In a sweeping effort to reduce the strain of hidden debt on its economy, China has launched a debt restructuring plan designed to bring local government finances into clearer view. This move, approved by policymakers in Beijing, involves a substantial 6 trillion yuan ($840 billion) debt swap, offering local governments official loans with better terms. The strategy aims to address China’s long-standing issue with hidden debt, particularly at the local level, while easing the financial constraints that have slowed the country’s economic growth.

The Origins of Hidden Debt

A significant portion of hidden debt has built up through local government financing vehicles (LGFVs), which are state-owned entities established to fund infrastructure projects. Although directly borrowing was restricted for local governments, these LGFVs have taken on debt through loans and bonds, circumventing traditional borrowing limits. Initially, this financing was directed toward high-demand infrastructure, but in recent years, with less demand for new projects, local governments have struggled to generate sufficient returns on new undertakings. Compounding these issues, the real estate slump has reduced revenues from land sales, putting local governments at further risk of default.

As of 2023, the International Monetary Fund estimated that China’s LGFVs held around 60.4 trillion yuan ($8.4 trillion) in hidden debt.

The Impact of Hidden Debt

The mounting debt has led many local governments to cut costs by reducing civil servant wages, delaying pension payments, suspending public services, and aggressively collecting fines to increase revenues. For example, provinces like Guangxi, Shaanxi, and Sichuan reported a spike in fines in early 2022, as authorities attempted to bridge budget gaps. This drive for quick revenue has hurt consumer and business confidence, and instances of forgery to increase fine collection in Hebei province prompted the central government to caution local governments against using such measures to bolster their finances.

The New Debt Swap Plan

The latest debt restructuring plan, announced last Friday, will raise the debt ceiling from 2024 to 2026, with an annual total of $558 billion in hidden debt to be converted into formal government loans. Additionally, the government plans to issue $112 billion in special bonds each year for five years to support local finances, Finance Minister Lan Fo’an revealed.

While the scale of the plan exceeded analysts’ expectations, firms like Goldman Sachs expressed caution, noting that its effectiveness would hinge on using funds to settle overdue payments to contractors and unpaid wages to civil servants. If managed well, Societe Generale analysts believe the plan could restore normal functioning in local governments by freeing up fiscal resources.

A History of Debt Control Efforts

China’s new strategy builds on previous attempts to control local debt, including a 2015 debt-for-bonds program and subsequent measures to manage refinancing. Recently, Beijing has introduced various economic recovery policies, including easing home purchasing restrictions and lowering interest rates. These moves underscore China’s commitment to stabilizing its economy, though experts say more robust stimulus measures may be required to secure long-term growth.