The end of implicit guarantees for local government debt? — by Mizuho Securities Asia Ltd

5 Jan 2015

  • Today is the deadline for local governments to declare their liabilities to the central government. Going forward, the government will back only debts recognized by the Ministry of Finance, while the rest will likely be subject to repricing based on real credit risks.
  • As part of fiscal reforms, this change marks the end of a grey area that allowed local governments to borrow cheaply through implicit guarantees, However, the actual classification process could prove messy, and will likely involve extensive bargaining between local governments and the MoF.
  • It is unclear how much of local government debt will eventually qualify as government debt, but we expect the classification process to reveal a larger problem with local government debt than the one exposed in the 2013 national audit. We maintain our view that the consolidation process will have a tightening effect on the economy in the near term.


Deadline for debt declaration of local governments:

Today is the deadline for local governments to declare their liabilities to the central government in order to receive definitive government support. The deadline was set as part of new fiscal legislation passed in September 2014 (see Policy shift to reform and crisis prevention, 25 Sep 2014).

Going forward, only those debts recognized by the MoF will be backed by fiscal resources, while the rest will likely be re-priced to reflect credit risks based on market mechanisms. Those bonds not backed by fiscal resources will need to be repaid by the revenues of the LGFV.

The change is a part of the central government’s fiscal financial reforms aimed at consolidating local government finances. Local governments will still be able to issue municipal bonds, but only selected social welfare projects (eg, social housing, highways and water management projects) will be approved at the senior government level. Public-private partnership will be required for future projects that are expected to generate reasonable revenue (see PPP to boost fiscal investment and reduce government debt, 8 Dec 2014).


Central government’s fuzzy definition of government debt suggests an extended bargaining period:

However, this debt classification process, which aims to eliminate the grey area of local government financing, could prove messy, as the exact definition of government debt is unclear. This will likely leave room for local governments to reclassify their debt and bargain with the Ministry. Local governments face a difficult decision. If the amount filed as government bonds is too large, they could face increased scrutiny from the MoF, and the cost of municipal bond issuance would have to increase. On the other hand, if the amount is too small, then local governments may have to shoulder the massive debt default risk on their own.

The actual purpose of the debt will also need clarification. For example, loans appropriated for building public roads could be incorrectly labelled as construction funds for toll roads because public-road construction generating no financial return would have trouble receiving bank financing. We expect many LGFV debts to be reclassified.


Exposing the true picture of local government debt:

In any case, we expect the actual amount of debt submitted for government recognition to be much larger than the CNY17.9t revealed in the June 2013 government audit. At that time, from the perspective of local governments, it was in their best interest to hide the true scale of their debt burden to avoid criticism.

Now, in order to be protected by the government’s guarantee, local governments will be required to reveal their true financial situation. In the 2013 audit, CNY10.9t of the CNY17.9t of local government debt was considered the direct responsibility of the local governments, along with CNY2.7t in guarantees and CNY4.3t in potential liabilities (see Local government debt under control 6 January 2014). In the current declaration, we estimate the portion of debt that is directly liable by the local governments will be much higher.


Handling the increased debt burden of local governments:

While this should help establish a healthier financial system over the long term, we believe solving the local government-financing problem will take time for several reasons:

1) It is the MoF’s responsibility to produce a complete list of LGFV to control further expansion of local government debt in the grey area.

2) Until local governments are able to issue municipal bonds, how these debts will be repaid will remain a question during the transition period.

3) The consolidation of local government debt could take years, and we believe the central government will find it challenging to prohibit further borrowing using informal channels.

4) Bank loans approved prior to the deadline may be delayed, as the banking sector may need to re-price based on credit risks. This delay could lead to short-term cash flow problems.

5) The details of the administrative system for issuing municipal bonds have not been determined.

Taking everything into consideration, we reiterate our view that in ending the government’s implicit debt guarantee, the consolidation process will have a short-term tightening impact on financing as any loopholes are closed. In 2015, we expect additional infrastructure projects to be approved partly as a fiscal stimulus to support the economy. Along with tax reforms, we expect the fiscal budget deficit in China to widen to 2.5% of GDP in 2015.


Mizuho Securities Asia Ltd

Economics Research

Jianguang Shen

+852 2685 2022

Michael Luk

+852 2685 2155Economics Research



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