Chinese Local Government Indebtedness

Visiting Scholar Xun Wu, a PhD student at Tsinghua University, is in residence at the CFP for the 2014-15 academic year to pursue his dissertation research on “Chinese Local Government Indebtedness: Systemic Risk and Financial Cost.”

Xun notes that total debt of Chinese local governments is around RMB 19 trillion, accounting for approximately 40% of China’s GDP. That debt has been growing at the rapid rate of 10-15% in recent years.

The debt stems from the Chinese economic growth model of “government plus finance.” The Chinese government strictly controls the financial system, and most funding flows into the government-directed investments such as infrastructure projects. Those projects tend to be low return and high risk. However, the implicit guarantee of Chinese central government enables local government to continue to borrow for unprofitable investments.

The risk of local government debt is transferred to the state-controlled banking system, and ultimately, if a crisis ensued, it would be borne by the entire economy. That arguably makes local government indebtedness the most important source of systemic risk for China. If not properly managed, it could lead to a combined banking, sovereign, and economic crisis.

To understand the forces driving the rise of local government indebtedness and the policies that could address the problem, Xun aims to answer three major questions with his research:

1. How is it that Chinese local governments can continue to borrow from the financial system despite increasingly high leverage ratios?

2. What are the limits to local government credit capacity and what could cause a sudden stop in lending?

3. How can the costs and risks of Chinese local government indebtedness, both to the financial system and China’s economy as a whole, be quantified?