Cracking the Code: Navigating the Debt Crisis of Chinese Local Governments and LGFVs in China

Local governments have played a pivotal role in China’s rapid economic growth, yet they have simultaneously faced unique financial pressures. The demands on local governments have increased significantly due to urbanisation and migration from rural areas, necessitating expanded services and infrastructure. Central government policies aimed at stimulating the economy after the 2008 financial crisis further intensified these demands by mandating extensive infrastructure projects, often on only a partially funded basis. In addition, some initiatives driven by local officials' career ambitions have had adverse effects on local communities. However, state budgetary constraints have severely limited the financial flexibility of local governments. To navigate these restrictions, local governments turned to off-balance-sheet local government financing vehicles (LGFVs) to fund infrastructure projects, often of a long-term nature and with low returns, and deliver essential services.

In recent years, many local governments and LGFVs have encountered significant financial challenges. Local governments rely heavily on real estate investments, which have been negatively impacted by stricter financial regulations and a downturn in the property market. There has also been economic strain since the Covid-19 pandemic. Although LGFVs are corporate entities subject to standard insolvency procedures, their debts are implicitly guaranteed by local governments. Consequently, the insolvency of LGFVs could threaten the financial stability of local governments. So far, the response to these financial difficulties has been largely ad hoc, with no reported LGFV defaults, but potential risks loom.

This paper begins with a brief introduction, followed by a comparative analysis of the Chinese domestic framework for managing financial distress in local governments (Section 2) and LGFVs (Section 3) against alternative approaches. Some of these alternatives have been identified in an INSOL International study on financially distressed local entities. The aim of this paper is to explore the benefits and challenges of implementing more structured, multifaceted, and innovative approaches to managing financial distress in these entities within China.