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China’s ‘Circular 15’ Addresses Local Governments’ Hidden Debts

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China’s ‘Circular 15’ Addresses Local Governments’ Hidden Debts

Local government financing vehicle bonds are coming under increasing scrutiny as a source of financial risk.

China’s ‘Circular 15’ Addresses Local Governments’ Hidden Debts
Credit: Depositphotos

Chinese regulators continue to address the country’s ongoing problems with local government debts. In a new notice, the China Banking and Insurance Regulatory Commission (CBIRC) and Ministry of Finance recently emphasized that banking and insurance institutions must not increase the hidden debts of local governments. This means that local government investment companies will be required to reduce existing debts, making them unable to easily find liquidity.

The “Guiding Opinions for Banking and Insurance Institutions to Further Do a Good Job in Preventing and Resolving Hidden Debt Risks of Local Governments” (Circular 15) stated that financial institutions may not add new hidden debts to local governments. Circular 15 also states that banking and insurance institutions must understand local government financing institutions’ debt and medium and long-term expenditures before providing finance. The CBIRC also issued a separate document providing guidance for local government debt risk mitigation. Banking and insurance companies will not be allowed to provide working capital loans or financing for special bond issuance.

Local government investment companies were deeply disappointed by the new rule, since banks play a key role in providing loans as a main source of indirect financing. In particular, the policy is expected to negatively impact those local government investment companies with hidden debts, forcing such firms  to resolve their debts. In order to combat rising debt, Circular 15 also requires local banking and insurance regulators create emergency risk response plans to resolve hidden debts.

Some local governments are already closely monitoring debt risks. Select provinces have required that standardized products, including detailed repayment plans, above the municipal level be monitored monthly.

As of May 2021, local government debt across the country stood at 27 trillion RMB ($4.16 trillion) Some of the debt has been issued in bonds. New local government bond issuances are expected to reach 4.62 trillion RMB by the end of this year. Already, local government bond issuance rose in the first half of 2021. The provinces with the largest urban investment bond issuance in 2021 include Jiangsu, Zhejiang, Shandong, Sichuan, and Hunan.

One of the major issues with local government debt is that local governments have been taking on new debt in order to repay old debt, rather than investing in new infrastructure projects. This is because a long period of time is required before infrastructure projects, such as shanty town renovations or park constructions, can become profitable. Refinancing bonds accounted for about 56 percent of the newly issued local government bonds, up from 20 percent in the past two years. Bonds used for refinancing have crowded out bonds used for infrastructure projects to some extent. Already, infrastructure investment declined 3.6 percent year-on-year in May. This decline, as well as lower project yields, will result in lower infrastructure growth for 2021.

Regulators are clearly poised to act on risks associated with indebted firms. As a result, other regulations have been issued to combat rising debt. For example, on April 13, the State Council issued the “Opinions on Further Deepening the Reform of the Budget Management System” (Circular 5), which requires further regulation of local government financing vehicles. The document encourages bankruptcy among highly indebted local government investment companies. As a result, local government investment companies experiencing financial fragility are likely to face a cutoff in financing availability.

Furthermore, the Ministry of Finance issued the “Local Government Special Bond Project Fund Performance Management Measures” in July to further regulate the use of funds and prevent debt risks. Local governments’ special purpose bonds are required to be linked to performance targets for the related bond projects. Project supervisors must carry out a performance evaluation before obtaining authorization to issue the special purpose bonds.

The aim of the new regulations is to improve the quality of local government infrastructure projects and to improve capital efficiency. This is because the government audit work report found that many special bonds have not been used for their stated purposes. The government has also indicated that it would not bail out local governments, which has led to nervousness among those invested in local government financing vehicle bonds. Experts have underscored that the aim is not to end local government investment companies but rather to improve the health of the industry.