China's Debt-Fueled Development

In early 2019, officials in Liuzhou were optimistic about their city's future. The economy was thriving, a new industrial district was underway, and an elevated light-rail system was being developed. Mayor Wu Wei credited the achievements to local party leaders' determination but omitted a crucial factor: significant off-the-books debt.

  • For years, Liuzhou and other Chinese cities accumulated trillions of dollars in hidden debt for economic projects.
  • This opaque financing contributed to China's rapid rise but now reveals the illusory nature of this growth, with overgrown construction sites, underused highways, and abandoned tourist attractions casting doubt on China's economic future.

Liuzhou raised billions for its new industrial district, building hotels and an amusement park, yet many areas remain vacant, with deserted streets and abandoned buildings.

State-owned Funding Vehicles

Central to the problem are state-owned funding vehicles that borrowed for local governments, often for projects with minimal returns. The real-estate market's decline in recent years has exacerbated the issue, as local governments lost a critical revenue source from land sales to developers.

  • Economists estimate this off-the-books debt at $7 trillion to $11 trillion, about twice the size of China's central government debt. The exact amount remains unknown due to the opaque financial arrangements.
  • As much as $800 billion of this debt is at high risk of default. If these vehicles fail to meet obligations, Beijing faces a dilemma: bailouts that encourage unsound borrowing or defaults that could harm banks and spur a credit crunch, further impeding economic growth.
  • Top Chinese leaders will address this at an upcoming summit, as accumulated debt limits China's economic stimulus ability. Annual growth slowed to 5.2% last year from 7.8% a decade earlier. The Ministry of Finance did not respond to requests for comment.
  • Local officials are being blamed. Mayor Wu was fired and charged with abuse of power for pursuing wasteful projects. The light-rail system project is stalled, and local officials are unable to answer questions about the city's debts.

Other cities are also halting infrastructure projects. Moody's Investors Service and Fitch Ratings have lowered China's credit outlook to negative, doubting local governments' ability to manage debt.

A Financial Sinkhole

China's municipal debt issue stems from a fundamental funding weakness. Beijing controls funds and limits local-government bonds but expects cities to drive growth with limited budgets. Deficit spending through local government financing vehicles (LGFVs) became a solution, allowing cities to bypass borrowing limits.

  • LGFVs raised funds for projects like infrastructure, but many were ill-conceived. In Liupanshui, Guizhou, LGFVs funded tourism projects, including a rarely snowy ski resort, resulting in idle, low-efficiency projects.
  • Research shows many LGFVs lack the cash to cover short-term debts and interest payments. With insufficient revenue, they rely on local governments and continuous borrowing. The International Monetary Fund found 80-90% of LGFV spending came from new financing.
  • Some LGFVs guaranteed each other's debts, making liabilities appear safer. In Liuzhou, one LGFV received guarantees from 13 other entities, all liable if it defaults. This interconnected borrowing worsened as liabilities grew, with LGFVs shifting assets to borrow more at lower costs.

City officials often lacked understanding of LGFVs. An investment banker recalled local officials inquiring if they had to repay an LGFV bond issue. The answer was yes.

Misguided Ambitions

Liuzhou, aiming to modernize its manufacturing sector, envisioned a district of factories and apartments. The Guangxi Liuzhou Dongcheng Investment Development Group raised loans and sold bonds for the project, leveling plots and installing infrastructure. Dongcheng amassed about $9 billion in liabilities by 2018, opening a convention center, amusement park, and hotel.

  • However, weak factory demand and lack of growth caught up with the city. The light-rail project was suspended, with Beijing never approving it. The amusement park and hotel were unprofitable, and all nine LGFVs in Liuzhou are cash-strapped, with nearly $29 billion of debt.
  • After the real-estate bubble burst in 2021, Dongcheng used borrowed cash to purchase land, filling government coffers. Yet, despite billions spent, the city's economic output last year was smaller than in 2019, with a 30% revenue decline.
  • The Ministry of Finance criticized Liuzhou's debt, leading to arrests and charges for city leaders and LGFV executives. Despite this, Liuzhou's LGFVs continue issuing bonds.

The IMF estimates LGFV debt across China will grow 60% by 2028. Locals express frustration over pork-barrel spending, questioning the need for a rail system when buses are underused.

Disclaimer

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Photo by Alejandro Luengo / Unsplash.