China scares people elsewhere, but not only for the reasons that Zi Jinping desires.[1] In recent decades, infrastructure projects powered much of China’s economic growth. Now there is a fear that China’s economy will not escape an avalanche of debt incurred to finance those projects. As part of its effort to build infrastructure, the government centralized the financing of local development and infrastructure schemes. Yet the central government wanted cities to take the lead in this effort. Perhaps the theory was that local people know better than a remote bank what opportunities exist in their communities. At the same time, the central government had traditionally kept a tight leash on borrowing by cities in the form of borrowing limits. So, where would the money come from if the cities could not issue many more bonds?
The solution came through cities borrowing from state-owned Local Government Financing Vehicles (LGFVs). The LGFVs may be state-owned, but they keep their own set of books. These are separate from the central government’s books. The LGFVs borrowed money from state-owned Chinese banks, then re-lent it to local governments all over the country. The banks lending the money seem to have believed that the government would never let the cities or the LGVFs default because it would wreak havoc on the country’s financial system.
The trouble is that those local governments did not always know what kinds of real opportunities existed, or they derived income from selling public lands to developers, or they didn’t care so long as they could keep their locals employed.[2] In any case, the result appeared in massive over-building relative to real demand. Since 2022, China’s real estate market has been slipping downward.
How much money is involved? It’s hard to tell for sure. Economists estimate that it is between $7 trillion and $11 trillion. (For comparison’s sake, the debt of the Chinese national government is estimated to be $4-5 trillion.) A big chunk of that debt—around $800 billion–is in the shadow of default.
There seems to be a fair amount of mutual back-scratching: many LGFVs guarantee the debts of other LGFVs even when both are heavily indebted; and some park their own assets with other LGFVs when their financial stability is being assessed.[3] Now central government officials are showing up in localities carrying a lot of debt. They are demanding to know “What in the Wide, Wide World of Sports is going on here?”[4] There mere presence seems to be paralyzing projects already under way.
“Well, let them go bankrupt: serve them right and teach everybody a good lesson,” would say theorists of capitalism. The thing is that another capitalist slogan holds that “Small debts are a problem for the borrower; big debts are a problem for the lender.” If the local governments default, then either the government has to step in with a bail-out or the banks have to write-down the loans. In the latter case, in particular, the result would be a tightening of credit throughout the economy. That might be hard to contain.
[1] Brian Spegele and Rebecca Feng, “Trillions in Hidden Debt Threaten China,” WSJ, 15 July 2024.
[2] One local government official has been arrested and charged with spending the borrowed money on “political vanity projects.”
[3] See: The Sting (1973) – Paul Newman card trick – YouTube
waroftheworldblog 