The Chinese Municipal Debt Crisis

by Peter Jeffrey, MPA’16, W’16

All of the concerns that China is currently facing can be traced to the massive urbanization that has occurred in China over the past half century. Between 1950 and 1960, the Chinese central government undertook multiple initiatives to industrialize and increase economic capacity, leading to a migration of 69 million people from rural communities to cities during this decade.[2] The pace of urbanization continued to rapidly accelerate throughout the close of the twentieth century with the urban population growing by 110 million throughout the 1980s and 157 million throughout the 1990s.[3] Currently, over half of the 1.35 billion Chinese people live in cities.[4]

This speedy urban expansion has not been cheap. Chinese cities have had to fund the requisite infrastructure needed for economic development and industrialization. In order to meet these development needs, cities needed to borrow. Unfortunately, the Chinese central bank prevented municipalities from borrowing without explicit permission.[5] Thus, Chinese cities were forced to establish alternative financing vehicles to fund the rapid development.[6] These local government financing vehicles (LGFVs), created by municipalities, allow subnational governments to borrow from investors and banks, backing these investments with the revenue generated from land sales and public assets. This borrowed money allowed municipal governments the ability to invest in needed infrastructure to meet the needs of urbanization. More than 10,000 LGFVs were set up throughout the country in order to finance these needs.[7]

By the end of 2013, Nomura, a leader in the financial services industry, estimated that these financial vehicles faced debt that totaled $3.1 trillion, roughly a third of the country’s GDP.[8]This rise has created great uncertainty in the municipal markets as investors began to worry over the sustainability of this path and the municipalities’ ability to generate the returns required to meet the high loan payments generated by steep interest rates.

In May 2014, the Chinese government finally took steps to develop a municipal bond market that would allow cities the ability to directly issue municipal bonds in an effort to better control the prodigious levels of municipal debt.[9]While the permission to issue bonds was limited to only a select number of cities, it is an important first step in establishing a long-term solution to this problem.

This past year, the central government announced that it would force the swap of municipal debt to municipal bonds in an effort to lower the burden of debt on cities.[10] The municipal bonds will have rates that will be far cheaper than the loans, which carry an interest rate around seven percent. The central bank, finance ministry, and bank regulator will work with municipalities and creditors to negotiate the swap that will ideally be mutually beneficial for banks and issuers.[11] The swap will lower the issuer’s burden and thus the bank’s cash flows, but will hopefully decrease the risk of the debt, as issuers are less likely to default on cheaper bonds, providing banks with healthier assets.[12]

It will be interesting to see if these strategies will effectively help address the ballooning debt, but recent events in the municipal markets appear to show continuing investor uncertainty over the ability of municipalities to meet their debt burdens. In August 2015, the Chinese municipal bond market showed signs of stress when the northeastern province of Laioning held an auction of 10-year municipal bonds that went undersubscribed.[13] This under-subscription comes after months of increased yields on municipal bonds.[14]Analysts at Fitch Ratings believe that much of this rise in yields and lack of demand has been created by too much supply in the market.[15] In order to address the lack of demand for municipal bonds, officials in Beijing will have to continue efforts to open up the municipal bond market to international investors, allowing municipal issuers access to more capital. 

Throughout the next few months, China will have to continue efforts to set up a well-functioning municipal bond market. The market must include credit ratings that will allow investors to understand the liabilities that municipal governments face, even those that are held by the LGFVs, that have often not been widely known. Moreover, the central government will need to start exploring plans should a municipality collapse and ask the central government for bailout support. Healthy cities are key to the economic growth goals of the Chinese government and the central government will feel pressure to ensure that all cities are able to build vital infrastructure projects and provide necessary services.

While the market watchers’ attention has understandably been on the Chinese stock markets, they would be smart to closely watch the challenges the municipal bond market is currently facing.