The Economist: China’s real estate slowdown reveals another troubling debt problem

When officials in the southern city of Liuzhou began a routine auction of parcels of land in June, they found few buyers. Only one of the five parcels received an offer; the rest were unsold. As in many cities in China, a recession in the real estate market has meant less demand for the land on which the apartment towers are built.

That’s bad news for local governments, which rely on sales to generate most of their revenue. It’s also a worrying sign for holders of bonds issued by local government finance vehicles (LGFVs), the half-public, half-corporate compounds that have become the cornerstone of Chinese development.

City revenues from land sales are often used to repay these bonds. After the auctions in Liuzhou failed, rating agencies downgraded two of the city’s LGFVs for fear that the government would have difficulty paying their debts.

LGFVs are one of China’s strangest financial innovations. In the mid-1990s, the central government implemented budget laws to prevent local bureaucrats from accumulating massive debts. In response, regional governments created LGFV as a solution. Vehicles, which number in the thousands, became important drivers of economic growth, helping to build bridges, houses and roads.

They also became one of China’s largest types of liabilities, racking up about 53 trillion yuan (US $ 8.3 trillion, or 52% of GDP) in debt on land and abroad, according to the Goldman Sachs bank. Although these loans do not appear in the public balance sheets, the local authorities are responsible for paying them back. Uncontrollable debts now threaten to disrupt the financial system.

The central government has spent years trying to reform China’s shadow financial system, but the debts that are hidden on balance sheets have been slowly shrinking. Let’s take shadow banking as an example. Although it has declined as a share of banking system assets, outstanding parallel loans remain high, at 57.6 trillion yuan at the end of September. Similarly, a municipal bond market now allows cities and provinces to raise funds. However, LGFV’s debts at the end of 2020 still exceeded central and local government bonds outstanding combined.

Many LGFVs make little profit from the bridges, roads, and water systems they build. Officials used to be able to make up the shortfall with income from land sales, but this is becoming more difficult. In a sales round this year for 22 of China’s largest cities, the premium earned on parcels was just 4.7% above the government reserve price, compared with 16.7% at the beginning of the year, according to Enodo Economics, a research firm.

The default of Evergrande, a developer with $ 300 billion in liabilities, and a more widespread malaise in the real estate industry means that demand for land could continue to suffer. New home prices fell for the third consecutive month in November, according to figures released Dec. 15.

No LGFV has yet defaulted on a bond. But many market watchers, like Macquarie’s Bank’s Larry Hu, believe it is only a matter of time. The vehicles will face offshore bond payments of $ 32.2 billion in 2022, up from $ 26.9 billion in 2021, recognizes Nomura, a Japanese bank. Many of them issue short-term debt simply to pay off other maturities.

Guangxi Liuzhou Dongcheng, an LGFV that was downgraded by S&P, a rating agency, in October, had 25.7 billion yuan (US $ 4 billion) in short-term maturities, for example. An average of 60% of LGFV bond issuance has not been allocated to new growth-generating projects, but to the payment of debts that mature in 2020 and 2021.

Many local governments appear to be bracing for a financial storm. Liuzhou has used about 20 billion yuan in public funds to make up for a capital shortfall in Dongtong Investment and Development Group, a vehicle that was downgraded in August by Fitch, another rating agency. An LGFV in Chongqing city defaulted on acceptance invoices from bankers in March. The subsidiaries of a provincial vehicle in Guangxi went bankrupt. The provincial governments of Jiangsu and Yunnan have issued guidelines demanding that collapsed LGFVs go into formal bankruptcy rather than hide under more debt.

Such reforms will not be easy. The value of local LGFV bonds stood at 11.9 trillion yuan in June, six times those issued by developers and one-tenth of China’s local bond market (see chart). A slight shift in sentiment towards the implied government guarantee for LGFVs could shake the markets.

This was highlighted by caution around “Document No. 15,” an internal circular issued by the banking regulator in July, which told lenders to cut off access to working capital loans for some LGFVs. Had the new rules been upheld, it could have caused a cash crisis for vehicles, similar to the one that brought Evergrande down. But they were quickly abandoned. Letting the LGFVs fail is a line that the central government is not yet willing to cross.

The situation illustrates the distorting power of the market of unfulfilled reforms. Many other sectors, such as property and complementary state enterprises, are no longer seen as supported by the central government. The failure of the authorities to decisively end their implicit support for LGFVs earlier this year has led many asset managers in China to consider them safe. The yields of LGFV bonds have approached those of government bonds. Funds have been poured in. “They are becoming a haven,” Hu says. They should be anything but.