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https://www.reuters.com/markets/asia/china-can-no-longer-extend-pretend-municipal-debt-2023-08-06/

Most economists expect Beijing to instruct state-owned banks to keep rolling over maturing debt with longer-term loans at lower interest rates, a strategy often referred to as "extend and pretend."

The banks, however, need to be selective based on the magnitude and urgency of any refinancing task. Debt restructurings hurt their own balance sheet, hampering their ability to finance other parts of the economy.

For many local governments "to keep vital functions you need transfers from Beijing and to develop you need to issue bonds - the central leadership is aware of that," a source at a state bank told Reuters after a recent work trip to two indebted provinces.

Local governments themselves will have responsibilities, above all to come clean.

Local governments are likely to use left-over bond issuance quotas from last year to swap "hidden debt" with official bonds on their balance sheet, according to analysts, with up to 2.6 trillion yuan to be issued.

How is China's municipal debt problem different from that of the U.S.? I heard that most of the local government debt is off-the-book. Is this the case for the U.S. also, which also somewhat has a problem with the debt the states are raking? And if it's different, why is China trying to put the local debt from their local government off-the-book and what advantages does it give? It's not like they won't have to repay it, so why keep it off-the-book?

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  • 1
    I think your premise that governments have to repay their debt is flawed. The government can renew and roll over debt forever and also has access to the printing press.
    – quarague
    Aug 30 at 6:36
  • @quarague, agreed, by controlling the currency you can cause inflation, and by inflation you can ultimately tax cash-holders and creditors. It's basically a right to inflict a debt jubilee on creditors, and do so incrementally.
    – Steve
    Aug 30 at 8:27
  • 3
    @quarague This is about municipal debt, not national debt. National debt denominated in the national currency can of course be inflated away. Municipalities don't have that option. If the national government is forced to take on these hidden debts then that becomes a different question. Aug 30 at 10:04
  • 1
    So perhaps a better question might be, "How is China's municipal debt problem different from the U.S.'s municipal debt problem?" Because there certainly are municipalities of all sorts, throughout the country, that have big debt problems. That might be a more accurate correlation.
    – ouflak
    Aug 30 at 11:00

3 Answers 3

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How is China's municipal debt problem different from that of the U.S.? I heard that most of the local government debt is off-the-book. Is this the case for the U.S. also, which also somewhat has a problem with the debt the states are raking? And if it's different, why is China trying to put the local debt from their local government off-the-book and what advantages does it give? It's not like they won't have to repay it, so why keep it off-the-book?

Short Answer

I can't speak much to the Chinese situation, although it is clearly corrupt and unsound compared to U.S. municipal bonds, but I am much more familiar with the U.S. side.

There isn't really a U.S. municipal debt problem at all.

The U.S. has a federal government debt problem, but it doesn't have a municipal debt problem.

Long Answer

Full disclosure: very early in my legal career I did municipal bond due diligence and prepared municipal bond prospectuses.

Institutional protections

State and local government debt is highly regulated under state law. The federal government also supervises the municipal debt industry, primarily through IRS regulation of eligibility for one of several kinds of tax-exempt bonds.

Certainly, some U.S. municipalities are more sound fiscally than others, but in general, this is a low risk area and municipalities do not tend to be overextended with debt.

In many states, most municipal bonds have to be approved by voters on a regular basis and the process of presenting these bonds for approval also results in another layer of transparency and checks and balances. Absent strict requirement for voters and/or legislative approval for issuing new state and local debt, most state and local governments are required to have balanced budgets, so municipal debt rarely reaches the level of the U.S. government federal debt and deficit spending for things other than capital improvements is rare.

Local governments tend to have stable revenue streams like property taxes as a strong base to support their municipal debt. Private enterprise bonds for government owned businesses which aren't supported by taxes (like airports and convention centers and stadiums) usually have quite conservative financial projections about the ability to repay. State government revenue sources like income taxes, mineral revenue, sales taxes, and public college tuition, are more variable, but since they are typically from a mix of sources, somewhat balance out.

The bond rating agencies for municipal bonds in the U.S. are not corrupt (certainly they are much less corrupt than the agencies that rated mortgage based securities during the financial crisis).

The lawyers who do the due diligence for municipal bond issuances are an elite, cohesive, seasoned, and through bunch of professionals (in part, because municipal bond investors tends to be one of the most affluent group of bond investors and sue if municipal bonds default or if there is fraud).

Even an isolated default on a rural cemetery district or irrigation district bond, the smallest and lowest stakes kind of local government debt there is, makes headlines in the municipal finance community and tarnishes the reputations of the professionals involved if they weren't sounding the alarm early on.

Secret deals and accounting mischief in municipal debt in the U.S. is the very rare exception.

Municipal bond default rates in the U.S. are very low

Defaults on municipal bonds in the U.S. are exceeding rare, result in only modest losses to investors in most cases when they happen, and only quite rarely impose hardships on state and local governments when they occur.

Just 800 private business companies (less than 5%) have investment grade bonds out of 23,000 U.S. companies with revenues over $35 million whose credit was reviewed by bond rating agencies. But, only about 1,800 companies with non-investment grade credit ratings, however, have actually issued publicly traded bonds (aka "junk bonds" aka "high yield bonds"). So, about 30% of publicly traded bonds are investment grade, less than 1% of investment grade bonds are AAA, and only about 0.2% of publicly traded bonds are AAA rated. Companies with sales of less than $35 million per year are not eligible for an investment grade bond rating. An investment grade bond rating, in practice, roughly corresponds to a "large capitalization" stock, although in principle, bond ratings are not directly dependent upon market capitalization. The rating system at Standard and Poors and at Fitch ranks investment grade bonds as follows (Moody's equivalent rating):

AAA (Aaa)

AA+ (Aa1)

AA (Aa2)

AA- (Aa3)

A+ (A1)

A (A2)

A- (A3)

BBB+ (Baa1)

BBB (Baa2)

BBB- (Baa3)

Bonds with ratings below BBB- or Baa3 are called "junk bonds" or "non-investment grade" bonds in contrast to investment grade bonds.

Historical default rates vary greatly, but in the S&P system through 2007, averaged about 0.6% for AAA, 1.5% for AA, 2.9% for A, 10.3% for BBB (the lowest investment grade), and 29.9% for BB, 53.7% for B, and 69.2% for any kind of C rating (the junk bond ratings). This is measured over the life of the long term bond and is not an annual default rate.

Historical default rates on municipal bonds are much lower than default rates on corporate bonds with the same rating until 2010 when Moody's and Fitch abolished the separate system (S&P abolished the separate system in 2001). More recent municipal bond issues are rated on the same scale as corporate bonds. For example, in the old system, S&P BB rated municipal bonds have about the same default rate on average as S&P AA rated corporate bonds. Investment grade municipal bonds as rated by any major bond rating agencies under the old system have default rates lower than AAA rated corporate bonds.

Within municipal bonds, there are two main categories, general obligation bonds, supported by the taxing power of the government, and private activity bonds, supported only by a government owned enterprise like an airport or government owned utility.

The former almost never default. For example, there were just 3 defaults on general obligation municipal bonds in the entire United States, from about 35,000 municipal bond issuers, from 1970 to 2009. Even in those three cases, none of those defaults was a total loss or anything close to a total loss for municipal bond investors.

The latter default at rates comparable to investment grade publicly held companies. Municipal bankruptcies are rare. For example. there were just twelve Chapter 9 bankruptcies filed in the calendar year 2014, out of roughly 90,000 local government entities that could issue bonds and declare bankruptcy under Chapter 9 (many of which issue multiple classes of bonds outstanding but default because they become unable to pay only certain private activity bonds for a single activity). Also about 10-20% of private activity bonds are reinsured by municipal bond insurers such as National/MBIA, Radian, CIFG and Syncora/XLCA, FGIC, ACA, Berkshire (BHAC), Assured Guarantee (AGO), and Financial Security Assurance (FSA), effectively reducing the risk for investors in these bonds even further and typically bringing them at at least an A credit rating.

As of 2011, according to Slate:

[H]istorically, their rates of default come in around one-third of 1 percent, far lower than the rates for, say, corporate bonds. Thus, investors around the world own about $2.8 trillion in American municipal debt—an amount that has more than doubled in the last decade and increased about 35 percent over the course of the recession. . . .

Municipalities issue two main classes of bonds. One comes with a "general obligation" pledge, meaning that the government agrees to raise taxes or take other measures to pay bondholders back. But they also issue riskier "non-GO" bonds, or revenue bonds—often to fund the construction of things like hospitals, universities, and housing complexes. It's those bonds where the defaults happen, for the most part. According to Moody's Investors Service, between 1970 and 2009, municipalities have defaulted on Moody's-rated debt only 54 times, and 51 of those defaults came from bonds to finance things like housing projects. . . .

[D]efaults on non-GO debt—for things like hospitals and housing projects, debt already considered more risky—are happening at a slower rate than in years past. The National League of Cities notes that there have been at least 72 defaults this year, down from 204 in 2009 and 162 in 2008. Considering the thousands of bonds issued in the last decade by the 50 states,19,000 cities, 4,000 counties, 15,000 school districts, and tens of thousands of individual projects—that's not too bad.

State governments and territories like Puerto Rico, are not allowed to file for bankruptcy and on rare occasions do default on their debts (nine states defaulted on their debts in the 1840s, for example). But this has grown most less common in the post-WWII era.

A brief period when California was issuing IOUs in the financial crisis was probably the most notable, but almost no bond investors or trade creditors of the state were impaired in the medium to long term, a few months delay in payment was pretty much a worst case scenario.

China's bond markets are corrupt

In contrast, in China, as of 2015, around 97% of existing yuan-denominated bonds hold ratings of double-A to triple-A—the best a company can get. (The source for this is from Fiona Law at the Wall Street Journal, cited by Christopher Balding, and ultimately Alex Frangos via Marginal Revolution.)

Basically, the bond ratings of all publicly listed Chinese companies were wildly overrated. Meanwhile, a Chinese government agency, the China Securities Finance Corp (CSF), central bank-backed refinancing institution, was as of 2015 "among top 10 shareholders of many listed-firms" as Chinese regulators have stepped in to prop up a collapsing stock market. Effectively, this is turning what had until recently been a mostly theoretical communist basis of the Chinese economy into one in which state ownership of enterprise is again rapidly becoming the norm.

In China, the corruption in the big business corporate bond sector spills over into the municipal bond sector.

China's underlying municipality economic environment is more turbulent than the U.S.

China is a society in wild economic transition with huge cities popping up all over the place every new decade from seemingly nothing. Even basics like property rights are in flux there.

In contrast the economic situation of most U.S. state and local governments is much more stable and stagnant. Debt markets do better in stable economic times (comparatively). The relevant property rights and legal framework have changed only modestly since the late 19th century in the U.S., and when it has changed, has made municipal bond risks lower and made municipalities less overextended.

For example, most municipalities now outsource management of their defined benefit pensions to state government, removing a major potential source of financial management problems and default risks for smaller, less professionally run, local governments.

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Question:

How is China's municipal debt problem different from that of the U.S.?

Short Answer

The US doesn't have a municipal debt problem.

China with more public businesses and a greater role for government in private businesses asks more of their municipal governments. China's municipal government's roles involve creating, growing, and being financially accountable for businesses. This is upside down in comparison with the United States. China's business roles for local government officials has lead to some questionable "business" practices in the pursuit of nationally mandated growth. China has both too many homes, and oddly not enough homes; and of coarse the municipal governments are paying for both. Now faced with a systemic crisis only partially of their own making; they are amassing crushing debt while their revenues are falling due to the very same crisis. China's national government has largely ignored their own role in this long developing crisis and so far have left it up to the municipal governments to financially resolve.

In the US local governments are less involved and held less responsible for business failures. Business decisions are made by people more involved with the day to day running of those businesses, and they tend to make less risky market driven decisions. When failures occur they tend to be smaller more isolated. When large systemic failures occur the National government takes on a larger role and don't leave the crisis up to the municipals.

Answer

The US is a mature economy with slower growth and necessarily more conservative policies. The U.S. is also a decentralized economy, meaning folks create and manage their own businesses. The growth of those businesses is not dictated by Washington and financed by a state. China's economy has been an emerging one which means higher growth and they have been creative with ambitious policies to encourage that growth. China's economy is also centralized. Growth targets are determined by the national government and left to the municipal governments to manage and fund. Both are removed from the day to day management of the businesses they are directing.

In China this growth is financed both by incurring private and public debt, like in the US. Only in China where more companies are publicly owned and the government plays a larger role in all business. China relies on the local government to play perform the hands on role. The local Chinese governments are more involved in financing businesses, directing encouraging growth and are also held more accountable by the national government when things go wrong.

After years of over investment in infrastructure, and some rather questionable business decisions. Decisions performed in the pursuit of economic growth are starting to weigh on the municipals and Chinese economy.

China has at least 65 million empty homes

  • One-fifth of the homes in China, at least 65 million units — are empty.
  • That amount of empty real estate is enough to house the population of >France.
  • The ghost cities are a testament to China's reliance on real estate as >a driver of economic growth.

In the pursuit of growth at all costs, China has built and financed literally thousands of cities in remote rural areas nobody wants to live in. A decade worth of cities which will always remain primarily vacant. Image a single family home vacant for a year, five years, or ten years. After a while with no one taking care of it, it ceases to be habitable. Now imagine high rise buildings, sporting complexes, and roads. They call them ghost cities, built by bureaucrats who were fulfilling spending targets and weren't concerned with the economic viability of what they were financing.

Presently revenue from land sales, a primary source of income for municipalities, are down and the entire real-estate market estimated to be as much as 30% of China's economy is in crisis. China's national leaders have been hesitant to dip into the national budget to address these issues.

As revenue drops and projects fail it's been the municipalities which have been picking up the mounting expenses in the way of more debt to pay for what appears to many outsiders as a systemic national crisis. Nearly all of China's large real estate companies have defaulted on their loans.

  • Evergrande
  • Country Garden
  • Kaisa Group
  • Fantasia Holdings
  • Sunac
  • Sinic Holdings
  • Modern Land

The other side of the crisis of having too many homes is not having enough homes. In China you don't pay for your home; then move in the next day. In China you pay for your home before construction begins sometimes years before construction begins. So these large Real-estate companies are going under with trillions of dollars of people's money and hundreds of billions of dollars worth of debt. People who have paid for homes that have yet to be built. So the local governments are now responsible for building those homes too and trying to financially patch together the failing real-estate companies as the crisis threatens to cascade through the economy.

As China’s property crisis grows, is the global economy at risk? China’s property woes pose a substantial risk to its economy, which is already under strain due to Beijing’s harsh “zero-COVID” policies and slowing global growth. By some estimates, real estate accounts for 30 percent of GDP – about twice the equivalent share in the United States.

Between financing the debt for the mandated growth targets, infrastructure projects, and keeping the looming real-estate crisis at arms length, while dealing with falling revenues themselves it's understandable that now China has a growing municipal government debt crisis.

China can no longer 'extend and pretend' on municipal debt Local government debt reached 92 trillion yuan ($12.8 trillion), or 76% of economic output in 2022, up from 62.2% in 2019. Part of it is debt issued by local government finance vehicles (LGFVs), which cities use to raise money for infrastructure projects.

How is it different from the US? China loves central planning. America does not. At it's core China's issues aren't unprecedented for an emerging economy. What compounds these issues has been China's proclivity for central planning. (1) Removing decision making from those involved in the day to day business has contributed and compounded the problem while hiding it until it could not longer be ignored. (2) Furthermore after decades of large economic growth, where much wealth has been created, China is hesitant to allow their people to experience the other side of capitalism. The pain of financial loss when things go wrong. I don't know if either is within China's mindset to address as both are existential for their system. It will be interesting to see what they come up with.

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It's not exactly clear to me what you're asking here, but generally speaking (meaning not specific to municipal debt) the issue with "hidden debt" in China [or anywhere else] is that is (ahem) less straightforward to estimate. Also generally speaking, not knowing the true size of liabilities can more easily bring about a financial crisis.

As for China, the issue is that the amount hidden municipal debt appears to be a large size of their economy, and about half of China's government debt...

The “hidden debt” issued by local government financial vehicles, entities created to circumvent borrowing restrictions and used to channel funding for infrastructure spending, might have totaled 65 trillion yuan ($9.6 trillion) by the middle of 2022, according to a recent estimate by analysts at Mars Macro, an economic research firm based in Hunan.

That’s more than 20% higher than the estimate of 53 trillion yuan made by Goldman Sachs in 2021.

That would be equivalent to more than half of China’s GDP. Overall, Chinese government debt is now equivalent to 102% of its GDP, the analysts estimated.

The thing is that others have given different estimates for [this] hidden local government debt in China, e.g. Fitch said it was only 30% "on the books" but

Their affiliated financing units owe debt equal to an additional 40 to 50 percent of national output — although there may be some double counting as local governments borrow and then shift the debt to their financing units, Fitch said.

So you can see that large variation in estimates is in itself a problem. The Politburo seems to agree on that, as they've issued a command/pledge to "adamantly curb any new hidden debts" in April.


As was noted in some comments under Q, the central government can ultimately print its way out of any debt in their domestic currency. Local governments don't control a [legal tender] printing press, so their debt is harder to deal with. It can result in services shutdown etc. (Going back to the 1st source)

Last year, a number of cities suspended bus services due to budget constraints, including Leiyang in Hunan province and Yangjiang in Guangdong, according to operators’ announcements.

Separately, Hegang, the city in Heilongjiang province, made history in early 2022 by becoming the first to be forced to undergo a fiscal restructuring due to grave debt distress, according to state media reports. As a result, it must cut spending on infrastructure projects, reduce government subsidies to industries, stop hiring new staff and sell assets, according to rules published by the State Council.

Public sector jobs, considered the most secure in the country, were also affected elsewhere. In June, several wealthy eastern provinces — including Guangdong, Zhejiang and Jiangsu -— slashed pay by as much as 30%, according to Chinese news website Caixin.

This kind of problem however is indeed at its core (and by that I mean glossing over the hidden aspect of the debt) no different in the US, if a municipality runs out of funds and ways to borrow.

There is one aspect however where China's looser legal system (or more centralized control) may make a difference in the opposite direction. The central government there could more easily bail out municipalities, again if it chooses to do so. (Nobody is going to go to the Chinese supreme court to challenge the supreme leader [president] if he decides to do something along those lines.) There has been some talk of that [i.e. central government involvement], but details [like with many such things in China] are less transparent.

Chinese leaders last month pledged, without detailing, to help ease their debts, signalling worries over a potential chain of municipal debt defaults destabilising the financial sector. [...]

The extent of any central government involvement, and any conditions attached to it, are still subject to debate, two policy advisers told Reuters. Whether the package of measures will be a short-term or multi-year plan also remains unknown.

However, the conundrum of bailouts is ultimately no different in China than anywhere else.

It is an unsustainable situation that puts Beijing in a bind: provide no help and the economic model unravels with severe consequences on growth and social stability, or step in at the risk of encouraging more reckless spending.

But they may have already done some of that by shifting some $130 billion local debt to provincial. (Still this is like 1-2% of the problem.)


BTW, since 1994 it's been formally illegal for Chinese local governments to run a deficit...

the 1994 Budget Law made it illegal for local governments to incur budget deficits

but they found workarounds (especially after they were required to finance the 2008 stimulus) via the vast expansion of "locally controlled, state-owned companies—the original LFVs—whose explicit purpose was to borrow for public spending".

The way this scheme was arranged is somewhat flabbergasting for what is theoretically a centrally controlled country (this other paper uses a different acronym/translation, but they mean the same thing by LGFPs as the previous one means by LVFs):

LGFPs dragged local governments into accumulating local debt. LGFPs raise money from the financial market through many channels: bank loans, issuing corporate bonds (Chengtou 城投 bonds) and using other financial derivatives such as trust products, finance leases, structured notes, and so on. Most of these financing methods have terms of less than five years. Local governments also helped LGFPs to boost their credibility. First, land was injected into the companies as physical collateral. Because land belongs to the state, it was a nominal asset of LGFPs that the companies had the right to develop. LGFPs calculated the future income that could be derived from the land after its development and used this value to collateralize. Second, local governments issued guarantees on behalf of LGFPs to pay investors with fiscal revenue if the companies could not pay the debt. The guarantees were issued in secret because they violated the central regulation on restricting local debt. The guarantees were the main reason that LGFPs were able to keep leveraging market capital; however, they also blurred the boundary between the LGFPs’ debts and local government debt. The amount of LGFP debt guaranteed by local governments, which was the major part of the “implicit local debt,” reached alarming levels when compared with local government income in the early 2010s. Yet the exact amount remained unknown. This implicit debt posed a huge risk to local financial systems owing to its vast amount, lack of transparency and uncertainty. The fact that LGFP debt could hardly be separated from local government debt is the reason why most studies use the term “local debt,” instead of “local government debt,” to analyse the debt situation in China.

IMHO, the word "secret" should probably not be taken too seriously there. It was most likely an open secret.

OTOH, since 2015 all local governments in China were allowed to issue their own bonds (LGBs). This was intended as a way to make this shadow issue of LGFPs go away, but it didn't really happen for somewhat complicated reasons, but basically LGB were used in addition to LGFPs... because why not? One reason is that the central government has some [more] say in how LGBs are issued.

N.B. the 2015 changes in Chinese law also added a "no bailout" clause for local government's bonds (although given the wording in the source I found, I'm not entirely sure if that was added to a law or was more of a political commitment or regulation):

Another important reform measure put forward in the State Council’s document is to require that local governments should take responsibility for their debts and the central government will not come to their rescue, sending a signal of “no bailout” within the framework of vertical decentralization. The signal of “no bailout” is aimed at tightening local budget constraints and cracking rigid payments by the central government, and is set to have far-reaching institutional impacts.

The document in question is "the No.43 document issued by the State Council in 2014".

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