Economists frequently highlight that China grapples with a trifecta of challenges known as the three Ds: debt, deflation, and unfavorable demographics. Recent developments surrounding America’s presidential election have introduced a fourth concern: the potential return of Donald Trump, who has vowed to impose high tariffs on Chinese exports should he reclaim the White House. In anticipation of these mounting threats, investors had hoped for a robust fiscal rescue package to be unveiled post a critical legislative meeting on November 8th. However, China’s leadership appears immobilized by caution. Following the meeting, the finance ministry introduced a new strategy aimed at addressing the pressing issue of debt, yet it refrained from presenting any measures to effectively combat deflation.
Lan Fo’an, the finance minister of China, announced that local governments would be permitted to issue additional bonds valued in the trillions of yuan to address riskier “hidden” debts. These hidden liabilities are predominantly associated with local-government financing vehicles (LGFVs), which are quasi-commercial infrastructure entities backed by city and provincial governments. At the end of 2022, the outstanding debts of LGFVs totaled approximately 60 trillion yuan ($8.6 trillion), with Goldman Sachs estimating that around one-fifth of this amount is considered risky. To alleviate this burden, local governments will have the capacity to issue bonds up to 10 trillion yuan over the ensuing five years.
For the past 15 years, hidden debts have loomed as a persistent concern for both China’s ruling authorities and investors. Local governments, restricted from issuing numerous bonds independently, resorted to LGFVs as a means of raising financing. Lou Jiwei, who served as China’s influential finance minister from 2013 to 2016, made efforts to rein in these debts during the initial term of Xi Jinping’s presidency. His strategy established the groundwork for the current initiative. Local governments were granted the ability to sell more bonds (which entails explicit obligations) to replace the implicit, off-balance-sheet debts generated by LGFVs. As Mr. Lou articulated, the objective is to “open the front door and close the back door.”
However, the back door continued to swing open as local governments, driven by ambitious economic goals, resorted to generating excess debts. In recent years, the sustainability of these hidden debts has significantly diminished. China’s ongoing economic slowdown has adversely affected tax revenue, coupled with a downturn in the property market, which has critically undermined land sales—traditionally a major revenue source for local authorities. In response, officials have resorted to slashing public services, liquidating state assets, and pressuring businesses for overdue taxes and fees. A notable instance of this was a staggering 66,000 yuan penalty levied against a grocer in Shaanxi province for the sale of just 2.5kg of subpar celery. In a desperate measure, China’s cabinet has implored the most heavily indebted provinces to “smash the pots and sell the iron,” effectively a rudimentary approach akin to cashing in family heirlooms.
While the central government expresses resentment towards the financial indiscipline exhibited by lower-tier authorities, it pursues a delicate balance, fearing the fallout from allowing these local entities to fail. There has yet to be an explicit default permitted on local government bonds, including those issued by LGFVs. Although bailouts have occurred, they are often begrudging and indirect. Mr. Lan mentioned the need to clear “landmines” one by one. The strategy announced on November 8th is designed as a proactive method to mitigate risks, rather than a reactive measure in the face of financial crises. Mr. Lan stated that this initiative aims to liberate local officials’ time and focus for other pressing matters. Furthermore, as the cost of financing “front-door” bonds is more favorable than the riskier back-door debts, the plan is anticipated to result in 600 billion yuan in interest savings for local governments over the next five years.
While the intended interest savings are a positive development, they represent less than 0.1% of China’s anticipated GDP over the forthcoming half-decade. Investors had been hoping for more substantial and direct initiatives to invigorate spending and battle deflation. Reports suggest the government is deliberating over potential financial handouts for impoverished households, as well as subsidies aimed at encouraging childbirth. Additionally, there are speculations regarding the expansion of a trade-in program that mirrors America’s “cash for clunkers” initiative, incentivizing consumers to trade in their old vehicles, refrigerators, air conditioners, and various appliances for newer, eco-friendlier alternatives. While some of these proposals may surface in the coming months, it is evident that China’s leadership does not perceive immediate urgency in rolling them out.
It appears that China’s rulers are being strategic in conserving their fiscal resources for the more significant challenge they will encounter if Mr. Trump goes ahead with his threats to initiate a renewed and intensified trade war. Key economic events looming on China’s political horizon include the party’s economic-work conference scheduled for mid-December and the subsequent gathering of its rubber-stamp legislature in March, during which the government is expected to announce the budget and growth targets. There is hope that Mr. Trump’s intentions may become more transparent by that time.
Nevertheless, China’s tendency to “keep its powder dry” may not be as wise as it appears. The absence of stimulus measures has resulted in real resources, such as labor and capital, remaining underutilized. This situation does not reflect careful resource management but rather signifies wastefulness. Unlike gunpowder, which can be stored, the time and energy of China’s workforce cannot be hoarded indefinitely.
**Interview with Dr. Mei Chen, Economist and Financial Analyst**
**Interviewer**: Thank you for joining us today, Dr. Chen. We’ve just seen significant developments regarding China’s local government debt situation. Can you explain why this issue is particularly concerning for the Chinese economy right now?
**Dr. Chen**: Thank you for having me. Yes, the local government debt situation is quite alarming. Over the past few years, we’ve witnessed a staggering increase in total local government debt, rising from 14.7 trillion yuan in 2015 to 30.5 trillion yuan in 2021. This 106.48% surge signals deep-rooted financial issues, especially considering the ongoing economic slowdown, which is further exacerbated by unfavorable demographics and deflationary pressures.
**Interviewer**: Right, and with America’s political landscape shifting, particularly with the possibility of Donald Trump imposing high tariffs on Chinese exports, how do you see this affecting investor confidence in China?
**Dr. Chen**: That’s a critical point. The potential return of tariffs on Chinese goods could further strain an already fragile economy, making investors wary. The hope was that, following the legislative meeting on November 8, China would introduce a strong fiscal rescue package. Instead, we saw a cautious approach from the leadership, which could heighten investor anxiety.
**Interviewer**: The recent announcements by Finance Minister Lan Fo’an regarding local government bonds certainly caught attention. Could you elaborate on the strategy introduced to manage the hidden debts associated with local government financing vehicles (LGFVs)?
**Dr. Chen**: Certainly. Minister Lan has authorized local governments to issue up to 10 trillion yuan in new bonds over the next five years to tackle these hidden debts. LGFVs have acted as a sort of “back door” for local financing, and they now represent a massive liability, with estimates suggesting that about 12 trillion yuan of their debts are considered risky. This new approach is aimed at replacing these implicit debts with explicit bonds, which should lead to more transparency and better management.
**Interviewer**: You mentioned the risks associated with the hidden debts. What consequences might arise if local governments continue to over-leverage themselves?
**Dr. Chen**: If local governments fail to manage their debt levels responsibly, we could see a cascading financial crisis. The sustainability of local government debts is already under significant strain due to decreasing tax revenues and declining land sales. This can lead to drastic measures such as cutting public services or increasing fees on businesses, which can destabilize the economy further.
**Interviewer**: There’s a talk about the central government wanting to avoid defaults. How can the government balance maintaining local government stability while also ensuring financial discipline?
**Dr. Chen**: This is a delicate balancing act. The central government has shown resentment towards financial indiscipline at lower levels but fears that outright failures of these local entities could destabilize the economy. The strategy of “clearing landmines” is more preventive than reactive. By encouraging local governors to focus on “front-door” bonds, the government hopes to mitigate risks before they escalate, even if these measures are somewhat reluctant.
**Interviewer**: you mentioned the projected interest savings. Do you believe this will be sufficient to address the systemic financial issues?
**Dr. Chen**: While the plan’s projected interest savings of 600 billion yuan over five years sounds promising, it’s important to remember that this figure represents less than 0.1% of China’s anticipated GDP. If systemic issues are not resolved, this may only serve as a Band-Aid rather than a solution. The key will be ongoing reforms that promote sustainable financial practices among local governments, which is easier said than done.
**Interviewer**: Thank you, Dr. Chen, for your insights. It’s clear that while the measures announced are a step in the right direction, the path forward is fraught with challenges for China’s economy.
**Dr. Chen**: Thank you for having me. It will be an interesting time ahead as we watch how these changes unfold.
