Local government financing vehicle

Background

Since 1980, two years after China's economic reforms began in 1978, local governments shared their tax revenue with the central government in a Chengbao scheme. The arrangement allowed them to retain any surplus revenue after paying the central government an agreed amount, which ensured that local governments were incentivized to grow the local economy.[6] The tax-sharing system reduced the share of revenue that went to the central government and caused local governments to reduce taxes while increasing non-budgetary revenues, such as administrative fees, which did not need to be shared with the central government.[6]

A tax reform was introduced in 1994 to increase central revenue. Local tax revenue decreased to below 50% of China's total fiscal revenue from around 80%.[12] However, local governments were still responsible for more than 70% of regular expenditure.[12]

The reform also prohibited local governments from issuing bonds[6] and required them to maintain a balanced budget and no debt. This made it much harder for them to secure financing for infrastructure development.[13] Further restrictions were introduced in 1996, when the People's Bank of China published its General Rules for Loans that prohibited local governments from borrowing in any form.[6]

However, the 1994 reform allowed local governments to finance projects by leasing land. In addition, the central government gave up its share of land transfer proceeds, so the proceeds would belong entirely to local governments.[12] This incentivized local governments to increase land value by developing infrastructure, and LGFVs emerged as a solution to the problem of raising finance for these projects.

Origins

Some have argued that the Shanghai Urban Construction Investment and Development Corporation was the first LGFV created, in 1992.[14] It issued the first LGFV bond, the Pudong New Area Construction Bond, that supported the development of the Pudong district of Shanghai.[15] However, it has also been said that the Shanghai LGFV did not utilize land finance unlike later LGFVs.[16]

The LGFV model that became ubiquitous across China began in the city of Wuhu, Anhui. In 1998, the Wuhu government established the Wuhu Construction Investment Company to borrow ¥1.08 billion from China Development Bank (CDB) to invest in six projects related to highways, water utilities, and waste management,[17][6] following the bank's advice that creating a separate company would reduce credit risk.[18] The loan was taken out for a basket of projects, allowing socially beneficial projects that were unlikely to turn a profit to be supported by those that were more likely to produce returns.[17]

In the return for the loan, the Wuhu government promised to inject into the investment company bankable infrastructure assets, the profit from which could then be used as collateral for borrowing. CDB further enforced the promise by keeping a close relationship with the Anhui provincial government that had oversight over the Wuhu authorities.[17]

Land financing was later introduced to allow more borrowing. The Wuhu government initially used tax revenue to repay the loan, but from 2002, the Wuhu Construction Investment Company used proceeds from land sales as collateral, which provided larger sums for repayment.[6] To borrow an additional ¥1.095 billion from CDB, the Wuhu government allowed the company to bid for and auction off its land for revenue to guarantee repayment.[17]

The Wuhu model was spread to other cities, including Tianjin in 2003 for transport, river management, urban landscaping, and land projects.[17]

2008 financial crisis

The 2008 financial crisis prompted the Chinese government to introduced a ¥4 trillion (US$562 billion) national stimulus plan.[19] 72% of the stimulus plan consisted of infrastructure funding, and the central government funded only 30% of the package.[20] This rapidly increased the rate of borrowing by local governments through LGFVs, with around two-thirds of the package funded through borrowing.

De-risking (2010–2020)

The People's Bank of China and various parts of the Chinese government began to warn about the financial and fiscal risks of LGFVs in 2010. Early policies focused on minimizing the short-term risks of debt but not the system of LGFVs.[8]

In 2014, Chinese local governments were permitted to borrow money directly, in an attempt to reduce their reliance on LGFVs. A study by Chang-Tai Hsieh, Bai Chong'en and Zheng Song estimates that off-balance-sheet by local governments contributed to around 11% of GDP in 2014 and 2015.[9]

In 2015, the Chinese government introduced a Free Trade Zone in Nansha District, which trialed a new model of land finance to encourage private investment in development.

By 2017, bonds represented 90% of local government debt, up from 7% in 2014 (when most debt was borrowing from banks).[21]

In 2018, the central government announced that it would not bail out LGFVs that go bankrupt, in order to signal the need for caution to the financial markets.[13]

Around this time reforms were made which increased local government's share of value-added tax from 25% to 50%, and granted them a share of the consumption tax.

It was estimated that revenue from the sale of land use rights constituted 60-80% of local government revenue in 2018.[22] In 2019, LGFV bonds constituted 39% of total outstanding corporate bonds in China's domestic (onshore) bond market, with widely varying credit risks.[23]

2020 property crisis

In 2020, the Chinese property sector crisis heightened concerns about local governments' reliance on LGFVs and land sales, with local government bonds reaching 28.6 trillion yuan (US$4.5 trillion), or 23% of the entire Chinese bond market.[24] The International Monetary Fund estimated that local government debts nearly doubled from 2018 to 2023, reaching 66 trillion yuan (US$9 trillion), nearly half of China's annual economic output.[19]

In 2021, new regulations prohibited financial institutions from providing fresh liquidity to LGFVs.[25] Following these regulations, local governments are required to raise funds through issuing bonds, subjecting them to stronger oversight.[25]

Although no LGFV has ever defaulted (as of 2023), some have been making last-minute payments,[26] which can indicate financial distress.

Property tax proposal

In October 2021, The Wall Street Journal reported that the central government was planning to implement a nationwide property tax, to tackle real estate speculation and provide local governments with more stable revenue. However, the report detailed widespread resistance within the Chinese Communist Party, leading to various alternative proposals including state-owned housing. On 23 October, a five-year trial of the proposed tax was announced for select regions with particularly hot property markets, such as Shenzhen, Hangzhou and Hainan.

Although the property tax could reduce government reliance on land value through LGFVs, it has been estimated that a property tax could reduce land value by 50%, and that this risk to property owners was contributing to lower land sales.[27] In April 2023, the government completed a unified real estate registration system, which could enable the property tax to be implemented.[28]

Other work

In July 2023 China's state-owned banks began providing loans to LGFVs with a generous repayment period of 25 years, in an attempt to relieve some of the pressure.[29]

Peking University academic Yang Yao attributed the problem of unsustainable local government debt to various political economy issues, including the moral hazard of local governments not bearing the risk from their borrowing, and frequent rotation of officials. To improve the situation, Yao proposed 4 billion yuan of central government support, along with a variety of debt restructuring options, such as integrating the budgets of all state-owned enterprises with their corresponding governments.[30]

In 2023, a study by David Daokui Li concluded that local government debt was 50% higher than previously estimated by the IMF and World Bank.[31] The study found that the majority of debts were for infrastructure, and the level of debt was unsustainable without central government support.

By 2024, economists estimated that the indebtedness attributable to LGFVs had reached between US$7 trillion and US$11 trillion, the Wall Street Journal reported. Of that debt, US$800 billion was estimated to be at high risk of default.[32] Many projects funded by LGFVs were found to be ill-conceived and poorly planned. The IMF estimated that LGFV debt in China will have grown by 60% in 2028 compared to 2022 levels.[33]