Ever since China's 2009 stimulus program, commentators have felt squeamish about swelling Chinese local government debt burdens – a feeling that only intensified as GDP growth slowed, exposing increasingly limited revenue sources. Local governments, in a rush to tap policy stimulus, utilised Local Government Financing Vehicles (LGFVs) to raise bank loans to invest in infrastructure development, thus promoting urbanisation and growth. This led to excess investment and as China clamped down on its booming property market, it cut a prime funding source for local governments, thus exposing creditors to default risk. On 8 March 2015, China's Ministry of Finance (MoF) issued a 1 trillion RMB quota for local governments to convert LGFV debts into lower-yielding municipal notes. The question we look to answer is whether this is a game changer for China or merely another exercise in kicking the can down the road.

Background to LGFVs

LGFVs are not a recent phenomenon in China, they have been in existence since the 1980s when the first was set up in Shanghai to facilitate local infrastructure development. Many more were set up following the Asian Financial Crisis as China limited local government bond issuance and bank lending, and then again in 2009 in reaction to the government's stimulus package.

Following the central government's rapid centralization of revenue sources in 1994, the only major remaining source for local governments is land sales, supplemented with some revenues from utilities, tolls and infrastructure projects. Indeed, they have little discretion over tax rates and policy, while central government transfers are mainly to cover current spending, leaving little for infrastructure investment without off-balance sheet financing. This was intended to instil greater discipline on local government spending.

Chart 1: Local Government Revenue and Expenditure
(% of General Government Revenue & Expenditure)

Local Government Revenue and Expenditure

Source : Zhang et al. 2013

In 2009, as a policy response to the ensuing global financial crisis, China launched an unprecedented stimulus program to boost growth through infrastructure investment and urbanisation. But you will not find evidence of this in the headline fiscal statistics because the majority of this was conducted through an expansion in bank credit. With limited capacity for local governments to borrow on-balance sheet and forbidden from taking on bank loans directly, LGFVs were utilized to access this stimulus program. The perception of an implicit central government guarantee made LGFVs attractive credits for banks and led to a surge in bank loans in 2009. As the economy recovered these stimulus measures were unwound before loosening resumed in 2012 – except that banks were now more reluctant to lend directly to LGFVs and this gave rise to Trust loans (Chart 2) and more direct bond issuance by LGFVs.

Chart 2: Local Government Market Financing (% of GDP)

Local Government Market Financing

Source: IMF Working Paper
“Fiscal Vulnerabilities & Risks from Local Government Finance in China” Zhang et al. 2014

These waves of liquidity undoubtedly led to some reckless lending and overly ambitious projects as local governments competed for growth. Estimates of the total amount of local government debt outstanding vary, but the last official estimate by China's National Audit Office (NAO) put the figure at around RMB 17.9 trillion by mid-2013. Based on the MoF's disclosures, BCA, an independent research house, estimates this figure to have risen to around 20tn by end 2014 (“China Investment Strategy – Weekly Report, 18 March 2015). Similarly, Goldman Sachs estimates the total to be around 21tn by end 2014 (“Untangling China's credit conundrum” 26 Jan 2015).

In September 2014, the State Council issued Article No. 43 in order to resolve local government financing issues. One key recommendation of this article was that from 2016 onwards, all government funded projects will need to be financed by municipal bonds issued by provincial governments and would be included into fiscal budgetary planning. It also stipulates that for public projects with commercial viability, governments should finance via project based bonds or Public-Private Partnerships (PPPs) going forward and LGFVs should be shut down, consolidated or transformed from 2016.

On March 8th, the MoF issued a 1 trillion RMB quota for local governments to convert some LGFV debts into lower-yielding municipal notes, together with 600bn of new approved municipal bond issuance (increased from 400bn in 2014). This swap arrangement represents around 56% of LGFV debt expected to mature in 2015 according to NAO's survey.


There are several implications of these developments, chief among them being lower borrowing costs for local governments, greater transparency in China's debt markets and ultimately a lower equity risk premium for Chinese stocks, particularly banks. For debt markets, we are likely to see a swathe of new issuance in the municipal and corporate space, with the crowding-out impact likely moving from loan markets to debt markets.

The MoF estimates that the 1 trillion debt swap program will save local governments between 40-50bn RMB in borrowing costs this year, an effective decrease of 4-5% in borrowing rates. Extrapolating this to the entire RMB 20-22tn outstanding would result in savings of around 1tn or 1.5% of current GDP – although this is a best case scenario.

It is important to note that this exercise does not lower leverage within the system; it is merely a transfer of off-balance sheet debt into more formal fiscal liabilities. By migrating to more formal financing channels, it should also give rise to more market discipline and more effective risk pricing compared to the previous system. Municipal debt should be formally included on broader government debt to GDP ratios giving market participants greater transparency on China's true debt profile. The focus likely will shift to other problem areas like overleveraged and inefficient SOEs, as these still make up the majority of corporate debt in China.

Chart 3: Debt by major borrower segment (% of GDP)

Debt by major borrower segment

Source: CEIC, JPMorgan — *Includes Bills, Trusts and Entrusted

Greater clarity on local government debts and reduced borrowing rates should improve the financial markets' perception of risk within the banking system. LGFV defaults were one of the main segments stress-tested by analysts when trying to gauge potential non-performing loan formation in the banking sector. Lower systemic risk should help bring down the equity risk premium of Chinese stocks and in particular bank stocks. For this to happen the market needs to assume that the debt swap facility will be implemented on an annual basis covering those debts due that particular year, something that is difficult to assume without further disclosures on the outstanding debt and the quality of underlying assets.

Shares in China Construction Bank, one of China's largest banks by assets, de-rated considerably as asset quality concerns intensified post the 2009 stimulus, despite its return on equity remaining largely unchanged over the period. We note here that its A-share listing has started to re-rate reflecting renewed optimism amongst mainland investors that the worst may be behind us.

Chart 4: China Construction Bank, Return on Equity and Price-to-Book ratios (%)

China Construction Bank, Return on Equity and Price-to-Book ratios

Source: Bloomberg

The direct impact on banks is to free up capital and loan quotas whilst eroding net interest margins. LGFV loans account for approximately 5% of total loans and have a 100% risk weighting vs. municipal debts at 20%. Hence this swap will lead to a reduction in risk weighted assets (RWA) and an uplift in capital. Similarly, when LGFV loans are reclassified into municipal debt, they drop out of the loan-to-deposit ratio calculation, thus allowing more room to lend into under-served areas (private corporates and retail sectors) of the economy. It may also result in some release of provisions otherwise set aside for bad debts in this segment. This whole exercise should help to reduce the “crowding out” impact local governments have had on private sector borrowers in bank loan channels.

We do not anticipate that this move will lead to a dramatic uptick in new credit formation and would be concerned if this were to occur. These developments are less about the quantum of credit and more about the move toward more efficient credit allocation. The migration from off-balance sheet to more formal channels is also well underway in other segments of China's credit system. “Shadow banking” finance channels have slowed significantly since mid-2013, while growth in corporate debt issuance, equity raising and conventional bank loans has picked up.

Chart 5: Total Social Financing Components (% growth YoY)

Total Social Financing Components

Source: CEIC, JPMorgan

One unanswered question is who is the end buyer? This will define whether this measure is akin to fiscal stimulus and/or a liquidity injection by the government or People's Bank of China (PBoC). We will watch this closely, but our base case is that banks will be the initial buyers in a straight swap of loans for debt, and then sell them in secondary markets to insurers, institutions and retail investors (likely via Wealth Management Products and internet money market products). We think the Chinese government would want to avoid placing more funds in the hands of local governments following their recent track record, but it is an option if growth started to materially disappoint. Notably, the State Council also recently moved to allow the Social Security Fund to invest, for the first time, up to 300 billion RMB into local government debt, thus adding another sizable investor to the list.

Going Forward:

This exercise bides time for authorities to address more fundamental issues within China's fiscal framework. A more streamlined mechanism between central and local governments for capital allocation and budgetary decisions needs to be developed to ensure a repeat of this episode cannot occur. The most pressing issue for buyers of municipal debts is the chronic mismatch between local government revenue sources and expenditures.

As discussed previously, local governments have been overwhelmingly reliant on land sales as a source of revenues ever since the central government centralised revenue sources in 1994. Their reliance on land sales for financing resulted in an over-supply of real estate that, in turn, makes the property market highly susceptible to a cyclical downturn.

VAT implementation and distribution, direct property taxes (currently being piloted in Shanghai and Chongqing), SOE restructuring and asset sales are some of the key measures required to improve revenue sources on a sustainable basis. China's public sector asset base remains huge and there is plenty of potential for restructuring inefficient SOEs and asset sales. It is difficult to get accurate and timely data on the asset side of the government's balance sheet, but as we note from the IMF's estimates in the following chart that there remain huge amounts of capital in natural resources and for-profit non-financial SOEs.

Chart 6: Public Sector Balance Sheet (% of GDP)

Public Sector Balance Sheet

Source: Yang et al (2012), IMF staff estimates

As LGFV repayment issues subside, the focus should shift to restructuring and possible sale of underperforming and inefficient SOEs. From a capital allocation perspective, we would also like to see policies to gradually remove implicit state guarantees, improve profitability and eventually allowing weaker institutions to fail. This is pre-requisite for more efficient and market orientated capital allocation by banks and credit markets. We note from recent bank management briefings that they have started to discuss the possibility of SOE defaults, something that was unheard of before the era of Xi Jinping and the new leadership's unprecedented anti-graft campaign.

Another important change would be to develop more sustainable metrics besides GDP growth to assess provincial government performance. This would lead to more productive investment decisions, helping to alleviate the threat of new bad debt formation. In October 2014, the State Council announced it would establish assessment accountability mechanisms, in which local government debt levels would be made one of the hard measures for evaluating performance. We believe that this is definitely a step in the right direction and note that Shanghai has decided not to set a GDP growth target at all this year, the first province ever to do so.


Despite the western world's conclusions that China was headed for a shadow banking/LGFV induced financial crisis, it has shown it retains plenty of tools at its disposal to avoid such a scenario. A key reason China has been able to avoid a crisis has been the central command function of the state together with its closed financial system. In such a system, so long as confidence is maintained, it is unlikely for widespread bankruptcies or bank runs to occur without intention.

We believe LGFV debt swaps are a game changer but they must be complemented with strategic reform to how local governments allocate capital, raise revenues and finance infrastructure projects. These reforms are essential if China wants to ensure a similar event will not occur in the future.

In isolation, this debt swap should help reduce the equity risk premium in China's equity markets and in particular, its banking sector. We note again here that mainland investors have reacted much more positively than overseas investors with Shanghai Composite Index up 13% since the announcement and MSCI China up only 4%. (through March 31,2015)

Chart 7: Index Price Performance 1Q 2015
(re-based to 100 as of 31 Dec 2014)

Index Price Performance 1Q 2015

Source: Bloomberg

The Shanghai Composite Index now trades at a trailing price to earnings multiple of 19.4x while MSCI China trades at only 11.4x. While A-share markets have been largely driven by heavy retail buying and margin finance, it is premised on confidence in China's leadership and their ability to restructure the system's vulnerabilities and drive forward its next economic chapter. We expect international investors will gradually reach similar conclusions.

While there are over-leveraged segments in the Chinese economy, there remain two large components of the system's balance sheet that remain largely underutilised - the central government and the consumer (and arguably large parts of the private sector, excluding property, that have been crowded-out by local governments and SOEs). While this debt swap should alleviate some of this crowding-out affect, deposit insurance (announced on March 31st) and better social security systems are two pre-requisites for 'unleashing' the Chinese consumer. These are necessary if China is to achieve its goal of transitioning its economic growth model more towards consumption and away from investment. We note that Chinese consumers still hold 73% of their financial assets in cash deposits, far more than developed market peers (Chart 8). The central government remains under-leveraged by international standards and as we have seen before, still has a very strong asset side of the balance sheet, which provides further room to manoeuvre (Public Sector Balance sheet chart and govt debt.

Chart 7: Composition of Household Financial Balance Sheets (% of Total)

Composition of Household Financial Balance Sheets

Source: CEIC, Goldman Sachs

Chart 8: Total Government Debt (% of GDP)

Total Government Debt

Source: Central Intelligence Agency — *Includes LGFV estimates based on NAO survey

The importance of President Xi Jinping's strong leadership cannot be stressed enough. Under him China is undergoing dramatic changes. While the most thorough cleansing of state corruption is ongoing, elements of China's grand strategy are becoming more evident both domestically and on the global stage. Domestically we are seeing efforts to correct financial system vulnerabilities, promote market based risk-pricing and open up capital markets. While on foreign policy, key examples include its “One Belt, One Road” initiative and the establishment of the Asia Infrastructure Investment Bank (AIIB).

We remain optimistic that China is emerging from a tough period in its economic development cycle and this is one of the first steps in addressing system vulnerabilities. While this move does not alter the trend for slower GDP growth, it should provide greater confidence in the country's ability to deal with other well documented issues. Mainland investors have grasped this concept and we believe it will not be long before western investors start to reach similar conclusions.