Debt swaps to rejuvenate local governments

On Nov 8, the Standing Committee of the National People's Congress approved an increase of 6 trillion yuan ($828 billion) in the local government special bond ceiling to replace outstanding hidden debt — or liabilities of local governments that are not officially recorded.

The increase is designated for swapping outstanding implicit debts, providing local governments with more room to better develop the economy and ensure people's livelihoods.

Local governments will be eligible for local government special bonds worth another 4 trillion yuan over the coming five years starting this year to finance debt swaps, or 800 billion yuan each year, said Minister of Finance Lan Fo'an.

The new measures will add a combined 10 trillion yuan to China's debt relief resources. Meanwhile, the 2 trillion yuan of hidden debts resulting from housing improvement projects in rundown areas due by 2029 and beyond will be paid in accordance with the original contracts.

As a result, the amount of hidden debt that China's local governments need to deal with is expected to drop from 14.3 trillion yuan to 2.3 trillion yuan, significantly alleviating debt resolution pressure.

In summary, 10 trillion yuan in direct funding plus 2 trillion yuan in naturally maturing debts will resolve 12 trillion yuan of implicit debts within five years. The significance of debt swaps lies not only in its "largest scale in recent years", but also in the substantial optimization of fiscal debt resolution strategies and its incentive effect on local government behavior.

First, the direct funding scale of 10 trillion yuan and the move to resolve 12 trillion yuan of debt mark the largest such efforts in history, demonstrating the central government's resolve to prevent and mitigate risks, standardize debt management, and promote economic growth, thereby boosting confidence and expectations.

Second, this reflects a significant optimization in debt resolution strategy, shifting from a focus on risk prevention to a better balance between stabilizing growth and managing risks.

Third, it reduces the fiscal pressure of current debt resolution and interest payments for local governments, freeing up more fiscal resources and efforts to develop the economy, provide public services, better implement tax and fee reductions, and improve the business environment, thereby enhancing the incentive effects on local government behavior.

It is reasonable to believe that, under this comprehensive set of measures, Chinese local governments will shift from an emergency response mode back to focusing on normal development, regaining their capacity and enthusiasm for economic growth.

This shift has been a critical factor in China's economic growth over the past 46 years of reform and opening-up. Of course, resolving debts and mitigating risks cannot be expected to be accomplished overnight, a long-term effort to establish systems is more crucial.

In the next phase, it is necessary to strengthen the monitoring of the standardized use of local debt resolution funds and address fundamental issues in debt risk prevention by stabilizing macro tax burdens, clarifying the boundaries between government and market, ensuring that the central government holds more fiscal powers and raising the proportion of central government expenditure accordingly, establishing capital and debt budgets, and promoting the transformation of local government financing vehicles.

The new round of large-scale debt swaps is significant in extending the local debt maturity cycle, reducing interest payment pressure, and steering local governments from debt resolution to economic development and public service provision, thereby transitioning from emergency response to focusing on economic development.

The importance of debt swaps lies also in the substantial optimization of fiscal policy measures for debt resolution and their incentive effects on local government behavior.

First, overall, the debt resolution effort has exceeded expectations and is the largest such in recent years. With 10 trillion yuan in direct funding plus 2 trillion yuan in naturally maturing debts, 12 trillion yuan of implicit debts will be resolved within five years. This reflects the central government's resolve to prevent and mitigate risks, standardize debt management, and promote economic growth, boosting confidence and expectations.

Lan disclosed that as of the end of 2023, China's implicit debt totaled 14.3 trillion yuan. Through an increase of 6 trillion yuan in the local government special bond ceiling and the annual allocation of 800 billion yuan from each year's newly issued local government special-purpose bonds for five consecutive years, combined with 2 trillion yuan of hidden debts resulting from housing improvement projects in rundown areas due by 2029 and beyond, the local governments' debt burden will drop to 2.3 trillion yuan by 2028, with annual average debt resolution dropping from 2.86 trillion yuan to 460 billion yuan, less than one-sixth of the original level, greatly easing debt resolution pressure.

Second, this reflects a major optimization in debt resolution strategy, transitioning from a primary focus on risk prevention to better balancing growth stabilization and risk prevention. This strategic shift signifies that in the next phase, stabilizing growth and development will be prioritized, enhancing the fiscal policy's support for high-quality development and countercyclical adjustments.

Currently, there is a broad consensus that fiscal policy can play a greater role during economic downturns, with monetary policy mainly serving a supporting role. Of course, the specific intensity needs to consider future uncertainties, external shocks, and fiscal sustainability.

Third, the debt swaps reduce the fiscal pressure on current local government debt resolution and interest payments, enabling local governments to allocate more fiscal resources and efforts to economic development and public services, such as increasing investments in education, healthcare, and environmental protection, thereby enhancing local economic endogenous growth and societal well-being. It is estimated that this could save approximately 600 billion yuan over five years. Moreover, debt swaps help local governments better implement tax and fee reductions, alleviating and even eliminating issues such as arbitrary fines and fees in some regions, thus improving the business environment.

Fourth, for LGFVs, debt swaps assist in shedding historical debt burdens and preparing for transformation and development. Through debt swaps, LGFVs can systematically divest implicit debts, clarify debt responsibilities, reduce debt burdens, and enhance financial stability. This allows them to focus more on developing operational businesses, improving operational efficiency and profitability, and laying a solid foundation for successful transformation.

In the long term, resolving local debt issues fundamentally requires addressing them from three dimensions: fiscal system reform, debt budget management, and transformation of LGFVs.

When it comes to fiscal system reform, it is necessary to stabilize macro tax burdens, clarify the boundaries between government and market, centralize fiscal powers and expenditure responsibilities, and consolidate institutions in depopulating districts and counties.

On the debt budget system front, we need to strengthen local government debt management by establishing debt and capital budgets. This includes comprehensive debt risk warning and prevention mechanisms, strict control over new debt, and ensuring debt levels align with economic development. The current debt management primarily focuses on balance and quota management, but lacks detailed debt budgets, covering size, structure, repayment schedules, and investment directions. It is necessary to establish detailed debt and capital budgets.

For LGFVs, we should accelerate the market-oriented transformation, steering them toward more market-oriented, professional, and standardized operations. By introducing social capital, optimizing governance structures, and improving operational efficiency, these companies can enhance their self-sustaining capabilities and market competitiveness, reducing reliance on local governments.

The writer is chief economist at Yuekai Securities.

The views do not necessarily reflect those of China Daily.