China’s local government debt expansion: what will happen next?

China’s recent public debt pile-up since the start of the pandemic has caused increasing concern for the market. A notable aspect of this surge is the rapid accumulation of debts in the on-balance sheet accounts of local governments, particularly due to the decreased land auction sales resulting from a housing market downturn.Although the off-balance sheet debt of local government financial vehicles (LGFVs) has been also rising, it has grown at a slower pace due to more stringent regulation. This is a positive development for managing local government debt risk, but shifting the objective to limit the on-balance sheet account will be a more challenging task. Different from the LGFVs that can be contained via regulatory measures, the property market reflects China’s structural challenges. China’s housing market is not expected to return to its golden growth era in the foreseeable future, even as it stablizes.Further analysis of the debt data reveals that the increase in debt is widespread across Chinese provinces, regardless of their level of development. Both more developed and less developed regions have exhibited similar patterns of debt growth. This suggests that the public debt challenge will be a systematic issue for China. However, the situation will still pose a greater problem for less developed regions, as their interest burden is relatively worse compared to their growth rate.Against the backdrop, we expect  the Chinese government to adopt three possible approaches to tackle with the challenge.First, the Chinese central government is expected to take on a larger debt burden and increase transfers to local governments, supported by its strong credit rating and the issuance of special treasury bonds.Second, the PBoC and other state-dominated financial institutions will be likely to increase their holdings of government bonds to inject liquidity and keep interest rates low, strengthening the sustainability of public debt and potentially leading to de facto quantitative easing (QE).Third, the Chinese government will implement fiscal reforms to review public spending rigorously, enhance efficiency, and explore options for restructuring existing debt obligations, potentially collaborating with private entities to alleviate immediate financial strain.