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The world watched as China provided more details on the 10 trillion RMB “stimulus.” When the details were finally revealed, however, it turned out that the Chinese government had no intention of stimulating the economy with additional fiscal resources. Worse, the program to digest “hidden debt” articulated by the Minister of Finance Lan Fo’an actually would take money away from current expenditures and local investment. This would depress local government spending and potentially put further downward pressure on the economy. The only rationale for this approach is that China is preparing to use further deflationary pressure to balance against the effects of additional U.S. tariffs, which have become foreseeable with Donald Trump’s re-election. In other words, the main focus of economic policy continues to be a high dependence on exports to maintain growth, rather than any demand side program.
When the market first learned of a 10 trillion RMB stimulus from Beijing, it reacted with enthusiasm as the Chinese stock market achieved its best week since 2008 in late September. Yet, the enormous size of local debt and of the Chinese economy in general, it still would have been a modest stimulus at best. To revive economic momentum, the best use of the funds would have been a one-time payment of all back wages owed to government workers, many of whom are owed months of wages, as well as additional transfer payments to low-income households. However, investors learned that the focus of the stimulus would be on alleviating local government debt. An alternative approach with a smaller impact would have been 6 trillion RMB in central government debt issuance to write down the local government financing vehicle (LGFV) debt of the most fiscally strapped places, followed by another 4 trillion RMB to repay back wages or some form of transfer payments to households. This at least would have taken debt off of local governments’ balance sheets, as well as stimulating some effect on the economy.
As it transpired, the Chinese government’s approach appears to be primarily an accounting exercise, lacking a discernible positive economic impact. Furthermore, there is a potential risk that this strategy could introduce a negative drag on economic performance. First of all, local debt in China has reached a gargantuan scale. Just accounting for the bonds outstanding of local governments and LGFVs, local debt has surpassed 60 trillion RMB by the end of 2023, or a little less than 50 percent of GDP. However, the thousands of LGFVs also owe additional bank loans, estimated by me to be between 40 and 85 trillion RMB, making total local debt between 75 percent and 111 percent of China’s GDP at the end of 2023[1]. In addition, there are trillions more in liabilities in the form of debt packaged in complex financial products, back wages to government workers, and accounts payable to vendors. The true scale of local government liability in China likely is between 100 percent to 130 percent of GDP.
Thus, the Minister of Finance Lan Fo’an’s pronouncement that there is only 14.3 trillion RMB in “hidden local debt” is completely not credible. Just the loans owed by LGFVs alone would be several times that size. The finance minister also assumed that the hidden debt would not increase in the coming years, which contradicts the pattern of relentless increase in LGFV debt in the past decade. Moreover, the announced plan is not a central government bailout; it merely empowers local governments to issue more lower yielding official debt to write down the “hidden debt.” Thus, the overall amount of local debt does not go down. Still, Lan announced that there would be 600 billion RMB in savings on interest payments “over the course of five years.” At 120 billion RMB per year, the positive impact is less than 0.1 percent of GDP.
The worst part of the latest debt replacement plan was encapsulated in this innocent-sounding statement made by Lan: “for five years starting in 2024, we will take 800 billion RMB per year from the issuance of earmarked local debt to repair the financing of local government funds by repaying outstanding debt, which can reduce hidden debt by another 4 trillion RMB in total.” Looking at the 2023 usage of local debt, the Ministry of Finance announced that 4.7 trillion RMB of newly issued debt was the so-called “refinancing debt,” that is, debt issued to repay debt coming due. Of the 4.7 trillion RMB in refinancing debt, 3.3 trillion RMB was used to repay bonds coming due in 2023, implying that the remaining 1.4 trillion RMB was used to repay LGFV loans and other forms of non-bond debt of local governments. So, Lan’s statement either implies that the government would allocate less money to address non-bond debt, that is, 800 billion RMB instead of 1.4 trillion RMB, or that the overall size, and thus proportion, of refinancing debt would increase, taking funds away from the current usage portion of local debt issuance.
There is reason to think that Lan meant the latter, that an additional 800 billion RMB in local debt would be allocated to refinancing purposes. For one, trillions in local government bonds will come due each year, necessitating trillions in refinancing bonds to repay them. Thus, any further resolution of “hidden debt” would require additional allocation of local debt for refinancing purposes. Also, besides the approved 6 trillion RMB in special bonds to replace the “hidden debt,” Lan did not recommend any addition to the overall local debt limit, which is now targeted at 35.52 trillion RMB by the end of 2024. Thus, the 800 billion RMB in additional debt replacement would need to come from local bonds originally designated for current usage and project financing.
Using 2023 as an example, of the 9.3 trillion RMB in local debt issued, 50.5 percent of it was in refinancing bonds, leaving 49.5 percent for current usage and project finance. If the refinancing amount were to increase by 800 billion RMB, current usage and project financing would be left with 41 percent or 3.8 trillion RMB. Hidden debt may decrease by 800 billion RMB in the short run, but local governments would also have 800 billion RMB less to spend. Net, the two programs announced by Lan, the 6 trillion RMB in debt replacement and the reallocation of 800 billion RMB per year for repayment, would diminish local government spending by 3.2 trillion RMB over five years, if the additional debt limit is not approved.
If the economy slows, the central government likely will approve greater debt limits for local expenditures and for refinancing. Still, this likely will be an iterative process, which discounts its impact on the economy. This program will not generate the kind of stimulus that the market had hoped. The pressing question remains: why is this the case?
Given the likelihood of new tariffs from the United States with Trump’s re-election and the existing deflationary pressure in the economy, why would the government not seek to increase domestic demand with a demand-side stimulus? From the perspective of the Chinese government, which seeks to dominate industrial supply chains and maintain the solvency of the central balance sheet, a demand-side stimulus would undermine both of these objectives by decreasing the competitiveness of Chinese exports and worsen the central balance sheet. Although this deflationary approach would weaken growth further, the deflation in China would partially counteract the impact of higher tariffs, and by pushing more debt onto the local balance sheets, the central government can still claim it has a low debt level. Yet, this approach also is not a free lunch. With further deflation, the unemployment problem will not improve, keeping Chinese society in a state of discontent. Additionally, the dual challenges of weak domestic demand and higher tariffs may lead to the emergence of a much larger non-performing loans problem in the industrial sector. These problems may create greater headaches for China’s economic bureaucrats than the ones they are trying to avoid.
[1] Author’s calculation based on this report:
https://china.ucsd.edu/_files/2023-report_shih_local-government-debt-dynamics-in-china.pdf
