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China Policy Patches Alone Won't Fix LGFVs' Fraying Liquidity

This report does not constitute a rating action.


China's local government debt-raising vehicles are fraying at the periphery. The country's lower-tier LGFVs account for nearly 90% of the borrowing in this sector, or about RMB50 trillion in debt per our estimate. S&P Global Ratings believes that the liquidity soundness of the lower-tier entities is deteriorating quickly, with a build-up of short-term debt amid depleting cash.

To address such matters, China's politburo in July urged for measures to address imminent repayment risk among city, district and county-level borrowers (a so-called "package of plans"). These are likely to include local government bond issuance to be used for LGFV debt swaps, loan rollovers, cuts to funding costs, and enhanced coordination among central and local governments.

We view the steps as a realignment of past measures. The steps reflect the realities of limited wiggle room within the fiscal system and banks' own financial health.

Local government financing vehicles (LGFVs) collectively owe about Chinese renminbi (RMB) 60 trillion (US$8.3 trillion) in debt, per our estimate. Many of the entities are not commercially run and lack the profits and cash flow to service sizable liabilities.

The sector is simply the most visible and obvious outcome of China's reliance on debt-driven growth for local and regional development. Unwinding this debt will be a monumental challenge given its sheer size and LGFVs' modest commercial viability.

LGFVs have been struggling with increasing liquidity pressure over the past two years. Their difficulties began after Beijing started to clamp down on LGFVs' use of off-budget borrowing, which has led to spiraling debt levels (see "China LGFVs: Debt Control Will Outrank Infrastructure Stimulus In 2022," published April 20, 2022, on RatingsDirect).

Funding Cost Control Is Positive, But Maturities Are Shortening

Many entities are grappling with a deteriorating maturity structure and are falling into distress, with more to come.

The strains come despite--and perhaps partially because of--five years of government directives and myriad efforts by key stakeholders to "solve" the LGFV debt problem. Measures have mostly centered on resolving hidden debt, or off-budget borrowing. There was a temporary disruption to measures in 2020, when credit flowed to boost a pandemic-impaired economy. Financing conditions have since tightened. LGFV debt growth has finally started to decelerate, to high single-digit annual growth from double-digit growth.

However, slower debt increases have not strengthened entities' ability to service debt. Efforts to roll over maturing debt while cutting funding costs have resulted in ever shorter maturities amid stubbornly expanding debt levels. Over the past five years, the sector's cash to short-term maturities ratio halved to just 0.5x from 1x (see chart 1).

Chart 1


Meanwhile, short-term maturities have grown faster than total debt, with short-term maturities (due within 12 months) more than one-quarter of total debt at the end of 2022.

Chart 2


Chart 3


If we take a closer look at all Chinese cities with over RMB50 billion of LGFV debt, we find 12 particularly under liquidity stress.

Chart 4


Chart 5


Beware The Hidden Risks

Liquidity depletion is a typical trigger for most LGFV distress cases. Liquidity strains often result from financing/refinancing difficulties and signal greater difficulties are ahead for an issuer. Without fresh funds, entities can only use internal cash or strive for nonpublic debt restructuring to avoid a public debt default. A recent case would be when Kunming Rail Transit (unrated) ran down its cash to just 1% of what it was 12 months ago by March 2023 to repay debt (see "Kunming Rail Transit's Liquidity Crunch Underlines Dilemmas Facing China's LGFVs," July 26, 2023, on RatingsDirect).

We view as remote the probability that a series of LGFV defaults will cause sector-wide contagion over the next 12 months. Refinancing for the sector will likely stay stable with the new measures on the horizon.

That said, we see at RMB1 trillion of short-term maturities for LGFVs in the cities showing acute liquidity strains for the entities. That is about one-third the total debt owed by these LGFVs in these cities, for which we deem liquidity strains to be "impending" based on these criteria:

  • The LGFVs within a city had less than 40% of cash to short-term maturities as of end-2022; and
  • Their cash balance has declined by over 30% in the past two years; and
  • The city's LGFV net domestic bond financing (annualized first half 2023) dropped more than half from its peak during 2018-2022.

For cities from economically weaker regions, we believe this could result in larger contagions beyond just single cities. This could stunt the financing for an entire province.

More cities are on the verge of repayment crisis, as liquidity dries up. This is especially true in Guizhou province, which shows broad intra-province contagion. This is despite the fact that government and bank measures have been used to address the crisis and shore up financing for a while. This province still stands out, with half of the 12 cities we deem to be under highest pressure. We would consider these cities to be emerging risks.

The LGFVs in Lanzhou city registered the biggest drop in cash balance, of 58%. The LGFVs in Liuzhou city had short-term maturity ratio of 45%, the worst of surveyed entities. The ratio is a measure of debt maturing within 12 months, to total debt. Bijie city LGFVs had the lowest cash to short-term maturity, at just 8%. Securing new funding will be a pressing task in order to tie themselves over.

However, bigger sparks could surface from the eastern seaboard and central regions where almost two-thirds of China's overall LGFV debt sits. If credit events arise and are not rapidly addressed, this could shake market confidence across the entire sector.

Although most of the cities flagged as having impending liquidity issues are from economically weaker regions, there are several of these cities that are still enjoying relatively strong financing support both from banks and the capital market. They continue to have seemingly good access to financing but strains on their liquidity continue to accumulate as their debt size snowballs.

For instance, strains are apparent in Jiangsu province, which has the most LGFV borrowings. The province has half of the 12 cities with liquidity notably weakening (see chart 3). This is due to the province's aggressive debt raising by lower-tier LGFVs. Despite its LGFV debt growth rate dropping to below the national average, there is still over RMB8 trillion of LGFV debt in the province, with almost three-quarters from district/county level LGFVs.

We believe that any unexpected credit events erupting from these economically stronger regions will have the potential to shock markets at an even larger scale and could rattle a much wider cohort of LGFVs in China, making the problem much harder to resolve.

Possible Paths For LGFV Comeback

Without a comprehensive debt solution, LGFV liquidity crunches may gain momentum. This includes entities in cities previously rehabilitated by government-led debt resolution measures.

For instance, Zhenjiang LGFVs managed to restore their financing access in 2020-2021 via loan extensions and asset sales. Still, their average short-term maturity ratio was still high at over 40% through 2018-2022, requiring regular refinancing. Accordingly, when regulation dampened debt growth, liquidity profiles weakened fast. The cash levels of the city's entities sank 43% in 2022.

Another case in point, Tianjin LGFVs' financing recovered in 2022 following intervention by its local government. Domestic bond net financing in the first half of 2023 almost rebounded back to the level seen in full-year 2019, but at a cost: the ratio of the entities' short-term debt to total debt rose to nearly 40%. Debt keeps piling up, meaning that cash must be used to pay interest, negating any chance the entities can improve their liquidity positions.

Chart 6


Steep Maturity Walls Are Looming

LGFVs in regions demonstrating the weakest debt-servicing capacity have had to contend with the fact that it's harder to refinance in the capital market. In the past 18 months, such entities have booked negative net bond financing volumes.

Some face large short-term onshore bond maturities, and continuous maturity walls over the next couple of years (see chart 7). For instance, Zhenjiang, Kunming, Weifang and Shangrao's LGFVs must manage RMB20 billion-RMB60 billion of onshore bonds maturing over the year to June 2024. LGFVs in Weifang, Guiyang, Liuzhou, Zhenjiang, Zunyi, Kunming and Shangrao will need to repay or refinancing a similar volume of debt over June 2024-June 2025).

Chart 7


Amid tightened regulation for offshore issuance from LGFVs, LGFVs from a few critical cities will to be tested by large maturities for offshore bonds over the next three years (see chart 8). Zhenjiang-based LGFVs are under the most pressure, they will collectively see US$1.3 billion in offshore bonds coming due. Kunming-based LGFVs will need to address nearly US$500 million in maturing offshore bonds over the same period, as will Shangrao's city-level LGFVs.

Chart 8


What's Next If This Isn't Enough?

There is no surefire way to tackle LGFV liquidity challenges. The latest measures are aimed at addressing the most pressing LGFV liquidity strains, but they won't resolve the debt issue. Lower-tier LGFVs have a limited ability to generate cash. It is increasingly unfeasible for them to rely on land and infrastructure development cost rebates from local governments as cash for debt servicing.

We expect bank refinancing will remain the primary means to refinance maturing LGFV debt and to cover interest payments. Regulations and low appetite will likely restrict funding from capital markets to high-risk regions.

With limited fiscal wiggle room, banks and governments will likely coordinate to allocate scarce capital to the most worthy LGFVs. Banks finance about two-thirds of LGFV sector debt, mainly in the form of loans. However, banks cannot accommodate widespread restructuring of distressed loans, as the lenders have to look after their own financial health.

The latest round of policy moves may give markets a small confidence boost. It may also tighten policy coordination among key stakeholders. However, the ultimate effectiveness of the new measures hinges on how well they tackle LGFVs' short-term refinancing challenges while facilitating a long-term debt resolution.

The repeated interventions has not stopped the growth in LGFV debt, which has risen by 80% over the past five years. The fact that planners keep retrying similar policy moves, despite limited results, suggests they may need to do more.

Editing: Jasper Moiseiwitsch

Digital design: Evy Cheung

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Primary Credit Analyst:Laura C Li, CFA, Hong Kong + 852 2533 3583;
Secondary Contact:Christopher Yip, Hong Kong + 852 2533 3593;
Research Assistant:Rick Yoon, Hong Kong

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