Early Optimism and Hidden Risks
In early 2019, officials in Liuzhou, a factory town in the southern region of Guangxi, were bullish about their city’s future. The economy was booming, a new industrial district was on the horizon, and an elevated light-rail system was in development. Mayor Wu Wei lauded the local party leaders’ efforts in a city report, but he didn’t mention the substantial hidden debt that had fueled much of the city’s economic expansion.
“The achievements of the past year have not come easily,” Mayor Wu Wei stated, crediting the perseverance and strategic planning of local party leaders. However, he omitted a critical element of the city’s growth strategy—the extensive off-the-books debt incurred for economic development projects. This hidden financial burden was instrumental in creating the illusion of prosperity and infrastructural advancement.
The Hidden Debt Crisis
Liuzhou and many other Chinese cities amassed trillions of dollars in debt that was kept off the books for years in order to finance different development initiatives. China became the envy of the world due in large part to its opaque financing system, which contributed to its rapid economic rise. However, today, the remnants of this debt-fueled growth are visible in overgrown construction sites, sparsely used highways, and abandoned tourist attractions, casting doubt on China’s future economic stability.
In Liuzhou, billions were raised to build the infrastructure for a new industrial district. A state-owned financing group acquired land, opened hotels, and even established an amusement park. However, much of the acquired land remains vacant, and many streets are deserted, with abandoned buildings standing as silent witnesses to the halted progress. “The government is broke,” lamented one local resident, reflecting the widespread frustration among the community.
State-Owned Funding Vehicles and Economic Impact
The core of this financial mess lies in the complex state-owned funding vehicles that borrowed money on behalf of local governments, often for projects with minimal economic returns. These entities, known as local government financing vehicles (LGFVs), allowed cities to circumvent borrowing limits set by Beijing. As China’s real estate market deteriorated over the past three years, local governments could no longer rely on land sales to real estate developers, a crucial revenue source.
Economists estimate that the size of such off-the-books debt ranges between $7 trillion and $11 trillion, about twice the size of China’s central government debt. This total is not precisely known, likely not even to Beijing, due to the opaque nature of these financial arrangements. As much as $800 billion of this debt is at high risk of default. If the financing vehicles fail to meet their obligations, Beijing faces a dilemma: bail out these entities, potentially encouraging further unsound borrowing, or let them fail, risking serious losses for Chinese banks and a potential credit crunch that could further erode economic growth.
This looming threat is expected to be a key topic at an upcoming summit of top Chinese leaders. The built-up debt is a significant factor preventing China from implementing more robust economic stimulus measures. Annual growth slowed to 5.2% last year, down from 7.8% a decade earlier.
Accountability and Consequences
Local officials are currently bearing the brunt of the blame. Wu, the former leader of Liuzhou, was fired in November and charged with abuse of power and other crimes related to wasteful “political vanity projects.” The city’s light-rail system remains unfinished due to a cash crunch and increased scrutiny from central government officials.
Liuzhou’s experience is not unique. Many cities across China are scrapping infrastructure projects that have long driven growth. Moody’s Investors Service and Fitch Ratings have downgraded China’s credit outlook to negative, primarily due to concerns about local governments’ ability to service their debt.
Victor Shih, a professor at the University of California, San Diego, who researches China’s politics and financial system, noted, “The reckoning has arrived.” The municipal debt problem stems from the way Chinese cities fund themselves. Beijing controls the purse strings and limits local government bonds while expecting cities to spur economic growth and provide services with limited budgets. As a solution, cities turned to LGFVs to fund infrastructure projects, bypassing borrowing limits.
Examples of LGFV Projects
The municipal debt dilemma grew out of a fundamental weakness in how Chinese cities fund themselves. Beijing controls the purse strings and puts limits on local-government bonds. At the same time, China expects cities to kick-start economic growth and provide services with limited budgets.
Deficit spending provided one solution. Chinese cities discovered decades ago that they could take on debt through state-owned entities known as local government financing vehicles, or LGFVs, to fund sewers, streets and the like.
Because the debts don’t appear on government ledgers—only on the LGFV books—cities were able to sidestep borrowing limits. The bonds were attractive to Chinese banks and other institutional investors that assumed cities were on the hook to pay them back. Investors figured that allowing bond defaults by LGFVs is too risky for China’s financial system and too costly for its economy.
Many of the projects funded by LGFVs turned out to be ill-timed, ill-conceived or both.
Liupanshui, a city in the region of Guizhou, set up six LGFVs for 23 tourism projects, including construction of a ski resort on a mountain that typically gets enough snow for less than two months a year, though it also is open for offseason recreation. State media reported that 16 of the 23 city ventures are idle “low-efficiency” projects.
Another LGFV, in neighboring Yunnan province, ran up $8.4 billion in debt to build projects, including “artistic living space.” After the housing was done, not enough people wanted to live there. The project was sold in 2021, literally, for a few cents, to another LGFV in the same province.
Rhodium Group, a research firm, found that only a fifth of nearly 2,900 LGFVs it reviewed last year had enough cash to cover their short-term debt obligations and interest payments.
With little cash coming in from its investments, the LGFVs have stayed afloat with money from local governments—and by continuing to borrow. Research by the International Monetary Fund in 2022 found that 80% to 90% of LGFV annual spending came from new financing.
The LGFVs sometimes guaranteed each other’s debts, which made their swelling liabilities look safer to investors. In Liuzhou, one LGFV received guarantees from 13 other state-owned entities in 2022, making all of them liable if it defaults. Some had shared addresses or similar names. A financing vehicle called Liuzhou Urban Investment Construction Development provided $99 million of debt guarantees to Liuzhou Urban Construction Investment Development.
LGFV borrowing became more aggressive as their liabilities grew. Some LGFVs, working together, shifted assets from their balance sheets to another’s when issuing bonds, allowing them to borrow more at lower costs, according to bankers and investors.
Some city officials who initiated LGFVs seemed clueless about how they worked. An investment banker recalled meeting local officials in northern China in 2022 about a potential LGFV bond issue.
The officials had a question: Would they actually have to pay it back?
Yes, they would, the banker recalled telling them.
The Financial Sinkhole
The municipal debt dilemma grew out of a fundamental weakness in how Chinese cities fund themselves. Beijing controls the purse strings and puts limits on local-government bonds. At the same time, China expects cities to kick-start economic growth and provide services with limited budgets.
Deficit spending provided one solution. Chinese cities discovered decades ago that they could take on debt through state-owned entities known as local government financing vehicles, or LGFVs, to fund sewers, streets and the like.
Because the debts don’t appear on government ledgers—only on the LGFV books—cities were able to sidestep borrowing limits. The bonds were attractive to Chinese banks and other institutional investors that assumed cities were on the hook to pay them back. Investors figured that allowing bond defaults by LGFVs is too risky for China’s financial system and too costly for its economy.
Many of the projects funded by LGFVs turned out to be ill-timed, ill-conceived or both.
Liupanshui, a city in the region of Guizhou, set up six LGFVs for 23 tourism projects, including construction of a ski resort on a mountain that typically gets enough snow for less than two months a year, though it also is open for offseason recreation. State media reported that 16 of the 23 city ventures are idle “low-efficiency” projects.
Another LGFV, in neighboring Yunnan province, ran up $8.4 billion in debt to build projects, including “artistic living space.” After the housing was done, not enough people wanted to live there. The project was sold in 2021, literally, for a few cents, to another LGFV in the same province.
Rhodium Group, a research firm, found that only a fifth of nearly 2,900 LGFVs it reviewed last year had enough cash to cover their short-term debt obligations and interest payments.
With little cash coming in from its investments, the LGFVs have stayed afloat with money from local governments—and by continuing to borrow. Research by the International Monetary Fund in 2022 found that 80% to 90% of LGFV annual spending came from new financing.
The LGFVs sometimes guaranteed each other’s debts, which made their swelling liabilities look safer to investors. In Liuzhou, one LGFV received guarantees from 13 other state-owned entities in 2022, making all of them liable if it defaults. Some had shared addresses or similar names. A financing vehicle called Liuzhou Urban Investment Construction Development provided $99 million of debt guarantees to Liuzhou Urban Construction Investment Development.