

By China's fiscal design, LRGs receiving the onlending debts assume the debt servicing responsibility.  Onlending tend from provincial-level to lower-tier LRGs has been growing over the past four years. We believe this is a more likely way to provide funding rather than via raising budgetary support.

Upper-tier LRGs typically have firm mechanisms in place to shield their fiscal positions from growing risks from lower-tiers. Back in 2016, the central government issued an "Emergency Response Plan for Local Government Debt Risk Management." Provincial-level governments have successively introduced local policies, with not much regional variation. The plan included comprehensive risk monitoring mechanisms and risk event classifications with corresponding action plans. The plan clearly underlines the responsibility of onlending borrowers to repay such debt using their own resources.

Chart 4a

Chart 4b

If lower-tier governments cannot fulfill their obligations, fiscal consolidation may be forced upon them to pay debt, instead of upper-level LRG directly taking on debt burden for lower-tier LRGs which will fan moral hazard.  Under forced fiscal consolidation, debt repayment would become top priority. Measures could be suspension of government expenditures, matched with intensified efforts to collect outstanding taxes and fees. Then revenues such as land sales proceeds after development costs could be fully channeled to repay debt and spending and infrastructure investment caps would be placed while asset sales could be considered. These should minimize the chances of upper-tier governments having ever to step in.

While public disclosure is scarce, some LRGs appear to already be subject to de facto fiscal consolidation plans due to their high debt and interest burden. We base our view on their stalling of new investments while monetizing assets and resources for debt repayments. Some even started doing so well before China imposed public investment restrictions on highly indebted regions.

However, upper-tier governments may be forced to assume partial and temporary debt servicing responsibilities if repayment stress at lower-tiers is present.  This is because of the nature of "onlent" debt: tier-one governments are the official issuers, hence the legal obligors. Upper-tier LRGs may deduct the sum from future transfers as a form of liquidity management. Tier-two governments are more at risk in assuming these temporary burden from tier-threes given tier-three governments have generally the weakest credit profiles among Chinese LRGs.

This separation of responsibilities will apply to the Chinese renminbi (RMB) 10 trillion hidden debt swap to be issued by tier-one LRGs over 2024-2028.  

The debt swap measures will make China's local government debt more transparent, in that they will swap out LRGs' hidden debt, which mostly reside with tier-two and tier-three LRGs. They will then replace them with debt sitting on tier-one LRGs' balance sheets--with the latter becoming the obligor of the new swap bonds. Tier-one LRGs will then onlend most of the swap bonds to tier-two, then from tier-two to tier-three.

We don't view the debt swaps as debt transfer between the different levels of governments--given the bulk of repayment obligation will stay with the original "hidden debt" obligor. However, deteriorating debt servicing ability at lower-tier governments pose more risks that upper-tier governments may need to extend temporary fiscal support, particularly for tier-two LRGs.

Chart 5

Debt risks of state-owned enterprises will likely stay contained at the level of original local-government ownership

Risks have been accumulating for local SOEs amid difficult operating conditions in the past several years.  We believe most lower-tier SOE debt risks are resolvable within the same LRG.

Chinese LRGs provide support mainly through coordinating and bridging resources from other local SOEs or financial institutions. Those successful resolutions pose limited contingent risk to the upper-tier SOEs, as they are generally addressed at an early stage and often are resolved with help of SOEs owned by the same LRG owner.

Furthermore, LRGs may tolerate SOE defaults on low-risk impact instruments, particularly those with tighter capacities. For example, occasional cases of non-payment or discounted settlements on non-standard debt and commercial papers indicate many in a tight spot have been allowed to work out issues that way.

China's ongoing local debt risk resolution measures should help to delay the risk transfer process for the next two years, as tools are made available to resolve risks mostly within the same tier.  Such measures include those since July 2023 whereby financial institutions were guided to provide refinancing support to selected regions or entities in the next two to three years, as well as the hidden debt swap measures which can pay back some debts at some SOEs. These measures could help reduce immediate debt risks at selected SOEs.

We expect upper-tier SOEs' involvement could continue where lower-tier governments' capacity to support SOEs are tight.  This is also true where risks from lower-tier SOEs could induce wider financing instability and even weighing on the economic prospects of the whole region. We view the risk impact to upper-tier SOEs as low, however, because upper-tier SOEs' involvement is typically limited to liquidity support. This type of support is usually of small size and short-term in nature.

One example would be Xi'an New Area, where provincial and municipal financial bureaus and their respected SOEs together contributed 70% of the initial investment for a government guidance fund of RMB5 billion in 2023. The aim was to provide short-term liquidity support exclusively for Xian's city and district SOEs.

Rare cases of capital involvement by upper-tier SOEs do point to some risk transfer to higher level. One example is Qingdao's establishment of Dongding Industrial Group in 2023, a municipal level SOE that primarily conducts business within Licang district. We believe the SOE was established to address the district's structural SOE debt and liquidity issues. This may entail higher risk assumed by the new municipal SOE and some, albeit measured, transfer of contingent liabilities from the district to the municipality.

Contingent liabilities from weak lower-tier FIs are likely, but the magnitude is manageable, as these institutions are rather small

Support for regional banks will primarily come from their shareholders, including their local government owners.  The loss will first be covered by banks' shareholder and investors of their loss-absorbing instruments; if this is not enough, their respective local governments may step in. Only if those lower-tier governments don't have capacity to provide support, the risk could spill over to upper tier governments--most likely via SOEs or financial institutions they control.

There are a few precedents where upper-tier local or central SOEs have stepped in after shareholders first took substantial losses.   Take the risk resolution of Heng Feng Bank, a bank formerly under Yantai city government, as an example. With mounting pressure on the bank's asset quality leading to a de facto insolvency in 2019, it went through restructuring with capital injection from both Central Huijin (a central SOE, contributing to 60% of new capital) and Shandong AMC (a provincial SOE, 36% of new capital). The provincial government, through its AMC, ultimately became the bank's controlling shareholder after acquiring around 13.5% of share from Central Huijin.

We view the provincial government to have assumed the bank's contingent liabilities, whose recapitalization cost would have been around 24% of Shandong's provincial level operating revenue in 2023. Despite the large capital injection from upper-tier government and entities, the original shareholders also took a substantial loss of around 80% against its end 2016 book value, according to news reports.

Consolidating small regional banks could transfer contingent liabilities to provincial governments, in a few cases.  In recent reform of financially weaker rural financial institutions in eight provinces, two of them-- Liaoning and Hainan--merged many rural financial institutions into provincial-level entities. This will consolidate and transfer contingent liabilities to their provincial governments. However, the other six provinces (Zhejiang, Jiangsu, Henan, Shanxi, Guangxi, Sichuan) adopted the model of "united banks," which retains contingent liabilities at the original lower-tier government levels.

Recapitalizing banks using LRG debts risk transferring select lower-tier bank risks upward.  For example, Hebei (along with a handful of other provinces) issued special purpose bonds to replenish capital of small and midsized banks. The proceeds were given to Hebei State-Owned Financial Capital, a provincial SOE, which injected into five city-level rural commercial banks and 17 rural credit communities. The injection amounted to 5.6% of the province's direct government bond issuance in 2023.

Meaningful redistribution of revenue and expenditure between the central government and LRGs could effectively improve LRG fiscal position

The central government will likely keep growing operating transfers to supplement LRG fiscal resources.  We expect it will also continue to issue extra or special treasury bonds to share more of the spending burden in the next several years compared with previous years. We believe the central government will value efficiency and productivity in its growing support to local investment and will likely focus on projects aligned with national strategic priorities.

Fiscal reform with respect to redistribution of revenue and expenditure between central-government and LRGs could help improve fiscal health of lower-tier LRGs--a likely path as indicated in an important policy meeting in July 2024.  Based on our sensitivity analysis, we believe LRGs' budgetary performance could improve by about 4%-5% of adjusted total revenues under some scenarios. That would bring LRG's budgetary performance back to pre-pandemic levels, all else being equal. Our scenario assumes 5% of LRG operating expenditures are reallocated to central government or 80% of domestic consumption tax is transferred to LRGs.

The impact to local regions may vary, though. For example, consumption tax sharing with LRGs and moving collection points to the sales stage would likely benefit wealthier regions to a greater extent, due to more active consumption activities in higher-end products and services.

The central government is committed to curb aggressive government-led investment through debt at lower-tier LRGs and their SOEs, particularly in highly-indebted regions. On the other hand, economic stability still requires public funding as part of the fuel. Defusing debt risk and spurring regional economic initiatives will be a tough balancing act for fiscal stability.

Digital design: Evy Cheung

Appendix

Related Research

• China's Local Governments: Downside Risk Is Rising For Fiscal Consolidation, Dec. 17, 2024
• China Brief: More Transparency Means More Official Debt For Local Governments, Nov. 12, 2024
• Chinese Local Governments Brief: The Search For Alternative Revenues Won't Be Easy, Oct. 9, 2024
• Is It Working? China's LGFV Debt De-Risk Program One Year On, July 25, 2024
• China's Local Governments: Capacity To Support SOEs Will Be Tighter For Longer, July 8, 2024
• Research update: China Ratings Affirmed At 'A+/A-1'; Outlook Stable, June 27, 2024
• China LRGs: Recouping Revenue Is Key To Fiscal Sustainability, March 27, 2024
• China's District And County Recovery Crimped By Property Slide And Debt Checks, Sept. 13, 2023
• Institutional Framework Assessment: China Provincial Governments' Capital-Light Framework To Support Fiscal Positions, Aug. 10, 2023
• Institutional Framework Assessment: China's Push To Delink LRGs From SOEs Relieves Some Pressure On Tier-Two Governments' Elevated Debt, Aug. 10, 2023
• Institutional Framework Assessment: Critical Local-Spending Responsibilities Still Weigh On Tier-Three LRGs' Fiscal Positions, Aug. 10, 2023