China local debt rise is significant, but manageable

The 34% rise in China's local government (LG) debt from mid-2013 to end-2014 is significant, but major reforms to control higher leverage, to monitor finances better and facilitate more sustainable sources of revenue, will mitigate financing costs and reduce risks associated with the debt, says Fitch Ratings.

Three factors are likely to have driven the high level of growth. First, the slump in land sales through 2014 most probably contributed to greater debt accumulation to finance infrastructure projects. Land sales by local governments grew only 3.3% in 2014, and slumped by 38% yoy over the first seven months of 2015. Second, more stringent classification criteria of LG debt means that the authorities are likely to be factoring in more contingent liabilities under the total LG debt stock. Third, the broader macroeconomic slowdown has contributed to lower fiscal revenue growth.

The trends that resulted in the rising debt load in 2014 are likely to continue in 2015. Notably, general government revenue growth has continued to slow over the first seven months of the year alongside the slowdown in economic growth and falling land sales. A government fiscal response to bring forward some infrastructure spending to 2015 could also contribute to increasing local government debt this year.

Fitch maintains that the debt load is still manageable despite the rapid rise in LG debt in 2014 and the likely further increase this year. Aggregate debt to operating revenue of Chinese LGs was 109% at end-2014 compared with around 92% in June 2013. The authorities have announced a number of reforms as part of a structural overhaul of local government financing since 2014, which Fitch views as positive steps towards greater sustainability and accountability. The framework for an improved debt-monitoring system, which was included in legislation to enable local governments to issue debt directly, will significantly enhance transparency in local government debt management.

In addition, the introduction of a LG debt limit - CNY16trn by end-2015, from the present outstanding direct debt of CNY15.4trn, and a CNY3.2trn programme where higher-cost debt is swapped for lower-cost bonds - could mitigate the risks from the rise in total LG debt since 2013. Fitch expects LGs to directly save at least CNY100bn per annum in financing costs under the current debt swap programme quota. The swap could also bring down additional financing costs of contingent liabilities from local government financing vehicles.

The Chinese authorities updated their LG debt numbers last week, which showed that the debt stock, including both LG direct debt and the debt of policy-driven Local Government Financing Vehicles, jumped to CNY24trn (USD3.8trn) from CNY17.9trn in the 18 months to end-2014. This was higher than Fitch's initial estimate of CNY20trn. With the latest figures, LG debt equated to around 38% of China's 2014 GDP.

Direct debt was the principal factor driving growth. Debt-funded investment by LGs in fixed assets increased by 43% over the period to CNY15.4trn, while indirect and contingent liabilities rose by 21% to CNY8.6trn.

Data on LG debt was only provided in aggregate, and details at the individual province and region level remain unknown. That said, it is important to highlight that there are large geographical discrepancies between provinces/regions, with less developed areas likely to face greater pressures on debt servicing than wealthier, coastal regions. But fiscal equalisation programmes to transfer revenues between provinces/regions, as well as sovereign support, remain key factors to manage the debt loads in areas facing greater fiscal pressures.