Local Debt Risk "Debt Reduction Strategy" from the Perspective of Local Governments

Source: Institute of Financial Technology, Tsinghua University

Editor's note: Risk prevention is the eternal theme of financial work. In recent years, the debt pressure of local governments in mainland China has risen, and the debt structure is characterized by "three more and three less": that is, there is less central debt, more local debt, less general debt, more special debt, less explicit debt, and more implicit debt. These structural characteristics will have a negative impact on fiscal policy, government debt management, and investment and financing mechanisms, so adjusting the appropriate debt structure has become an important issue. In order to prevent and resolve local government debt risks, the central government actively supports local governments to do a good job in resolving hidden debt risks, urges local governments to coordinate all kinds of funds, assets, resources and various supportive policies and measures, and pays close attention to cities and counties to increase their efforts, properly resolve existing hidden debts, optimize the term structure, reduce interest burdens, and gradually alleviate debt risks. How to better prevent and defuse local debt risks? What is the fundamental path to solve the problem of "turning debts"? How to further upgrade the optimal structure of debt + debt management? Clarifying the above problems is of long-term significance for cracking local debt risks and maintaining the long-term mechanism of local financial security. IMI Financial Insight publishes this article for readers.

Guided by the spirit of the Central Financial Work Conference, a long-term mechanism and management mechanism for resolving local debt risks should be established to maintain local financial security

Abstract:As one of the important factors affecting local economic development and financial security, local debt risk has been paying close attention to the mainland government in recent years. On the whole, although the debt level of the mainland government is not high in the international arena and the debt burden of the central government is relatively light, the scale of implicit debt in some localities is relatively large, and the problem of local debt risk still needs to be resolved. At the end of October 2023, the Central Financial Work Conference was held in Beijing, which repeatedly mentioned "preventing and resolving financial risks" and clearly proposed to establish a "long-term mechanism for preventing and resolving local debt risks, establishing a government debt management mechanism compatible with high-quality development, and optimizing the debt structure of central and local governments." Guided by the spirit of the Central Financial Work Conference, the research team of the Financial Security Research Center conducted research on how to better prevent and resolve local debt risks. Firstly, the research group defines the perspective and related concepts of the problem of "debt", and then gives suggestions on measures to resolve the risk of local debt, and finally concludes that "standardized development and market-oriented operation" is the fundamental way to solve the problem of "debt".

Since 1997, the National Financial Work Conference has been held every five years to chart the course for financial supervision and reform in the coming period. At the end of October 2023, the highest-level meeting in China's financial sector was upgraded from a "national" financial work conference to a "central" financial work conference. The difference between the two words highlights the importance of this meeting and fully reflects the centralized and unified leadership of the CPC Central Committee over financial work.

At this meeting, the term "prevention and resolution of financial risks" was mentioned many times, and the word "risk" appeared 19 times in the press release. Among them, "local debt risk" is still the key risk area that this conference focuses on. The meeting emphasized that "comprehensively strengthen financial supervision and effectively prevent and resolve financial risks", and clearly proposed to establish a "long-term mechanism for preventing and resolving local debt risks, establish a government debt management mechanism compatible with high-quality development, and optimize the debt structure of central and local governments." Compared with the 2017 "National Financial Work Conference" on the risk of local government debt: "Local party committees and governments at all levels should establish a correct view of political performance, strictly control the increase of local government debt, hold them accountable for life, and check their responsibilities." The expression of this meeting is relatively modest, which is a summary of the ideas and operational pilots of a package of local government debt resolution in the previous period, and is a principled and guiding requirement for local government debt resolution in the future. In fact, as early as 2010, the Central Economic Work Conference proposed to "strengthen the management of local government debt". At the end of 2014, the State Council issued the "Opinions on Strengthening the Management of Local Government Debt", which clarified the responsibilities of the government and enterprises, stipulating that government debts shall not be borrowed through enterprises, and corporate debts shall not be repaid by the government. In early 2015, the Budget Law was promulgated to further clarify that local governments and their subordinate departments are not allowed to borrow debt in any way, except for the issuance of local government bonds.

Although the central government has been repeatedly reiterating its orders, it remains concerned about the problem of local government debt. However, due to the constraints of deep-seated problems such as the economic development model, the problem of local government debt has not been effectively resolved, and has even gradually become an important hidden danger restricting economic development and affecting financial security in recent years. Due to the complexity of the local government debt problem, it includes not only some theoretical issues, but also many policy and practical issues such as fiscal and financial affairs. Guided by the spirit of the Central Financial Work Conference, this paper aims to sort out some basic concepts in the underlying logic, and provide reference suggestions for local governments to establish long-term debt risk resolution mechanisms and debt management mechanisms to maintain local financial security.

One

It is necessary to first clarify the perspective of "debt".

The relationship between the central and local governments is the basic relationship between vertical power and resource distribution in the state system. On specific issues of rights, responsibilities, and interests, such as human rights, administrative rights, and financial rights, they are constantly being reformed and optimized in accordance with the needs of the new situation.

The issue of "turning debts" into debts is a key issue in the game between the central and local governments, and it must be in a "tight balance" for a long time. This state includes top-down, where the central government communicates its demands to governments at all levels and transmits necessary and sufficient pressure; and bottom-up, when governments at all levels express their difficulties to higher-level governments and strive for support and assistance from policies, funds, and resources. The balance point of this state is that all parties to the debtor are responsible for their own duties, seeking to maximize the efficiency of the debt and minimize the risk.

As of the end of 2022, the balance of the central government's national debt was 25.6 trillion yuan, far lower than the balance of local government debt of 35.1 trillion yuan (excluding the debt of local financing vehicles). Therefore, the Central Financial Work Conference proposed to "optimize the debt structure of the central and local governments". This proposal means that in the future, the central government may adopt the method of strengthening the debt management of the central government and appropriately raising the debt level of the central government through transfer payments, so as to help solve the debt problem of weak local entities with weak economic development, high debt pressure, and no debts to issue and nowhere to move. However, "optimizing the debt structure of the central and local governments" is not a long-term mechanism for resolving local government debt, and local governments cannot expect the central government to implement a "one-size-fits-all" policy. That is, the local high-cost debt is completely replaced by the low-cost debt of the central government, and the local debt is converted into the central debt. This is because this move will break the necessary tight balance between the central and local governments on the debt issue, and will inevitably bring about greater problems in the fiscal, financial, and economic fields.

Therefore, on the premise of maintaining the "tight balance" between the central and local governments on the issue of debt resolution, this paper proposes the corresponding debt resolution management mechanism and long-term mechanism from the perspective of local governments. This perspective determines that local governments inevitably include important measures to Xi learn from the experience of the government at the same level and seek all-round support from the government at the higher level in the specific debt reduction strategy. In fact, if we look at the resolution of the overall debt from a broader perspective, the factors that can be discussed become extremely limited - strengthening one's own strength in the process of development, obtaining incremental funds, reducing the debt ratio, and maintaining financial security are the fundamental ways.

Two

What kind of debt is "debt"?

(1) Classification of debts related to local governments

There are at least four types of debts related to local governments:

1. The "statutory" debt of the local government

That is, local government special bonds and general bonds issued by local governments with themselves as the main body of financing are included in the fiscal budget. At present, the "statutory" debt of 35 trillion yuan of local governments is within a safe and controllable range.

2. "Hidden" debts of local governments

The "hidden" debts of local governments are based on statistics, and the hidden debts of the entities and the scale of the hidden debts of each entity shall prevail according to the statistics of the local government full-caliber debt monitoring platform of the Ministry of Finance. Since the "hidden debt" of local governments is not a legal concept, it is necessary to start from the essence of understanding this concept, namely:

(1) From the perspective of legal relationship, implicit debts may be debts of enterprises and other entities, but in essence, they are debts that need to be borne by local governments themselves, and the main body of debt repayment is still the government;

(2) from 2015 onwards, it is illegal to increase the hidden debt (at least in violation of the Budget Law of the People's Republic of China);

(3) Determination of new implicit debts: If a debt exceeds the scope of the enterprise's market-oriented debt repayment, and the excess part is paid by the local government in various forms, the excess part will be judged as an implicit debt;

(4) Local governments can have normal economic exchanges with enterprises, but they need to grasp two basic principles: one is to carry out the necessary government procurement procedures, and the other is that pricing must be market-oriented.

3. Debts of local "urban investment companies".

Local "urban investment companies" were born in a special historical period and played an important role in promoting local economic development, but they also accumulated a large amount of debts that are difficult to count and repay. At a minimum, the liabilities of local urban investment companies include:

(1) Credit facilities with banks;

(2) Standardized securities (standardized bonds) issued by the National Development and Reform Commission, the Stock Exchange and the National Association of Financial Institutional Investors;

(3) Non-standardized credit (trust companies, financial leasing companies, microcredit companies, etc.) with licensed loan non-bank financial institutions;

(4) Debts payable with financial institutions such as leasing and factoring under the support of real trade scenarios and in a compliant state;

(5) Debts payable with financial institutions such as leasing and factoring in a non-compliant state without the support of real trade scenarios and solely for the purpose of financing;

(6) Debts (advance receipts, payables, notes payable, etc.) formed with upstream and downstream enterprises in trade transactions;

(7) Securities issued on the local financial asset trading platform or debts formed by assuming the obligation to sell and repurchase with "receivables" as the underlying assets;

(8) Private lending with a third party.

4. Debts of local "state-owned enterprises".

In addition to urban investment companies, state-owned enterprises (SOEs) that are subordinate to the local state-owned assets system and the financial system will also borrow according to their own business needs, and the source of debt repayment is their own profits. Although the debt of local SOEs is not highly correlated with local governments, since local governments are de facto shareholders, if they are not properly disposed of, it will also adversely affect the local financing environment.

(2) What kind of debt is "turned into debt"?

The Politburo meeting held in July 2023 changed the caliber of "local government debt" to "local debt". In this central financial work conference, the expression of "local debt" was continued. This shows that in a broad sense, local governments need to implement unified management of statutory debts, implicit debts, urban investment debts and local state-owned enterprise debts, and include them in the scope of debt resolution. It is understood that the Ministry of Finance and other departments are also studying and formulating measures to combine local government implicit debts and statutory debts.

However, the "localized debt" in a narrow sense has gone through four rounds since 2015.

The first three rounds of "debt-turning" were mainly for the resolution of local government hidden debts.

Through the issuance of replacement bonds, the implementation of small-scale pilot projects for the resolution of hidden debts in established counties, and the issuance of special refinancing bonds for the expansion of the pilot projects for the resolution of hidden debts in established counties and the pilot projects without hidden debts in the whole region, the implicit debts of local governments have been made explicit, and the total amount of local debts has not changed. Through the gradual elimination of hidden debts, the distinction and isolation of government debt repayment and enterprise debt repayment responsibilities will be realized.

The current round of "debt" is mainly to resolve the debts due (not only hidden debts) in 12 key provinces, including the three eastern provinces, Tianjin, Inner Mongolia, Ningxia, Gansu, Qinghai, Chongqing, Guangxi, Guizhou, and Yunnan.

In fact, the above-mentioned regions are allowed to issue local government special refinancing bonds (a total of 1.5 trillion yuan) to raise the level of local debt, and use bond issuance funds to provide large-scale liquidity support to urban investment companies.

Through the above-mentioned four rounds of debt, two effects have been basically achieved:

First, the obvious alleviation of the debt of weak entities in urban investment;

Second, the government's debt repayment responsibility and the enterprise's debt repayment responsibility are relatively clear and differentiated.

The above results have laid the foundation for local governments to establish a long-term mechanism for debt resolution.

According to the index system involved, this paper uses a confirmatory factor analysis model to calculate the index weights based on the factor load. The weights calculated in this way can better reflect the correlation between the index and the dimension, and the evaluation results are more objective and effective.

(3) Local governments need to "jointly manage the four debts" and treat them differently

Due to limited resources, the emphasis on "four debts co-management" is not "four debts co-management".

On the one hand, local governments should establish a "single account" of the full set of debts of the government at their own level. On October 21, 2023, Pan Gongsheng, Governor of the People's Bank of China, pointed out in the State Council's report on financial work that local governments should "establish a statistical monitoring system and strengthen policy implementation". Local governments need to refine and coordinate various elements of various types of debts, such as principal, issuance interest rate, secondary market transaction interest rate, maturity time, difficulty of renewal, default impact and other factors, and use visual means to display them on computers, mobile terminals and other devices for managers at all levels to consult and reference, and use scientific and technological means to carry out overall management of all debts.

On the other hand, different debts need to be treated differently in order to allow limited resources to be invested in the debts that need to be resolved the most. The following principles should be grasped in the case of differential treatment:

1. "Statutory debt" - scale up the scale

The total amount and use of local government "statutory debt" is strictly regulated by the Ministry of Finance. Under the current dual needs of local governments to resolve hidden debts and economic development, incremental funds have become the "rigid demand" of any local government. The issuance of local government bonds is the lowest-cost and most compliant source of funds for local governments.

Therefore, local governments need to actively communicate with the Ministry of Finance to expand the scale of local government bond issuance and strictly implement the purpose of bond issuance (starting from 2021, the Audit Office of the People's Republic of China will pay special attention to the use of local special bonds).

2. "隐性债务"——存量:有序化解,增量:坚决遏制。

(1) Orderly resolution of existing "hidden debts"

Since the "hidden debt" is essentially the debt of the local government, the existing debt must be repaid. However, due to the limited resources of local governments, the repayment of implicit debts needs to be treated differently according to the actual situation. In 2018, the Ministry of Finance issued the "Instructions for Statistical Filling of Local Full-caliber Debt Inventory", which describes six ways of debt resolution, including: repayment of financial funds, repayment of government equity and rights and interests of operating state-owned assets, use of project carry-over funds, repayment of operating income, compliance into enterprise operating debts, repayment by borrowing new loans, extension and other means, and resolving by bankruptcy reorganization or liquidation. Local governments need to flexibly operate the six debt reduction methods mentioned by the Ministry of Finance according to the actual situation, so as to maximize the amount of debt funds for local governments and solve the problem of resolving hidden debts as soon as possible.

(2) Resolutely curb the growth of incremental "hidden debt".

As mentioned earlier, implicit debt is inherently illegal. The central government has repeatedly issued orders to resolutely curb the growth of incremental "hidden debts". Local governments need to resolutely draw a clear line between the rights, responsibilities and interests of the government and enterprises in the process of increasing debt, adhere to the necessary government procurement procedures in economic exchanges with enterprises, adhere to the principle of marketization, and put an end to the growth of hidden debts. For the central government, it is necessary to strengthen auditing, implement a zero-tolerance policy for hidden debt increments, and deal with them as soon as they are found.

and (3) the subsequent impact of the resolution of "hidden debts".

For local governments, the resolution of hidden debts can help local governments to travel lightly, finance funds and reduce financing costs by more compliant means, and for local urban investment companies, the resolution of hidden debts can reduce the debt ratio of urban investment companies and reduce financing costs. The removal of the Ministry of Finance's hidden debt list by the company itself can reduce various financing restrictions imposed by financial institutions on the company and further expand compliance financing channels. For financial institutions: in the short term, with the resolution of hidden debts, the debt ratio and financing costs of local governments and urban investment companies will be reduced, which is conducive to the improvement of the local financing environment, the improvement of the credit level of urban investment companies, and the strengthening of the safety boundary of standardized urban investment bonds Financial institutions need to optimize the risk control system and investment standards of standardized urban investment bonds to avoid the transmission path of default of standardized urban investment bonds from financial institutions to the real economy.

3. "Urban investment debt" - strengthen classified management, and keep and retain

Local governments need to strengthen the debt control of local urban investment companies, formulate an accountability mechanism for the debt management of urban investment companies, and require urban investment companies to establish transparent and accurate debt books, and timely report to higher levels of government on their funding needs for different debt cycles. All provinces should establish their own "631" debt reporting mechanism. That is, it is necessary to coordinate the maturity of debts 6 months in advance, to secure the source of funds 3 months in advance, and to put the funds in place 1 month in advance.

At the same time, for different types of debts of urban investment, in the case of limited resources, classified management is implemented:

(1) Exhaust resources to ensure standardized bonds, and not be the first standardized bond default area;

(2) Directly facing the collective debts of the people, such as the fixed financing products issued by the local financial exchanges, and strive to repay the debts and avoid mass incidents;

(3) Bank credit, strive to obtain policy support, and strive to strive for extension and interest rate reduction support;

(4) Other compliance debts shall be handled according to the actual situation;

(5) For non-compliant debts, all parties shall be jointly liable.

4. "State-owned enterprise debt" - handle it carefully, and a sense of responsibility is the key

Since local state-owned enterprises are completely market-oriented, the relationship between corporate debt and the government is relatively weak in theory. However, since the government is a shareholder of state-owned enterprises and the daily business of state-owned enterprises is inextricably linked with local governments, it is not uncommon for local state-owned enterprises to default on their debts and have a stampede impact on local financing and even affect local economic development. In retrospect, the costs paid by local governments (higher financing rates, reduced financing scale) far exceeded the amount of defaults by local SOEs, and the gains outweighed the losses. Therefore, local governments still need to be cautious about the debts of local state-owned enterprises, strengthen the sense of responsibility of the government and enterprises, and avoid the problem of new officials ignoring old accounts.

Three

Three necessary measures for local government debt resolution

(1) Do everything possible to consolidate their own debt resolution responsibilities

The Central Financial Work Conference clearly requires that "the responsibility for financial risk disposal be tightened and consolidated". For local governments, they need to do everything they can to increase revenue and reduce expenditure, and consolidate their own debt resolution responsibilities. At a minimum, more effective debt resolution measures include:

1. Accelerate the merger and integration of financing platforms and implement classified management

Local governments should comprehensively sort out the business characteristics, asset characteristics and profitability of financing platforms, and implement classified management of urban investment companies in the region.

(1) The urban investment companies in the list have gradually become extension agencies of government departments, implementing limited financing to ensure the safety of short-term debts.

For urban investment companies with strong public welfare attributes (enterprises included in the list of new financing platforms), they can consider integrating strong and weak or establishing new urban investment entities to absorb and merge urban investment companies in the original region. The integrated urban investment will be positioned as an extension agency of government departments, no longer arrange new market-oriented business, make full use of its "legal" financing function during the transition period, make use of the credit rating of strong entities and the bond issuance qualifications of all entities, maximize the use of capital market tools, issue bonds to repay mature bonds and replace bank loans, realize the debt security of standardized bonds and bank loans of urban investment companies in the list, and effectively expand the financing channels of local debt.

(2) Enterprises with both urban investment attributes and market-oriented attributes should accelerate market-oriented transformation and make good use of capital market financing tools during the transition period.

As such enterprises still have strong urban investment attributes, on the one hand, they can continue to use capital market financing tools to borrow new bonds and bank loans to repay old bonds. On the other hand, it can inject advantageous resources in the region into enterprises, promote their market-oriented transformation, and use various market-oriented financing tools to help business development. In the process of market-oriented transformation, it is no longer allowed to undertake the policy tasks of local governments.

(3) Industrial state-owned enterprises with weak urban investment attributes

Adhere to the principles of marketization and rule of law, strictly separate government from enterprises, and local governments only fulfill and enjoy the rights and obligations of investors through local state-owned assets and financial systems. Local governments are resolutely prohibited from providing any form of credit guarantee for such enterprises. Enterprises operate independently and are responsible for their own profits and losses.

2. Revitalize existing assets and improve asset utilization efficiency

In June 2022, the General Office of the State Council issued the "Opinions on Further Revitalizing Stock Assets and Expanding Effective Investment" (Guo Ban Fa [2022] No. 19), which raised the revitalization of stock assets to a new strategic level. This requires local governments to establish a "one account" of assets in addition to establishing a "one account" of debts, systematically sorting out the ownership relationship, defects in confirmation of rights, operation status and other elements of various assets, and classifying and revitalizing them:

(1) For assets that need to be continued to be held, it is necessary to improve the operational efficiency of the assets, and the introduction of professional teams or market-oriented cooperation can be considered to increase the level of return on assets. In this regard, breaking the existing pattern of interests is key.

(2) For the sale of assets as a whole, it is necessary to make full use of the platforms of local property rights exchanges, carry out the listing and sale of assets in accordance with laws and regulations, and actively cooperate with asset brokerage service institutions to expand the number of counterparties and improve the success rate of transactions.

(3) For securitizable assets, it is necessary for the main leaders to lead the team to form an asset sorting team, find the most suitable financial institutions to cooperate, and strive to solve various asset defects. Make full use of the professional capabilities of financial institutions and use asset securitization tools such as CMBS, quasi-REITs, and public REITs to improve the overall level of asset securitization.

3. Establish a local government debt resolution and equalization fund.

Led by the provincial government, the provincial financial funds and the surplus funds of state-owned enterprises will be integrated to maximize the amount of social funds, establish a debt resolution and equalization fund in the region, and undertake the public issuance of standardized bonds and the directional financing plan issued by the gold exchange in the region with payment pressure, so as to ensure local financial security and governance stability.

(2) Improve the level of communication with financial institutions and seek cooperation with financial institutions in an all-round way

Financing from urban investment companies is a relatively sensitive and important issue for major financial institutions. In the current environment, urban investment assets are still relatively safe assets and still have high allocation value. This requires the main persons in charge of local governments and urban investment companies to improve their professional capabilities and service attitudes.

On the one hand, it is necessary to strengthen the study and Xi of financial regulatory policies, especially the new policies issued by relevant regulatory authorities to resolve local debt risks. For example, the Measures for the Administration of Risk Classification of Financial Assets of Commercial Banks issued on February 11, 2023 provide new provisions on the five-level classification of restructured assets and risks. We should make full use of financial regulatory policies and seek a balance between the resolution of local debts and the interests of financial institutions.

On the other hand, it is necessary to enter the bureau, personally lead the team, and conduct general communication and earnest talks with major financial institutions, including the five major state-owned banks, the two major policy banks, local city commercial banks, central and local AMCs, and other financial institutions, and make full use of standardized bonds, asset securitization, credit financing, and other financial instruments to realize the "exchange of low for high, long for short, and new for old" of local debt, and further optimize the structure of local debt.

(3) Improve the level of communication with financial institutions and seek cooperation with financial institutions in an all-round way

Due to the huge amount of debts of local governments, it is necessary to seek the support of the central government to the greatest extent possible to achieve a complete resolution of the debts by relying solely on their own strength.

Since 2015, the central government has carried out four rounds of local government bond swaps, including:

From 2015 to 2018, it issued replacement bonds to replace debts in the form of non-government bonds;

In 2019, the implicit debt resolution pilot of the established counties;

From 2020 to 2022, special refinancing bonds will be replaced by hidden debts;

Since 2023, we have resolutely curbed the growth of hidden debts and properly resolved hidden stock debts. It also emphasizes the blanket of debts.

It should be emphasized that each round of debt resolution led by the central government is not a "Generalized System of Preferences", and local governments need to actively study the policies of the central government, closely follow the spirit of the central government, and consolidate their own responsibilities to the greatest extent, demonstrate the determination, confidence and concrete results of local governments in debt reduction, and strive for the support of the central government to the greatest extent. If necessary, learn from Chongqing's experience Xi and apply to the central bank for support from SPV emergency liquidity financial instruments.

At the same time, although the actual situation of local government debt is different, it is necessary to learn from the experience (and lessons) of the government at the same level Xi the debt. Taking the bank loan extension of Zunyi Road and Bridge as an example, it at least includes: top-down policy support, supporting policies of financial institutions, active negotiation with the head office of the bank, standardized bonds must be guaranteed, full extension of bank loans in one step, disposal of non-standardized debt strategies, and many other experiences and practices that can be used to announce the news on the negotiation platform. Local governments should actively learn Xi from the government at the same level, be good at summing up experience, and do not blindly touch the elephant, blindly carry out debt extension or default, and bring unbearable burdens to the local economy.

Four

The fundamental path of "turning debt" into a standardized development and market-oriented operation

The debt resolution methods mentioned above are all specific measures for debt resolution in the case of limited resources, and are more of a stopgap measure for time and space.

To completely solve the problem of local debt, the only way to completely solve the problem of local debt is to adhere to the principle of marketization and rule of law, clarify the relationship between the powers, responsibilities and interests of local governments and enterprises, strictly implement the separation of government and enterprises, and the government and enterprises perform their respective duties, orderly promote the reform of local state-owned enterprises and the market-oriented transformation of investment companies, and introduce market-oriented assessment mechanisms and evaluation standards in the strategy, personnel, management, and operation of urban investment companies, so as to further release productivity and create value.

Source: This article is excerpted from the research report of the Financial Security Research Center of PBC School of Finance, Tsinghua University, Issue 11, 2023, the authors are Zhou Daoxu, Chen Xu, Zhou Jing, Liu Yushu, Chen Fang, Rao Qian, and Wu Yingying.