China has begun to issue additional bonds to help address a looming fiscal cliff in the winter months, signalling a greater tolerance for deficit financing as a new team of technocrats takes charge.

The unusual mid-year budget adjustment sends a clear fiscal policy signal. Enodo Economics projects a higher budget deficit target next year, following an upward revision of this year’s target to 3.8% of GDP.

In part, the issuing of Rmb1trn in special sovereign bonds in Q4 reflects the sluggish state of the economy early this year, which prompted central authorities to order the 2023 special bond quotas be used up before the end of the third quarter. That left a longer gap in financing for the winter, before new financing can officially be approved next March.

More broadly, the measures reveal Xi Jinping’s new economic team's determination to address debt issues that weighed heavily on the economy during his second term. The recent Central Financial Work Conference, a key twice-a-decade financial policy meeting, vowed to tackle financial risks associated with local government borrowing and set up a “system for resolving local debt risks and managing local government debt”.

The consolidated power of China’s new economic tsar paves the way for more coordinated policies to tackle debt risks from local governments and the property sector.

He Lifeng, who recently took over top economic and financial stewardship roles from his predecessor, Liu He, has been confirmed as the office director of the Central Financial Commission as well as Party secretary of the Central Financial Work Commission, the two most powerful financial policy-making bodies in China.

His appointment, following previous announcements of the new chief of China’s finance ministry, central bank and banking regulator, signals a complete transition to Xi Jinping’s new economic team and the top leader’s full trust in him.

Enodo expects a lower probability of local debt defaults; but on the negative side, strengthened Party oversight in the financial sector, as reiterated at the meeting, signals more state-led capital distribution. 

“Special” treasury bonds in Q4 for more flexible use

On Oct 24, China’s National People’s Congress approved a proposal to issue an additional Rmb1trn in sovereign bonds, to be managed under the category of “special treasury bonds”. Funds raised from the new sovereign bonds will “support the rebuilding of disaster-hit areas in the country and improve urban drainage prevention infrastructure to boost China's ability to withstand natural disasters”, according to the official readout. 

Enodo’s assessment is that if the official issuance were purely “special treasury bonds”, the funding would have to be used strictly for this purpose. However, in this case, the bonds are actually regular treasury bonds that are being managed as “special treasury bonds”.

Enodo's investigation revealed that the additional bond acts as emergency funding, enjoying both the flexible issuance timing of special bonds and the flexible use of regular bonds. This indirectly helps resolve local debt problems and fund new projects through central financial subsidies.

Additional treasury bonds should help alleviate local fiscal pressures in Q4 and support related public investment, given the context of sluggish local government revenue and indebted local financing platforms.

Frontloaded special purpose bonds to be used in Q1

Local governments had been told to complete the issuance of their 2023 quota of Rmb3.8trn in special purpose bonds (SPBs) by September to fund infrastructure projects, leaving a longer fiscal cliff than usual. Over the past five years, except in 2021, the authorities have front-loaded some of the following year's quota so they could cover the first quarter of local government spending. But this year the fiscal cliff started in Q4.

The legislature in October also passed a bill to allow local governments to frontload part of their 2024 SPB quota, although it has not disclosed the size of the quotas involved.

We expect that the frontloaded SPB debt issued in 2023 may be limited in scale, thanks to the large-scale new special treasury bond issuance plans for the rest of the year. Instead, it is likely to be concentrated in Q1 2024.

The stimulus package of the new special treasury bonds and the front-loaded 2024 SPBs will ensure continuity of state-backed investment from now until the new budget is officially approved at annual legislative meetings in March.

This allows local governments to keep up the pace of fixed asset investment, which grew 8.64% on-year in the first nine months of this year .

Refinancing to pay down local government financing vehicle debt

China is also taking steps to prevent sizable defaults of local government financing vehicle (LGFV) debt by issuing special refinancing bonds. 

During Beijing's previous local government debt clean-up in 2013-2016 the authorities carved out the debt they recognised as an obligation of local governments and swapped it for municipal bonds. LGFV bond debt worth about 9% of GDP at the time was left out, but market participants have continued to view these bonds as having an implicit government guarantee.

In October, local governments in China sold nearly Rmb1trn in special refinancing bonds to be used to repay hidden debts. The special refinancing bonds can only be used for repayment of LGFVs turning the implicit guarantee into explicit local government debt. 

Enodo Economics understands that this scheme allows localities to swap those off-balance sheet LGFV debts for special local bonds that carry lower interest rates.

According to market reports, this scheme focuses on "high-risk provinces" where mounting hidden debts have threatened localities’ ability to raise new funding. Since June this year, localities across China have submitted pilot plans for resolving hidden debt risks. Their plans include detailed data on local finance and economy, related assets, and land reserves, as well as budget expenditure reduction plans, arrears resolution plans and local debt resolution plans.

Financial authorities have identified a dozen provinces and cities as “high-risk” areas where more support will be provided — including the northern port city, Tianjin, and the inland port, Chongqing, both host to a number of infamous white elephant developments. We expect that these twelve will account for the main issuance share. 

Reuters reports that the State Council has restricted the ability of those debt-laden regions to take on new debts and the localities will only be allowed to take on specified projects approved by the central government. Rather, the new issuances will alleviate a debt overhang that was threatening to cause serious economic damage.

The quota for refinancing debt should still lie within the scope of local government debt limits and be issued in line with the principle of controlling the total size of local debt. 

Our calculations suggest that the maximum amount for refinancing debt issuance is only Rmb2.6trn for now, of which Rmb1trn has already been issued.

In heavily indebted regions, these new issuances of local debt are regarded as “borrowing new debt to repay old debt”, curtailing any fresh spending.

In short, China’s low debt-to-asset efficiency that comes from years of wasteful investment has finally come to haunt it. We estimate likely total credit losses in 2023 to be between 37% and 42% of China’s GDP. 

Conclusion

If the Party-state fails to work out a sustainable resolution to China's local government overborrowing dilemma or diversify local governments' fiscal revenue which traditionally relies on land sales, the task of placing the economy on sound footing will become even more challenging.

In Enodo’s view, the limited quota of refinancing debt and special treasury bonds is just a patch for worsening debt risks. It can only tackle short-term liquidity shortages, leaving economic policymakers still struggling to come up with a sustainable plan to manage debt risk and support the economy.

Clearly, the 2013-2016 round of local debt work-out has not resolved the issue. China’s policy of kicking the can of debt risk down the road without fundamentally altering its statist approach to investment and capital allocation has run out of road. 

Xi Jinping and his new economic tsar He Lifeng have the political power to push through fundamental changes. They are certainly not going to use their policy-setting power in an overwhelmingly free-markets way, but their success will depend on how the market perceives their solutions.