Title: Market Debates Scale & Method of Local Debt Swaps

The market widely anticipates that the deliberation of a package of fiscal incremental policies, including specific arrangements for debt reduction, will be a focus of attention. On October 25th, it was stated by relevant individuals attending the Development Committee meeting held by the World Bank in Washington, D.C., that the recent introduction of a package of incremental policies by the Chinese government has garnered widespread international attention. In addition to monetary policy, China will also increase the counter-cyclical adjustment of fiscal policy. A series of strong measures will be implemented to resolve local government debt, stabilize the real estate market, increase income for key groups, ensure people's livelihoods, and promote equipment updates and the exchange of old consumer goods for new ones. This will leverage government spending to stimulate social investment and consumption, thereby increasing effective demand. China is confident in achieving an economic growth target of around 5% for the year and continuing to inject momentum into global economic growth.

Some important arrangements of this series of strong fiscal policy measures are still pending review and approval by the Standing Committee of the National People's Congress. Discussions on fiscal incremental policies have not ceased.

Reporters from 21st Century Economic Report have found that, particularly around the measure with the greatest debt reduction effort in recent years, there are different voices in the market. Some suggest issuing special treasury bonds to replace local implicit debt, while others believe that it is more likely to continue issuing local government bonds to replace implicit debt. There are also different speculations about the specific scale of the "one-time large-scale" debt swap.

Advertisement

How to replace local implicit debt?

On October 12th, the Minister of Finance stated at a press conference held by the State Council Information Office that, in order to alleviate the debt reduction pressure on local governments, in addition to continuing to arrange a certain scale of bonds in the annual increase of special debt limits to support the resolution of existing government investment project debt, it is proposed to increase the debt limit on a one-time large scale to replace the existing implicit debt of local governments. This will intensify efforts to support local debt risk resolution, with detailed explanations to be provided to the public after the relevant policies have gone through the legal procedures. It needs to be emphasized that this policy, which is about to be implemented, is the strongest debt reduction support measure introduced in recent years. It is undoubtedly a timely policy rain that will greatly reduce local debt reduction pressure, freeing up more resources for economic development, boosting the confidence of business entities, and consolidating the "three guarantees" at the grassroots level.

Since the release of this blockbuster news, discussions around the "one-time large-scale debt swap" have not ceased. It should be pointed out that after the debt inventory confirmation in 2018, the national fiscal system locked in a considerable scale of "local existing implicit debt" formed by localities due to public welfare projects beyond statutory debt. Various regions have formulated debt reduction plans ranging from 5 to 10 years. The latest data released at the press conference by Lan Fu'an shows that by the end of 2023, the balance of implicit debt included in the government debt information platform nationwide has been reduced by 50% compared to the 2018 inventory, and the debt risk is controllable.

In this year's package of fiscal incremental policies, the priority of debt reduction has been raised to a high level, and an important reason is the shrinkage of land transfer income. Data from the Ministry of Finance shows that in 2021, China's land transfer income was about 8.7 trillion yuan, a historical high; however, in the following years, land transfer income has continued to shrink, with about 6.7 trillion yuan in 2022, reduced to 5.8 trillion yuan in 2023, and only 2.3 trillion yuan achieved from January to September 2024 (a year-on-year decrease of 24.6%).

Although land transfer income belongs to the "government fund budget," this budget is "expenditure-based on revenue" according to the Budget Law and is independent of the "general public budget" (mainly used for ensuring and improving people's livelihoods, promoting economic and social development, and maintaining the operation of state institutions and other revenue and expenditure budgets). However, land transfer income is an important source of funds for local investment and construction, as well as an important source of debt repayment funds for local special bonds and related urban investment bonds. The shrinkage of land transfer income will force some localities to use general public budget revenue to repay related debts, exacerbating the contradiction between fiscal revenue and expenditure.

A report on the budget execution in the first half of 2024 by an eastern economic powerhouse province stated that the significant decline in land transfer income has increased the pressure on local fiscal operations. In the first half of the year, the government fund budget revenue, including the province's state-owned land use rights transfer income, only achieved 25% of the budget, making it extremely difficult to achieve the annual budget target. Land transfer income and real estate-related taxes are important supports for the operation of city and county finances, and many city and county general public budget revenues are mainly used for the "three guarantees." Debt reduction and development mainly rely on land, and various expenditures have a high dependency on land.In this round of debt restructuring, there are differing opinions in the market on whether to adhere to the principle of "whoever's child, whoever takes care of it," and whether the central government should take on debt to replace local implicit debt.

Xingye Research's macro team stated that the new round of debt resolution may span from the end of 2024 to 2027, and the method of replacement could involve a combination of issuing national bonds or special national bonds, and using new bond quotas or existing quotas to issue local bonds. Given the emphasis on the central finance's significant debt capacity at the press conference, there may be a breakthrough in the debt resolution method this time, potentially replacing some local implicit debt with national bonds, which would make the reduction in financing costs more pronounced.

Chief Economist of CITIC Securities, Ming Ming, told 21st Century Economic Report reporters that, based on historical experience, it is unlikely that local implicit debt will be replaced through the issuance of special national bonds; it is more probable that it will continue to be done through local government bonds. Conducting a large-scale debt swap can significantly alleviate the fiscal and debt repayment pressures on local governments, freeing up more space and energy for them to focus on economic construction and development tasks.

A professor from Central University of Finance and Economics told 21st Century Economic Report reporters that from January to September, the net financing scale of urban investment bonds nationwide was negative, with some urban investment companies facing difficulties in borrowing new to repay old. Currently, it is a very appropriate policy measure to increase debt limits, replace local implicit debt with local government bonds, and resolve debt risks by extending terms and reducing debt costs. Some people expect to use national bonds to replace local implicit debt, which is equivalent to the central government repaying the existing debt borrowed by localities, leading to moral hazard and adverse selection, which is not conducive to regulating local borrowing behavior. It is important to adhere to "whoever's child, whoever takes care of it," with the central government not underwriting local debt, but flexibility can be provided in specific measures. For example, part of the 1 trillion yuan in ultra-long-term special national bonds issued this year was allocated for local use, with localities bearing a certain proportion of the repayment responsibility.

How large is the scale of bond replacement?

In addition to how to replace local implicit debt, the market is also eagerly anticipating the scale of this "large-scale" debt resolution.

The Budget Law, revised and passed on January 1, 2015, was officially implemented, lifting the restriction on local governments' right to borrow. From 2015 to 2019, during this round of large-scale local debt replacement, a total of 12.2 trillion yuan in local replacement bonds were issued from 2015 to 2018, with a small amount of replacement bonds still being issued in 2019.

In July 2023, the Central Political Bureau meeting called for effective prevention and resolution of local debt risks, and the development and implementation of a comprehensive debt resolution plan. In 2023, the Ministry of Finance arranged for more than 2.2 trillion yuan in local government bond quotas to support localities, especially high-risk areas, in resolving existing debt risks and clearing arrears to enterprises. Since 2024, the Ministry of Finance has arranged for 1.2 trillion yuan in debt limits to support localities in resolving existing implicit debt and digesting government arrears to enterprises.

China's government debt is managed with limits, and the balance of government debt must be within the limits approved by the National People's Congress. As of the end of 2023, China's statutory government debt balance was 70.77 trillion yuan, of which the national debt balance was 30.03 trillion yuan, and the local government statutory debt balance was 40.74 trillion yuan. At the end of 2023, the government debt balance was controlled within the limits approved by the National People's Congress, with the national debt limit at 30.86 trillion yuan and the local government debt limit at 42.17 trillion yuan.

From the above, it can be calculated that as of the end of 2023, the difference between the government debt balance and the limit is only 2.26 trillion yuan, with 0.83 trillion yuan of space remaining for national bonds and 1.43 trillion yuan of space remaining for local government bonds. Even if the existing 2.26 trillion yuan of debt space is fully utilized, this effort is clearly not enough to be considered the strongest in recent years, so it is necessary for the Standing Committee of the National People's Congress to review and approve an increase in the government debt limit.There are currently various discussions in the market. Some analyses suggest that the one-time debt replacement scale is expected to exceed 4 trillion yuan, while others believe it might be around 6 trillion yuan. There are also voices advocating for an increase to 10 trillion yuan.

The macro team at Xingye Research stated that, considering this is the most significant measure to support debt resolution in recent years, the scale is expected to be over 4 trillion yuan. By the end of 2023, the scale of local government financing vehicles' (LGFVs) interest-bearing debt was approximately 48 trillion yuan, with an average financing cost of 5.28%. Considering that replacement bonds are mainly medium to long-term, the current average yield of the 10-year government bond and the 10-year local government bond is 2.21%. If 4 trillion to 6 trillion yuan of local hidden debt is replaced with a combination of government and local bonds, interest expenses can be saved by 124 billion to 186 billion yuan.

Mingming indicated that from 2015 to 2018, a large-scale issuance of local government replacement bonds replaced a total of about 12.5 trillion yuan of local existing debt. Based on the balance of hidden debt and the 50% reduction mentioned by the Ministry of Finance since 2018, along with a series of debt resolution documents in recent years, it is expected that the debt replacement work will be gradually completed within the next three years, with the scale likely to be within 10 trillion yuan. For special refinancing bonds at the local level, there is still about 1.4 trillion yuan of quota available before the limit is increased; for special purpose local bonds, special bonds for debt replacement and resolution will continue to be issued in the future. If 2 trillion yuan is arranged annually, the total scale would be around 6 trillion yuan. The allocation among localities will take into account the fiscal revenue and expenditure as well as the debt ratios of each area for a coordinated arrangement.

Relevant individuals have stated that the scale of local hidden debt replacement can be referenced by the scale of LGFV bonds. In recent years, the maturity scale of LGFV bonds has been around 2 trillion yuan. If considering the continuous replacement of local hidden debt over the next three years, it is expected that the scale of this debt replacement will be around 6 to 7 trillion yuan.