Local government financing vehicle

A local government financing vehicle (LGFV) (Chinese: 地方政府融资平台), also known as a local financing platform (LFP), is a funding mechanism by a local government in China. It usually exists in the form of an investment company that borrows money to finance real estate development and other local infrastructure projects.^[1] LGFVs can borrow money from banks, or they can borrow on the open market by selling bonds known as "municipal investment bonds" or "municipal corporate bonds" (城市投资债券 or 城投债), which are repackaged as "wealth management products" and sold to individuals.^[2]

Since local governments in China are not allowed to issue municipal bonds,^[3]: 86 LGFVs have played a unique role in securing funding for local governments to develop their economies. However, the vehicles rarely make enough returns to pay back their debts, often requiring local governments to raise more money to pay back their creditors.

Both the number and the indebtedness of LGFVs have soared in recent years, sparking fears about their inability to repay debts as well as subsequent defaults.^[4] Although LGFVs are operated by local governments, who investors assume will remain accountable for them, the often-unsecured debt is classified as "corporate debt", and the central government has indicated it would not bail out a bankrupt LGFV.

Since land has traditionally been owned by the local governments, LGFVs have also turned to earning revenue by through land sales or leases, which can help to repay its creditors. Land can also be used as collateral to secure the bonds.^[5][6]

Mechanism

The LGFV borrows money from creditors, mostly by selling bonds in security markets. LGFVs then provide funding to comprehensive urban development projects.

The developments typically increase the value of the surrounding land, which is owned by the local government. The higher land value then boosts local government revenue, through the local government's leasing of land by selling land use rights (LUR).^[6]

The LGFV can then pay back its loans, using revenue from land leasing and any revenue from completed projects to pay back its loans. If these revenue sources were not enough, it could issue more bonds as a temporary measure to repay older bonds.

History

Economic reforms - 1970s and 1990s

After the economic reforms of the late 1970s, China's economic growth was largely fueled by rural areas. The result of this growth was that in 1993, only 22% of Chinese tax revenue was being collected by the national government.

In 1994, China underwent financial reforms with a goal of "fiscal recentralization", which aimed to boost the national government's earnings. In doing so, they shrank local tax revenue to below 50% of the total, down from 78%. Local governments still shouldered 70% of regular spending.^[7] The reforms also mandated that local governments must have balanced budgets and zero debt, which made it much harder for them to secure financing for infrastructure development.^[8]

The 1994 reforms, however, permitted local governments to engage in land financing, where they would earn revenue through leasing land. In addition, the reforms saw the central government give up its share of land transfer proceeds, so the proceeds would belong entirely to local governments.^[7] 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.

Global financial crisis of 2007-2008

The 2007–2008 financial crisis prompted the Chinese government to introduced a 4 trillion yuan ($562 billion) national stimulus plan.^[9] 72% of the stimulus plan consisted of infrastructure funding, and the central government funded only 30% of the package.^[10] This rapidly increased the rate of borrowing by local governments through LGFVs, with around two thirds of the package funded through borrowing.

Mid 2010s

In 2014, Chinese local governments were permitted to borrow money directly, in an attempt to reduce their reliance on LGFVs. By 2017, bonds represented 90% of local government debt, up from 7% in 2014 (when most debt was borrowing from banks).^[11]

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.

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.^[8]

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 (LUR) constituted 60-80% of local government revenue in 2018.^[12] In 2019, LGFV bonds constituted 39% of total outstanding corporate bonds in China's domestic (onshore) bond market, with widely varying credit risks.^[13]

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.^[14] The International Monetary Fund estimated that local government debts nearly doubled from 2018-2023, reaching 66 trillion yuan ($9 trillion), nearly half of China's annual economic output.^[9]

In 2021, new regulations prohibited financial institutions from providing fresh liquidity to LGFVs.^[15]: 128 Following these regulations, local governments are required to raise funds through issuing bonds, subjecting them to stronger oversight.^[15]: 128

Although no LGFV has ever defaulted (as of 2023), some have been making last-minute payments,^[16] 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 could reduce land value by 50%, and that this risk to property owners was contributing to lower land sales.^[17] In April 2023, the government completed a unified real estate registration system, which could enable the property tax to be implemented.^[18]

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.^[19]

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. As a solution he 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.^[20]

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.^[21] The study found that the majority of debts were for infrastructure, and the level of debt was unsustainable without central government support.

References