China weighs $853 billion debt swap to rescue local governments

China is considering allowing local authorities to issue as much as 6 trillion yuan ($853 billion) in bonds through 2027 mainly to refinance their off-balance-sheet debt, people familiar with the matter said, a key part of the government’s plan to shore up the world’s second-largest economy.

Officials are weighing the proposal to let provincial-level governments replace so-called hidden debt — borrowing through companies and other financing vehicles — with new official bonds carrying lower interest rates, people familiar with the matter said, asking not to be identified discussing private information. The International Monetary Fund estimated these entities held over 60 trillion yuan of debt as of last year.

The new issuance would form part of a multi-pronged plan outlined by China’s finance minister on Saturday to help the country meet its economic growth target of around 5% and defuse financial risks. While the debt swap wouldn’t address market calls for more central government borrowing and consumer stimulus, it would help free up cash at local governments to spend on everything from employee salaries to construction projects.

The Ministry of Finance didn’t respond to a faxed request for comment.

Investors appeared underwhelmed by an earlier report on the debt swap by Caixin, which also cited a 6 trillion yuan figure but said the bonds would be issued by the central government rather than provinces. China’s benchmark CSI 300 Index fell as much as 2.6%.

The people familiar with the planned local government bond issuance said officials haven’t decided how much sovereign debt will be sold.

Finance Minister Lan Fo’an on Saturday said Beijing would carry out a one-off debt swap at a scale that would be the “largest in recent years,” saying it would allow local governments to allocate more resources to develop the economy and lift business confidence. UBS Group AG economists including Wang Tao expected the size of the effort to be comparable to the 12 trillion yuan initiative from 2015 to 2018.

Lan also said local authorities will be allowed to use proceeds from special bonds to buy unsold homes to reduce housing inventory, following Chinese leaders’ pledge last month to stop the decline in the real estate market. Lan didn’t say when or how much of those loans will be issued, which unlike general bonds could only be used for public projects with returns.

What Bloomberg Economics Says...
“It wouldn’t be enough. Based on a similar debt-swap program over 2015-2018, and considering the impact of the housing rout on local finances, we think local governments will need more than 6 trillion yuan to deal with their ‘hidden’ debt.”

— David Qu, China economist

The planned swap would represent an official endorsement of tackling debt risks using special local government bonds. China has sold about 3.5 trillion yuan worth of new special local government bonds by the end of September, or 90% of the annual quota, Bloomberg calculation shows.

David Li Daokui, a professor at Tsinghua University in Beijing and a government adviser, told Bloomberg Television that a debt swap that helps local governments pay back their delayed payments to companies and employees would be the “biggest economic stimulus,” putting the amount at 10% of gross domestic product.

Local governments’ expenditures — including spending on infrastructure — have shrank to 36% of GDP from 41% previously because they’re running out of cash, Li said in an interview Monday.

“Local governments have been using short-term debt and loans to finance 20-year, 30-year, long-term infrastructure projects,” he said, referring to the borrowing binge through financing vehicles, known in short as LGFVs. “So it is irrational, even crazy or draconian, for local governments to pay back their debt in the coming one or two years. This is a self-inflicted wound.”

But the approach of shifting hidden debt onto local governments’ balance sheet may disappoint Li and other economists who have called for the central government to step up borrowing and take on more spending responsibilities.

Central government debt only accounts for less than a quarter of China’s GDP, a low level internationally speaking, according to data from think tank National Institution for Finance and Development.

“I do expect by the end of this month there will be a huge increase in central government debt, and using that the central government will support the local governments,” Li said. “And then the macro economy, or the real sector, will be back on track.”