China is poised to deploy a multifaceted approach, referred to as the “basket of measures,” to address the escalating risks of local government debt. This strategy includes measures like special bond issuance, debt swaps, loan extensions, and a contentious option of using the central budget. Local governments, crucial to China’s economy, have accumulated significant debt due to excessive infrastructure investments, plummeting land sales, and COVID-related expenses, leading to potential economic instability.
While Chinese leaders have signaled their commitment to tackling the debt crisis, the exact details and level of central government involvement remain uncertain. The implication of this shift in approach from demanding local administrations handle their debt issues could mark a significant turning point in resolving the municipal debt crisis.
However, challenges abound. Local government debt has reached alarming levels, comprising 76% of the GDP in 2022. This unsustainable situation leaves Beijing with a dilemma: either risk economic instability by not intervening or encourage reckless spending by stepping in too aggressively.
Potential options to address the issue include instructing state-owned banks to extend loans with lower interest rates (“extend and pretend”), allowing local governments to swap “hidden debt” with official bonds, and even selling or leveraging assets to raise funds. The central government, with its relatively low debt, could also play a role by issuing low-cost bonds to replace local debt.
Yet, this strategy is not without risks. By using the central budget to address local government debt, there is a concern of “moral hazard”—the possibility of encouraging reckless financial behavior. To mitigate this risk, various stakeholders, including financial institutions, local governments, and society at large, are urged to share the burden of debt.
While the specifics of this plan are debated, experts suggest that the success of these measures hinges on their scale, scope, and duration. Investors are closely watching to assess the impact and longevity of Beijing’s solution.
For China to permanently resolve the local debt issue, significant systemic changes are needed in how the economy operates. This might involve diluting growth performance criteria for local government officials and altering the evaluation framework to promote sustainability over unrestrained expansion.
Ultimately, Beijing faces a pivotal question: whether to accept a slower pace of local government investment and economic growth after decades of rapid expansion. The resolution of this question could profoundly shape China’s economic future.
Potential Risks:
Moral Hazard: The use of the central budget to address local government debt could incentivize reckless financial behavior, creating a moral hazard where entities believe they can take on more debt with the expectation of bailouts.
Overreliance on Debt Swaps: Relying too heavily on debt swaps to address hidden debt might mask the underlying issue without truly addressing the financial burden of local governments.
Asset Monetization Impact: Selling or leveraging assets to raise funds could have unintended consequences, such as reducing the availability of valuable resources in the future.
Central Budget Strain: Using the central budget to address local debt might strain government finances and limit its ability to respond to other economic challenges.
Long-Term Sustainability: A focus on short-term solutions could neglect the need for long-term structural changes in the economy, potentially leading to recurrent debt issues.
Economic Slowdown: Accepting lower growth as part of a restructuring effort may pose challenges to Beijing’s economic ambitions and could impact social stability.
Stakeholder Cooperation: Ensuring cooperation and burden-sharing among various stakeholders—financial institutions, local governments, and society—could prove challenging and affect the effectiveness of the measures.
Unforeseen External Factors: External economic shocks or global events could disrupt the implementation and success of these measures, undermining efforts to address the local debt problem.
Investor Confidence: If the measures are perceived as insufficient or ineffective, investor confidence could wane, potentially leading to market volatility and capital flight.
Unintended Consequences: Implementation of the basket of measures may lead to unintended consequences or complexities that were not initially foreseen, potentially exacerbating the issue further.
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