China has a problem, and if it can’t solve it, prepare for the next global crisis. Let’s take a look at China’s problem. As you know, China has announced a massive 10 trillion yuan ($1.4 trillion) debt package. This is China’s way of bailing out its local governments from a mountain of debt that is spiraling out of control. Some people probably see this as a smart move by the Chinese government to prevent a financial crisis and revive its economy. But they may be wrong.
Why, you may ask? Let’s start from the beginning. In 1994, China overhauled its tax system. This changed the way tax revenues were divided between the central government and local governments, such as municipalities, prefectures, counties, and villages. While the reform gave the central government a much larger share of the tax pie, local governments had to struggle. Over time, this change meant that local governments’ share of tax revenues fell below 40%, even as their national spending obligations exceeded 60%. They began to turn heavily to land revenue to fill the gap.
Fortunately, China’s land system made this easy. While all land technically belongs to the state, local governments have the authority to manage and lease the land in their regions. So they began leasing “land use rights” to companies, developers, and individuals. But this strategy hit a wall when the 2008 global financial crisis hit. The economy was slowing, and the central government needed a way to stimulate growth without taking on all the debt itself. So it came up with a solution – Local Government Finance Vehicles (LGFVs).
These LGFVs were separate from local governments but closely linked to them. Since local governments were not allowed to issue bonds or raise money directly at the time, LGFVs did this on their behalf. They often borrowed money from banks to finance major infrastructure projects like roads, bridges, and railways—anything that could boost their local regional economies.
Banks were more than willing to lend to LGFVs for two main reasons. First, LGFVs had a lot of land that they bought cheaply from local governments and sold to developers at a profit. This land pile also boosted their balance sheets and made them appear financially stable to banks. Second, the loans were essentially backed by local governments, so if an LGFV was in trouble, the government was expected to step in. But there was a problem. LGFVs were not regulated in the same way as local governments. They were like shadow appendages, borrowing heavily and buying up land. Unlike local governments, they could run deficits. So naturally, local governments, hoping for higher land revenues, forced them to borrow more for infrastructure.
Over time, this borrowing spiraled out of control. Moreover, since LGFVs were not required to report their finances like local governments, much of this debt was hidden or “off the books.” In 2011, local government debt reached 10.7 trillion yuan ($1.7 trillion), nearly a quarter of China’s GDP at the time. So yes, if LGFVs defaulted on their debts, the banks that lent them would face huge losses. That could trigger a financial crisis across China.
This probably scared the government too. So in 2015, they stepped in and changed the rules, allowing local governments to borrow directly. They could now issue bonds and borrow from banks, pension funds, insurance companies, and even regular investors.
The goal? Use these funds to pay off some of the LGFVs’ hidden debts. That’s exactly what China is doing now. It announced another major debt swap package worth 10 trillion yuan. This means that local governments will take on new debt to pay off old LGFV debt through a debt swap program. It will convert most of the risky LGFV debt into safer, government-backed municipal bonds. In other words, more LGFV hidden debt will come out of the shadows and onto the books, making it easier to track, manage and control.
The plan is to reduce hidden debt as much as possible in the coming years. But here’s the thing. This isn’t the first time China has tried this. Between 2015 and 2022, China issued more than 10 trillion yuan of similar “swap bonds” to convert hidden debt into official debt. While there is no official data on the exact size of the current hidden debt, research by the National School of Development at Peking University found that LGFV debt had risen to 54.6 trillion yuan ($7.8 trillion) by the end of 2022. That was up from 32.6 trillion yuan in 2018. This is a massive two-thirds increase despite the central government’s efforts to rein it in.
This time may not be any different. Because while swapping and revealing the debt may seem like a solution, it doesn’t address the fundamental problem: How will this debt actually be repaid once it’s on the books? Think about it. Local governments have already exhausted their budgets after spending heavily on COVID lockdowns to maintain China’s zero COVID policy. Now, they need more revenue to avoid paying these debts. But that’s not easy, because their main source of income, land leases, have dried up. After the Evergrande crisis rocked the real estate market, property sales and land revenues have slowed significantly. While some of this debt is now officially on the books, there’s still not enough money coming in to pay it off.
The real problem? The funds needed to repay this debt are closely tied to real estate. So swapping the debt may not actually work. So what will it do? Perhaps it’s time for China to conduct a full audit of its local governments and fully understand how much hidden debt they’ve taken on. Then it could rebalance the revenue sharing between the central and local governments and give local governments a bigger slice of the pie to help them avoid a financial crisis. Or maybe they need to explore new forms of taxation to raise local revenue.
We don’t know for sure. All we know is that China needs to get to the root of the problem rather than delaying it by allowing local governments to borrow new money to pay off existing debt. Will they be able to do that? Perhaps the next global crash could be the source of this.
