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The Hidden Risk in China’s Economy: Local Government Debt Weighs Down Growth and Finance

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China is facing challenges in reviving its economy this year due to the escalating local-government debt, which is currently exceeding $9 trillion and is still growing. Some local governments are urging banks to extend maturities and reduce interest rates to manage the increasing debt obligations. This year, Local Government Financing Vehicles (LGFVs) have onshore bonds worth 5.5 trillion yuan ($790 billion) maturing, the highest since 2021, as reported by Fitch.

The decreasing income from land sales and limited options for raising fresh funds have raised concerns about the ability of LGFVs to meet their debt obligations, impacting the broader banking sector and markets. The fiscal constraints of local governments to spend money will also challenge China’s economic growth target of around 5% this year, as LGFVs are instrumental in funding infrastructure projects, one of the significant growth drivers for the world’s second-largest economy.

In response to the issue, Chinese Premier Li Keqiang identified “preventing and defusing local government debt risks” as a critical task for the government. However, some Chinese banks with exposure to LGFVs are facing requests to extend their near-term maturities by up to six months and reduce interest rates. Due to the sensitivity of the matter, the sources declined to provide details and remained anonymous.

To mitigate the risk, Chinese financial institutions have been cautious about new lending to LGFVs over the past years. State-owned banks, asset managers, and insurers have been screening LGFV borrowers with weaker creditworthiness and disposing of them. LGFVs have also turned to offshore markets and raised a record $39.5 billion via dollar bonds last year.

However, authorities have recently heightened scrutiny of LGFVs’ dollar bond issuance to curb financial sector risks. The National Development and Reform Commission (NDRC) has turned down requests from lower-rated units, as reported by two sources with knowledge of the matter. The NDRC and the China Banking and Insurance Regulatory Commission did not immediately respond to requests for comment.

LGFV Sector Faces Refinancing Risk Amid Worsening Outlook

Fitch Ratings warned in a report last month that a decline in access to capital markets could heighten refinancing risk and worsen the liquidity crunch for LGFVs, especially for units located in less developed regions. The LGFV sector’s deteriorating prospects have also caused concern among shadow banks, which are lenders for industries unable to access bank funding directly, and made them wary of providing new loans to such units.

Alicia García Herrero, chief economist for Asia Pacific at Natixis, noted that while LGFVs used to rely on financing from the shadow banking sector, they have increasingly turned to onshore bond markets and, in some instances, offshore markets. She believes that certain projects may default, causing significant consequences for offshore bondholders in particular.

Despite this, some analysts think that the Chinese authorities will avoid massive defaults among LGFVs as doing so would make debt market access more challenging for both public and private issuers. According to Zhiwei Zhang, chief economist at Pinpoint Asset Management, LGFV debt remains manageable at present, and the priority is to prevent rapid growth and prevent a default from triggering market panic.

Source: reuters

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