Local government financing vehicle

In China, a local government financing vehicle (LGFV) is an investment company formed by local governments to raise funds, usually by borrowing money to finance real estate development and other local infrastructure projects.[1]

LGFVs allow local governments to finance infrastructure projects while complying with laws that prohibit them from issuing bonds or having deficits. Such restrictions and the need to invest in the local economy have made local governments to heavily rely on LGFVs as a fundraising tool.

LGFVs rarely make enough returns to pay back their debts, often requiring local governments to raise more money to pay back their creditors. Both the number and the indebtedness of LGFVs have increased in recent years, sparking fears about their inability to repay debts as well as subsequent defaults.[2] Although LGFVs are operated by local governments, who investors assume will remain accountable for them, the often-unsecured debt is classified as "corporate debt", and the central government has indicated it would not bail out a bankrupt LGFV.

Since land has traditionally been owned by the local governments, LGFVs have also turned to earning revenue by through land sales or leases, which can help to repay its creditors and be used as collateral for the bonds.[3][4]

Definition

LGFVs are established to perform different functions and have varying corporate structures and sizes.[5] Their names do not include "financing vehicles" but often "construction investment" or "developmental investment" to highlight their role in investment rather than financing.[6] Officially, LGFVs were not defined until 2010, when the State Council published a notice about their risks:[5][7]

In practice, LGFVs require further government funding to repay its loans used on projects, which can take form as subsidies[6]or a line of credit.[8] They are able to borrow or raise large sums due to an implicit guarantee from the government against

Mechanism

LGFVs allow local governments to bypass legal restrictions that prohibit borrowing from banks,[9] and before 2015, issuing bonds.[6][10] The local government typically transfers a parcel of land to an LGFV, which allows the vehicle to borrow from banks or shadow banks, or to issue bonds in the securities market, using the land as collateral.[9] Banks regard loans to LGFVs to carry little risk because they believed that the vehicles would be supported by the state and its credit.[8]

The LGFV then provides funds for urban development projects. The developments typically increase the value of the surrounding land, which is owned by the local government. The higher land value then boosts local government revenue, through the local government's leasing of land by selling land use rights.[4]

History

Background

Since 1980, two years after China's economic reforms began in 1978, local governments shared their tax revenue with the central government in a Chengbao scheme. The arrangement allowed them to retain any surplus revenue after paying the central government an agreed amount, which ensured that local governments were incentivized to grow the local economy.[6] The tax-sharing system reduced the share of revenue that went to the central government and caused local governments to reduce taxes while increasing non-budgetary revenues, such as administrative fees, which did not need to be shared with the central government.[6]

A tax reform was introduced in 1994 to increase central revenue. Local tax revenue decreased to below 50% of China's total fiscal revenue from around 80%.[12] However, local governments were still responsible for more than 70% of regular expenditure.[12]

References

M. Yu. Kozhevnikov. Debt of Local Governments of China: Assessment Issues and Analysis Studies on Russian Economic Development, Pleiades Publishing, 2019^
Donald C. Clarke. The Law of China's Local Government Debt Crisis: Local Government Financing Vehicles and Their Bonds GWU Law School Public Law Research Paper, 2016-06-05, retrieved 2021-02-16^
Meina Cai, Jianyong Fan, Chunhui Ye, Qi Zhang. Government debt, land financing and distributive justice in China

Property tax proposal

In October 2021, The Wall Street Journal reported that the central government was planning to implement a nationwide property tax, to tackle real estate speculation and provide local governments with more stable revenue. However, the report detailed widespread resistance within the Chinese Communist Party, leading to various alternative proposals including state-owned housing. On 23 October, a five-year trial of the proposed tax was announced for select regions with particularly hot property markets, such as Shenzhen, Hangzhou and Hainan.

Although the property tax could reduce government reliance on land value through LGFVs, it has been estimated that a property tax could reduce land value by 50%, and that this risk to property owners was contributing to lower land sales.[27] In April 2023, the government completed a unified real estate registration system, which could enable the property tax to be implemented.[28]

Other work

In July 2023 China's state-owned banks began providing loans to LGFVs with a generous repayment period of 25 years, in an attempt to relieve some of the pressure.[29]

Peking University academic Yang Yao attributed the problem of unsustainable local government debt to various political economy issues, including the moral hazard of local governments not bearing the risk from their borrowing, and frequent rotation of officials. To improve the situation, Yao proposed 4 billion yuan of central government support, along with a variety of debt restructuring options, such as integrating the budgets of all state-owned enterprises with their corresponding governments.[30]

In 2023, a study by David Daokui Li concluded that local government debt was 50% higher than previously estimated by the IMF and World Bank.[31] The study found that the majority of debts were for infrastructure, and the level of debt was unsustainable without central government support.

By 2024, economists estimated that the indebtedness attributable to LGFVs had reached between US$7 trillion and US$11 trillion, the Wall Street Journal reported. Of that debt, US$800 billion was estimated to be at high risk of default.[32] Many projects funded by LGFVs were found to be ill-conceived and poorly planned. The IMF estimated that LGFV debt in China will have grown by 60% in 2028 compared to 2022 levels.[33]

Local government financing vehicle

Definition

Mechanism

History

Background

References

Origins

2008 financial crisis

De-risking (2010–2020)

2020 property crisis

Property tax proposal

Other work

Other work