## _wp13243

## Source details

**Canonical URL:** [_wp13243](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp13243.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp13243.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp13243.pdf.json)

---

### I. Introduction — role and concerns about LGFPs
- Local government financing platforms (LGFPs) are the backbone of local governments in promoting infrastructure development in China and act as a vehicle to provide off-balance sheet quasi-fiscal support for local governments.
- Rapid credit expansion in 2009–10 increased LGFP activity as local governments, prohibited from direct borrowing by the Budget Law, relied on LGFPs to channel funding for infrastructure spending.
- Key risks:
  - Rapid credit expansion to LGFPs triggered concerns about local governments’ indebtedness, banks’ asset quality, medium-term financial stability, and sovereign risk if causes are not addressed.

### II. Function, structure, and funding of LGFPs
- Legal and operational status:
  - LGFPs are treated as municipal state-owned enterprises (SOEs) under China’s Company Law.
  - Primarily engaged in construction of public welfare projects, including affordable housing, infrastructure, social services, ecological and environmental protection.
- Funding and capitalization:
  - Local governments provide capital via budget revenue injection, transfer of land use rights and existing assets (roads and bridges), or receipts for bonds issued by the central government on behalf of local governments.
  - After meeting capital requirements, LGFPs finance the rest through bank lending or equity/bond markets.
- Banks’ credit assessment and local government support:
  - Banks assess LGFP creditworthiness using stand-alone repayment capacity plus regional economic situation, industry sector support, and local governments’ aggregate fiscal position.
  - Banks implicitly or explicitly assume local government ultimate responsibility for LGFP liabilities.
  - Local government support mechanisms include transfer of land as collateral, setting aside future revenues as subsidies, and explicit local government guarantees.

### III. Rapid development, scale, and chronology
- Formation and scale:
  - By mid–2009, at least 3,800 LGFPs had formed at provincial, prefectural, and county/city district levels.
  - NAO (June 2011) reported stock of local government debt reached RMB 10.7 trillion as of end-2010, with LGFP debt around RMB 4.97 trillion.
  - CBRC estimated loans to LGFPs stood at RMB 9.2 trillion as of end-2012.
- Role in fiscal adjustment and stimulus:
  - Centralization since 1994 moved major revenue sources to the central government; in 2002 central government ordered local governments to channel 50 percent of personal and enterprise income tax to the central government.
  - Central fiscal stimulus package (RMB 4 trillion) in late 2008: central government contributed RMB 1.18 trillion, with the rest provided by local governments.
  - Investment accounted for 49 percent contribution to GDP in 2011 (highest among G20 countries).
- Banks’ role in funding:
  - Of RMB 10.7 trillion local government debt as of end-2010, RMB 8.5 trillion represents bank loans to local governments.
  - Assuming same ratio, of RMB 4.97 trillion LGFP debt, RMB 4 trillion is in the form of bank loans.
  - RMB 4 trillion represents about 15 percent of corporate bank loans in the Chinese economy as a whole in 2010.

### IV. Banks, lending incentives, and internal weaknesses
- Drivers of bank lending to LGFPs:
  - Explicit and implicit guarantees by local governments encouraged banks to lend to LGFPs.
  - Banks faced pressure to increase market share and shareholder value, prompting expansion of LGFP lending.
  - Collateral, particularly land provided by LGFPs and local governments, gave banks comfort despite limited tools to price credit risk.
  - Local governments’ lobbying power may press conservative banks to lend, especially affecting smaller and local banks.
- Consequences:
  - Rapid expansion exposed weaknesses in banks’ risk management and internal controls.

### V. Debt maturity, geographic distribution, and bank asset-quality exposures
- Debt maturity and near-term burden:
  - About 24 percent (RMB 2.6 trillion) of local government debt was due in 2011, representing 60 percent of local government revenue (excluding the receipts from the sale of land lease rights).
  - Debt due in 2016 and thereafter accounts for 30 percent of the total local government debt; these debts represent another 70 percent of local government revenue in 2010.
  - Using the prevailing lending rate of 6.4 percent for medium- and long-term loans: the annual interest payment of RMB 4.97 trillion LGFP loans would be about RMB 320 billion, equivalent to about 6 percent of total revenues of local governments in 2011 (excluding land sales revenue).
- Geographic distribution:
  - Eastern region (11 provinces): about 55 percent of the total debt.
  - Middle region: 22 percent.
  - Western region: 23 percent.
  - Provincial example: Tianjin — sum of current and future LGFP loans is 11 times the transfer-adjusted revenue in 2010.
- Bank exposure and potential NPL impact (selected entries from Table 1):
  - ICBC: Gross NPL ratio (end-2011) 1.3%; Total loans 7,943,456 (RMB million); LGFP loans 510,000 (RMB million); Share of LGFP loans 6.4%; Incremental gross NPL ratio assuming 35% of LGFP loans become NPLs, 2.2%; Potential gross NPL ratio if LGFP loans become NPLs, 3.5%.
  - CCB: Gross NPL ratio (end-2011) 1.4%; Total loans 6,496,411 (RMB million); LGFP loans 284,000 (RMB million); Share of LGFP loans 4.4%; Incremental gross NPL ratio 1.5%; Potential gross NPL ratio 2.9%.
  - BOC: Gross NPL ratio (end-2011) 1.3%; Total loans 6,342,814 (RMB million); LGFP loans 380,000 (RMB million); Share of LGFP loans 6.0%; Incremental gross NPL ratio 2.1%; Potential gross NPL ratio 3.4%.
  - Agricultural Bank: Gross NPL ratio (end-2011) 2.2%; Total loans 5,628,705 (RMB million); LGFP loans 390,000 (RMB million); Share of LGFP loans 6.9%; Incremental gross NPL ratio 2.4%; Potential gross NPL ratio 4.6%.
  - China Development Bank: Gross NPL ratio (end-2011) 0.4%; Total loans 5,525,872 (RMB million); LGFP loans 3,683,915 (RMB million); Share of LGFP loans 66.7%; Incremental gross NPL ratio 23.3%; Potential gross NPL ratio 23.7%.
- Vulnerabilities:
  - Reliance on construction and real estate and dominance of land as collateral make banks vulnerable to a sharp economic slowdown and real estate correction.
  - Non-transparency of local governments’ fiscal positions prevents proper pricing of credit risk.

### VI. Sovereign balance-sheet, macro linkages, and land dependence
- Accumulated fiscal and land-sale figures:
  - Accumulated gaps between local fiscal revenues and expenditures during 1998 and 2011 amounted to RMB 18 trillion.
  - Land sales revenue rose from RMB16 billion in 1998 to RMB 3.2 trillion in 2011.
  - Accumulated annual land sales revenue during 1998 and 2011 amounted to RMB 13 trillion.
  - Adding LGFP loans of around RMB 4.97 trillion, total revenue roughly covered the gaps between local fiscal revenue and expenditure over that period.
- Sovereign balance-sheet items (2010) — selected entries:
  - Land assets: 44.3 (In trillions of RMB); 110.3 (In percent of GDP).
  - Deposits of government at central bank: 2.4 (In trillions of RMB); 6.0 (In percent of GDP).
  - Reserve assets: 19.7 (In trillions of RMB); 49.1 (In percent of GDP).
  - Domestic debts of central government: 6.7 (In trillions of RMB); 16.7 (In percent of GDP).
  - Sovereign external debts: 2.3 (In trillions of RMB); 5.7 (In percent of GDP).
  - Local government’s debts (excluding LGFPs): 5.7 (In trillions of RMB); 14.2 (In percent of GDP).
  - Debts from LGFPs: 5.0 (In trillions of RMB); 12.4 (In percent of GDP).
  - Policy banks’ debts: 5.2 (In trillions of RMB); 13.0 (In percent of GDP).
  - Contingent liabilities due to NPLs: 4.2 (In trillions of RMB); 10.5 (In percent of GDP).
  - Implicit pension debts: 3.5 (In trillions of RMB); 8.7 (In percent of GDP).
  - Total assets: 142.3 (In trillions of RMB); 354.4 (In percent of GDP).
  - Total liabilities: 68.6 (In trillions of RMB); 170.8 (In percent of GDP).
  - Net worth of the government: 69.6 (In trillions of RMB); 173.3 (In percent of GDP).
- Medium-term dynamics and risks:
  - Continued monitoring and curbing of LGFP development, together with declining land sales revenue, may increase sovereign risk.
  - Deficits-to-GDP ratios in some provinces exceed those in several high fiscal deficit countries.

### VII. Economic-structural consequences
- Rapid credit expansion to LGFPs:
  - Procyclical lending can produce excessive leverage in upswings and excessive deleveraging in downswings, increasing volatility and threatening financial stability and the real economy.
  - Credit to LGFPs can crowd out lending to the private sector, misallocate capital, increase reliance on investment, and exacerbate economic imbalances.
  - Short-term growth stabilization from credit expansion may jeopardize economic sustainability.

### VIII. Policy implications and recommended measures
- Overarching coordination:
  - Fiscal, monetary, and financial policies should coordinate to reduce local governments’ vulnerability to LGFP deterioration and prevent recurrence.
  - Address mismatches between local revenue and expenditure; strengthen fiscal transfers; establish a comprehensive framework to regulate and supervise local government budgets and financing; ensure sustainable resources from sale of land use rights via comprehensive land capitalization planning; encourage development of a local government bond market to diversify financing sources.
- Specific measures to address fiscal revenue–expenditure mismatches:
  - Transfers: unfunded local government responsibilities should be funded through a less ad hoc transfer system emphasizing transparency, predictability, and reliability; transfers should accommodate regional growth inequality; clarify expenditure responsibilities of local governments.
  - Property taxation: China should start levying property taxes to reduce reliance on land sales revenue; property taxes can provide resources for capital expenditure and curb housing market speculation.
    - Pilot programs in Shanghai and Chongqing permit collection of property taxes on newly purchased second homes or luxury residential property.
    - Implementation steps: identify property; assess property value; set tax rates; issue tax bills; collect taxes.
- Regulate and supervise local government budget and financing:
  - Four broad approaches: market-based discipline; cooperative arrangement; rule-based controls; administrative constraints.
  - Recommendation: a rule-based approach may be most suitable given centralized political system; market-based pilots could be conditional on preparatory reforms.
  - Fiscal transparency: create a complete public picture of local government finances including official budget items, extra-budgetary resources, local SOEs, contingent liabilities, and guarantees.
- Strengthening supervision and banking constraints:
  - State Council measures (June 2010) and follow-up implementation rules by MOF, NDRC, PBC, and CBRC aimed to assess debts, classify LGFPs, strengthen supervision, and prohibit local governments from guaranteeing LGFP debts.
  - April 2013 CBRC guidance (key requirements):
    - Banks’ stock of LGFP loans should not exceed the existing stock at end-2012.
    - Banks can grant new loans only to LGFPs with a cash flow coverage ratio above 100 percent.
    - Banks can grant new loans only to LGFPs with a liability-to-total asset ratio below 80 percent.
    - Collateral must comply with regulations.
  - Assessment: these measures are positive but fundamental drivers of LGFP proliferation must be addressed to prevent recurrence.
- Liability management and credible ex-post mechanisms:
  - Centralized management systems would enhance capacity to manage risk; conditional bailout and burden sharing with lenders recommended to avoid moral hazard.
- Allowing creditworthy local governments to issue bonds:
  - Municipal bond market pilots in Guangdong, Shanghai, Shenzhen, and Zhejiang.
  - Central government should make clear it will not provide any guarantees on bonds issued by local governments to reduce moral hazard.
- Ensuring sustainability of land capitalization and managing land supply:
  - China’s available construction land can provide 100 square meters per person (CICC, 2010).
  - Completion rate of planned land supply was 55 percent national level in 2009; Chongqing 81 percent; Shanghai 48 percent.
  - Under cited assumptions (total land value RMB 44.3 trillion at 2010; land prices increase at the same speed as in 2010; land sales revenue grows at the speed of the past couple of years), a rough estimate shows land may be fully sold by around 2021.
  - Managing amount and speed of land supply in a transparent and sustainable way would help provide sustainable resources and reduce incentives to hold back supply.
- Developing local government bonds into safe assets:
  - Besides RMB 1.1 trillion of central government bonds that could be first developed into safe assets, Chinese local governments could provide another $3 trillion (about RMB 20 trillion) in bonds for domestic and global investors.
  - A decline of one percentage point in the interest rate for the $3 trillion local government bonds would save RMB 200 billion in interest expenditure for local governments.
  - Standardized review and issuance will improve transparency, market discipline, and sustainability of land capitalization.

### IX. Governance of SOEs, extra-budgetary items, and transparency
- Local SOEs:
  - Commercially run local SOEs with sound finances and managerial independence should be kept at arm's length from local governments.
  - Local SOEs that are not commercially run and need support should be incorporated into local governments’ budgets.
  - All local SOEs should be monitored by all levels of government.
- Private enterprises and joint ventures:
  - Private enterprises and joint ventures carrying out public functions should be included in local governments’ finances when there is risk transfer to the private sector; BT and BOT contracts should be closely monitored.
- Extra-budgetary resources:
  - Extra-budgetary resources should be incorporated in the formal budget.
  - Land sales revenue example: local governments generated RMB 1.59 trillion from the sale of 209,000 hectares of land in 2009; 103,000 hectares were sold to real estate developers, up 36.7 percent year on year.
  - Central government could create a comprehensive information system to supervise local governments and publish key indicators of financial health.

### X. Regulatory approaches — trade-offs and evasive behavior
- Rule-based controls:
  - Advantages: clear, transparent, impartial; avoid extensive negotiations.
  - Trade-off: lack of flexibility could promote evasive behavior; flexible rules with escape clauses can lack credibility.
  - Forms of evasive behavior: classifying current expenditure as capital expenditure; creating off-balance sheet SOEs; accumulating hidden off-budget debts; sale-and-lease-back operations.
- Administrative approach:
  - Strictest control: central government directly controls borrowing via ceilings, authorizations, or centralized borrowing with on-lending.
  - Benefits: coordination in centralized systems.
  - Limitations: introduces implicit or explicit guarantees; central government may have imperfect information and select poorer-quality projects.

### XI. Conclusion — risks and comprehensive policy response
- Root causes of LGFP expansion:
  - Economic growth model reliant on investment; growing fiscal gaps in local governments; limited local financing instruments; heavy reliance on land sales revenue; unconstrained bank lending driven by incomplete commercialization.
- Main risks:
  - (i) credit risk leading to inability for banks to collect loans;
  - (ii) potential fiscal risk in Chinese provinces;
  - (iii) future collateral loss related to potential declines in land prices, creating contagion across local governments, the banking sector, the real estate sector, and the central government.
- Required policy actions:
  - (i) transform the growth pattern from export- and investment-driven to consumption-driven;
  - (ii) match local fiscal revenue and expenditure;
  - (iii) encourage qualified local governments to issue bonds;
  - (iv) manage the amount and speed of land release in a transparent and sustainable way.
- Further reforms to make local government debt safe assets:
  - Increase depth of China’s bond market by encouraging local governments with robust fiscal revenue and state-owned assets to issue more bonds;
  - Promote securitization of LGFPs’ loans and land;
  - Continue exchange rate liberalization and capital account liberalization to facilitate foreign investment in domestic local government bonds.
- Summary judgement: LGFPs represent a current risk to China’s economy, but with comprehensive policy implementation they could contribute to economic development and financial stability.

*Source: _wp13243 - References*

### References .............................................................................................................

### References

### I. Introduction — role and concerns about LGFPs
- Local government financing platforms (LGFPs) are the backbone of local governments in promoting infrastructure development in China and act as a vehicle to provide off-balance sheet quasi-fiscal support for local governments.
- The rapid credit expansion in 2009–10 increased LGFP activity as local governments, prohibited from direct borrowing by the Budget Law, relied on LGFPs to channel funding for infrastructure spending.
- Risks outlined:
  - Rapid credit expansion to LGFPs triggered concerns about local governments’ indebtedness, banks’ asset quality, medium-term financial stability, and sovereign risk if causes are not addressed.
- Paper scope and structure:
  - Sections II and III examine functions of LGFPs and reasons for expansion.
  - Section IV discusses exposure to real estate market volatility and economic distortions.
  - Section V proposes measures to address causes, risks, and recurrence.

### II. Function of LGFPs and relationship with local governments
- LGFP structure and activities:
  - LGFPs are treated as municipal state-owned enterprises (SOEs) under China’s Company Law.
  - Primarily engaged in construction of public welfare projects, including affordable housing, infrastructure, social services, ecological and environmental protection.
- Funding and capitalization:
  - Local governments provide capital via budget revenue injection, transfer of land use rights and existing assets (roads and bridges), or receipts for bonds issued by the central government on behalf of local governments.
  - After meeting capital requirements, LGFPs finance the rest through bank lending or equity/bond markets.
- Banks’ credit assessment:
  - Banks assess LGFP creditworthiness using stand-alone repayment capacity plus regional economic situation, industry sector support, and local governments’ aggregate fiscal position.
  - Banks implicitly or explicitly assume local government ultimate responsibility for LGFP liabilities.
- Local government support mechanisms:
  - Transfer of land as collateral for LGFP loans.
  - Land as future operating revenue when land use rights are sold.
  - Local governments sometimes set aside future revenues as subsidies, included in local budgets approved by local national congresses.
  - Explicit local government guarantees facilitate LGFP borrowing.

### III. Rapid development of LGFPs — drivers and scale
- Historical context:
  - LGFPs are a reincarnation of 1990s trust and investment companies; rebirth propelled by local fiscal shortfalls and incentives to promote investment.
- Scale and timing:
  - By mid–2009, at least 3,800 LGFPs had formed at provincial, prefectural, and county/city district levels.
  - NAO (June 2011) reported stock of local government debt reached RMB 10.7 trillion as of end-2010 (equivalent to 27 percent of GDP in 2010), with LGFP debt around RMB 4.97 trillion.
  - CBRC estimated loans to LGFPs stood at RMB 9.2 trillion as of end-2012.
  - In July 2013, NAO announced a national survey of local government debts; higher coverage expected though features remain similar.
- Revenue–expenditure mismatch:
  - Centralization since 1994 moved lucrative revenue sources (VAT, resource tax, and personal and enterprise income tax) to the central government; in 2002 central government ordered local governments to channel 50 percent of personal and enterprise income tax to the central government.
  - Local spending responsibilities remained roughly unchanged, widening imbalances between local government revenue and expenditure.
  - During normal times mismatch is addressed by central transfers and extra budgetary revenues dominated by land sales revenue.
- 2008–09 fiscal stimulus impact:
  - Central government introduced a fiscal stimulus package (RMB 4 trillion) in late 2008; the central government contributed RMB 1.18 trillion, with the rest provided by local governments.
  - Investment accounted for 49 percent contribution to GDP in 2011 (highest among G20 countries).
  - Fiscal pressures and promotion incentives led local governments to seek additional financial resources; LGFPs circumvented market-borrowing prohibition.
- Banks’ role in funding LGFPs:
  - Of RMB 10.7 trillion local government debt as of end-2010, RMB 8.5 trillion represents bank loans to local governments.
  - Assuming same ratio, of RMB 4.97 trillion LGFP debt, RMB 4 trillion is in the form of bank loans.
  - RMB 4 trillion represents about 15 percent of corporate bank loans in the Chinese economy as a whole in 2010.

### IV. Banks, internal weaknesses, and lending incentives
- Drivers of bank lending to LGFPs:
  - Explicit and implicit guarantees by local governments encouraged banks to grant loans to LGFPs.
  - Banks faced pressure to increase market share and shareholder value, prompting expansion of LGFP lending.
  - Collateral, particularly land provided by LGFPs and local governments, gave banks comfort despite limited tools to price credit risk.
  - Local governments’ lobbying power may press conservative banks to lend, especially affecting smaller and local banks.
- Consequences:
  - Rapid expansion exposed weaknesses in banks’ risk management and internal controls.

### V. Risks and vulnerabilities — real estate dependence and sovereign exposure
- Real estate market exposure:
  - Land owned by local governments is a principal source of LGFP capital, future extra-budgetary revenue, and collateral.
  - Declines in land values reduce LGFP ability to extract loans and may force land sales; forced sales into illiquid markets can create a vicious circle.
  - High reliance of China’s economy on construction and real estate exacerbates this vulnerability.
- Local government debt burden and repayment capacity:
  - NAO report highlights large overall scale of local government debt; over half related to LGFPs, with substantial repayment pressures for some local governments.
  - In 2009, the highest ratio of debt to financial resources available (e.g., local government fiscal revenue) reached 364.8 percent.
  - Local government liabilities breakdown:
    - Local governments entirely responsible for RMB 6.7 trillion (or 62.6 percent of the total debt stock of RMB 10.7 trillion).
    - Debt guaranteed by local governments was RMB 2.3 trillion (or 21.8 percent).
    - Total local government revenue (excluding receipts from sale of land lease rights) was RMB 4.1 trillion in 2010.
    - Income from the central government (tax rebates and transfer payment) was RMB 3.2 billion in 2010.
  - LGFP debt amounted to RMB 4.97 trillion, equivalent to two thirds of the sum of local government revenue and transfers from the central government.
  - Implication: if LGFPs experience financial difficulties, substantial financial support from local governments would be difficult.

### VI. Policy implications and suggested measures (summary from paper)
- Address revenue–expenditure mismatches at the local government level explicitly and comprehensively.
- Establish a comprehensive framework to regulate and supervise local government budget and financing.
- Ensure financial resources from sale of land are sustainable given constrained land supply in the medium term; implement a comprehensive strategy for land capitalization.
- Encourage issuance of local government bonds and develop them into safe assets to make land capitalization sustainable and alleviate sovereign risk by reducing transmission of contingent risk from local governments to the central government.

*Source: _wp13243 - References*

### 17.      Much of the local government debt matures in five years (Figure 9). About

### _wp13243 - 17.      Much of the local government debt matures in five years (Figure 9). About

### Debt maturity and aggregate burden
- About 24 percent (RMB 2.6 trillion) of local government debt was due in 2011, representing 60 percent of local government revenue (excluding the receipts from the sale of land lease rights).
- Debt due in 2016 and thereafter accounts for 30 percent of the total local government debt; these debts represent another 70 percent of local government revenue in 2010.
- Risk implication: local governments may face tremendous debt payment pressure in the coming years with elevating sovereign risk.
- Using the prevailing lending rate of 6.4 percent for medium- and long-term loans:
  - The annual interest payment of RMB 4.97 trillion LGFP loans would be about RMB 320 billion, equivalent to about 6 percent of total revenues of local governments in 2011 (excluding land sales revenue).

### Geographic distribution and provincial exposure
- Regional share of local government debt in 2010:
  - Eastern region (11 provinces): about 55 percent of the total debt.
  - Middle region: 22 percent.
  - Western region: 23 percent.
- Provincial example:
  - Tianjin: the sum of current and future LGFP loans is 11 times the transfer-adjusted revenue in 2010 (i.e., it would take Tianjin 11 years to pay back all its LGFP loans with transfer-adjusted revenue, assuming no new expenditures).
- Current vs. future debt definitions referenced from Shin (2010):
  - Current debt includes existing debt of LICs announced in regulatory filings and bond rating reports and lines of credit announced after January 1, 2004 and before January 1, 2008 (after appropriate discounting).
  - Future debt includes lines of credit announced in and after January 2008.
- Transfer-adjusted revenue defined as the sum of local fiscal revenue and the central government transfer amount.

### Channels to banks and bank asset quality
- About 15 percent of banks’ corporate loans are associated with LGFPs at end-2010.
- LGFP loan expansion targeted large projects with longer maturities, increasing the share of new medium- to long-term loans.
  - The share of outstanding medium- to long-term loans peaked at 61.2 percent in early 2011.
- Concentration in long-term loans can exacerbate the impact of the economic cycle on banks’ asset quality.
- Bank exposure and potential incremental gross NPL ratios (2011) — selected entries from Table 1:
  - ICBC: Gross NPL ratio (end-2011) 1.3%; Total loans 7,943,456 (RMB million); LGFP loans 510,000 (RMB million); Share of LGFP loans 6.4%; Incremental gross NPL ratio assuming 35% of LGFP loans become NPLs, 2.2%; Potential gross NPL ratio if LGFP loans become NPLs, 3.5%.
  - CCB: Gross NPL ratio (end-2011) 1.4%; Total loans 6,496,411 (RMB million); LGFP loans 284,000 (RMB million); Share of LGFP loans 4.4%; Incremental gross NPL ratio 1.5%; Potential gross NPL ratio 2.9%.
  - BOC: Gross NPL ratio (end-2011) 1.3%; Total loans 6,342,814 (RMB million); LGFP loans 380,000 (RMB million); Share of LGFP loans 6.0%; Incremental gross NPL ratio 2.1%; Potential gross NPL ratio 3.4%.
  - Agricultural Bank: Gross NPL ratio (end-2011) 2.2%; Total loans 5,628,705 (RMB million); LGFP loans 390,000 (RMB million); Share of LGFP loans 6.9%; Incremental gross NPL ratio 2.4%; Potential gross NPL ratio 4.6%.
  - China Development Bank: Gross NPL ratio (end-2011) 0.4%; Total loans 5,525,872 (RMB million); LGFP loans 3,683,915 (RMB million); Share of LGFP loans 66.7%; Incremental gross NPL ratio 23.3%; Potential gross NPL ratio 23.7%.
- Vulnerabilities:
  - Reliance on construction and real estate and dominance of land as collateral make banks vulnerable to a sharp economic slowdown and real estate correction.
  - Non-transparency of local governments’ fiscal positions (including extra-budgetary items, cross-guarantees, subsidiaries) prevents proper pricing of credit risk.

### Sovereign risk and macro linkages
- Transmission risk: LGFP losses could trigger central government bailouts of local governments or banks, increasing government debt and weakening sovereign creditworthiness.
- Accumulated fiscal figures and land sales:
  - Accumulated gaps between local fiscal revenues and expenditures during 1998 and 2011 amounted to RMB 18 trillion.
  - Land sales revenue rose from RMB16 billion in 1998 to RMB 3.2 trillion in 2011.
  - Accumulated annual land sales revenue during 1998 and 2011 amounted to RMB 13 trillion.
  - Adding LGFP loans of around RMB 4.97 trillion, total revenue roughly covered the gaps between local fiscal revenue and expenditure over that period.
- Sovereign balance-sheet items (2010) — selected entries:
  - Land assets: 44.3 (In trillions of RMB); 110.3 (In percent of GDP).
  - Deposits of government at central bank: 2.4 (In trillions of RMB); 6.0 (In percent of GDP).
  - Reserve assets: 19.7 (In trillions of RMB); 49.1 (In percent of GDP).
  - Domestic debts of central government: 6.7 (In trillions of RMB); 16.7 (In percent of GDP).
  - Sovereign external debts: 2.3 (In trillions of RMB); 5.7 (In percent of GDP).
  - Local government’s debts (excluding LGFPs): 5.7 (In trillions of RMB); 14.2 (In percent of GDP).
  - Debts from LGFPs: 5.0 (In trillions of RMB); 12.4 (In percent of GDP).
  - Policy banks’ debts: 5.2 (In trillions of RMB); 13.0 (In percent of GDP).
  - Contingent liabilities due to NPLs: 4.2 (In trillions of RMB); 10.5 (In percent of GDP).
  - Implicit pension debts: 3.5 (In trillions of RMB); 8.7 (In percent of GDP).
  - Total assets: 142.3 (In trillions of RMB); 354.4 (In percent of GDP).
  - Total liabilities: 68.6 (In trillions of RMB); 170.8 (In percent of GDP).
  - Net worth of the government: 69.6 (In trillions of RMB); 173.3 (In percent of GDP).
- Medium-term dynamics:
  - Continued monitoring and curbing of LGFP development, together with declining land sales revenue, may increase sovereign risk.
  - Deficits-to-GDP ratios in some provinces exceed those in several high fiscal deficit countries (Figure 12).

### Economic-structural consequences of LGFP credit expansion
- Rapid credit expansion to LGFPs:
  - Procyclical behavior and rapid credit expansion can produce excessive leverage in upswings and excessive deleveraging in downswings, increasing volatility and threatening financial stability and the real economy.
  - Credit to LGFPs can crowd out lending to the private sector, misallocate capital, increase reliance on investment, and exacerbate economic imbalances.
  - Short-term growth stabilization from credit expansion may jeopardize economic sustainability.

### Policy suggestions — overview
- General approach:
  - Fiscal, monetary, and financial policies should coordinate to reduce local governments’ vulnerability to LGFP deterioration and to prevent recurrence of LGFP debt proliferation.
  - Address mismatches between local revenue and expenditure; strengthen fiscal transfers; establish a comprehensive framework to regulate and supervise local government budgets and financing; ensure sustainable resources from sale of land use rights via comprehensive land capitalization planning; encourage development of a local government bond market to diversify financing sources.

### A. Addressing the fiscal revenue and expenditure mismatches
- Transfers:
  - Unfunded local government responsibilities should be funded through a less ad hoc transfer system emphasizing transparency, predictability, and reliability.
  - Transfers should accommodate regional growth inequality so less developed areas have sufficient funding.
  - Clarify expenditure responsibilities of local governments.
- Property taxation:
  - China should start levying property taxes to reduce reliance on land sales revenue.
  - Property taxes can provide resources for capital expenditure and curb housing market speculation.
  - Pilot programs in Shanghai and Chongqing permit collection of property taxes on newly purchased second homes or luxury residential property.
- Implementation steps for property taxes (cited process):
  - Identify property; assess property value; set tax rates; issue tax bills; collect taxes.
  - Good property tax criteria: fairness to taxpayers and benefit receivers; no distortion to economic behavior; accountability to taxpayers; ease of administration.

### B. Establishing a comprehensive framework to regulate and supervise local government budget and financing
- Four broad categories of regulation/supervision on local government borrowing (Ter-Minassian (1997)):
  1. Market-based discipline (rely on capital markets).
  2. Cooperative arrangement (negotiated central-local borrowing limits).
  3. Rule-based controls (central government imposes quantitative or qualitative constraints).
  4. Administrative constraints (central government directly controls borrowing).
- Recommendation for China:
  - Rule-based approach may be most suitable given centralized political system; cooperative and administrative approaches have limitations; a market-based approach could be piloted for some financially sound local governments conditional on preparatory reforms.
- Fiscal transparency:
  - Create a complete public picture of local government finances including official budget items, extra-budgetary resources, local SOEs or private enterprises performing government functions, contingent liabilities, and guarantees.
  - Expand the State Council’s LGFP debt assessment scope to include other SOEs, private enterprises transferring risk away from local governments, and liabilities such as payment arrears, on-lending, and social security.

### Recent supervisory actions and banking constraints
- End-2009 survey by CBRC, PBC, and MOF to assess local government indebtedness; banks required to set standards and classify LGFP loans by September 30, 2010.
- State Council measures (June 2010) launched four main policy measures:
  1. Assess, verify, and properly manage debts assumed by LGFPs.
  2. Classify and regulate the function and operation of existing LGFPs.
  3. Strengthen supervision of LGFPs’ lending activities and banks’ and other financial institutions’ lending practices to LGFPs.
  4. Prohibit local governments from guaranteeing LGFP debts.
- Follow-up by MOF, NDRC, PBC, and CBRC issued detailed implementation rules.
- April 2013 CBRC guidance (key requirements):
  - Banks’ stock of LGFP loans should not exceed the existing stock at end-2012.
  - Banks can grant new loans only to LGFPs with a cash flow coverage ratio above 100 percent.
  - Banks can grant new loans only to LGFPs with a liability-to-total asset ratio below 80 percent.
  - Collateral must comply with regulations.
- Assessment: these measures are positive steps (assessing indebtedness, classifying LGFPs, strengthening supervision, prohibiting unauthorized guarantees), but fundamental drivers of LGFP proliferation must be addressed to prevent recurrence.

*Italic: Source: _wp13243 - 17.      Much of the local government debt matures in five years (Figure 9). About*

### 36.      Some local SOEs can be more independent than others, but all should be

### _wp13243 - 36.      Some local SOEs can be more independent than others, but all should be 

### Monitoring and budget treatment of local SOEs
- Local SOEs that are commercially run, are in a sound financial condition, and have a good governance structure and managerial independence should be kept at arm's length from local governments.
- Local SOEs that are not commercially run and need support from local governments should be incorporated into the local governments’ budget.
- All local SOEs should be monitored by all levels of government.

### Inclusion of private enterprises and joint ventures in local government finances
- Private enterprises and joint ventures that carry out public functions, particularly infrastructure, should be included in local governments’ finances when there is risk transfer to the private sector.
- Build-transfer (BT) and build-operate-transfer (BOT) contracts are commonly used to channel private enterprise participation; because private enterprises use these contracts to secure loans from commercial banks, the risk transferred to the private sector should be closely monitored to ensure the transfer genuinely takes place, and their activities should be included in local governments’ finances.

### Extra-budgetary resources and transparency
- Extra-budgetary resources should be incorporated in the formal budget.
- The single biggest extra-budgetary resource for local governments is the land sales revenue from selling land use rights.
  - Land sales revenue for China's local governments rose more than 60 percent in 2009 as the country's property market surged.
  - Local governments generated RMB 1.59 trillion ($233 billion) from the sale of 209,000 hectares of land in 2009.
  - Of that, 103,000 hectares were sold to real estate developers, up 36.7 percent year on year.
- The central government could create a systematic and comprehensive information system to supervise local governments and make key indicators of local government financial health public to allow financial institutions and markets to control local governments’ borrowing activities.

### Strengthening management of direct and contingent liabilities
- A centralized management system would enhance local governments’ capacity to manage risk and address debt management vacuums, risky debt practices, revenue-payment mismatches, maturity mismatches, and large unfunded contingent liabilities.
- If local governments lack capacity to set up liability management frameworks, the central government could set up a centralized management system to manage risks shared by the central and local governments.

### Credible ex-post mechanisms and conditional bailouts
- A credible ex-post mechanism for resolving local governments’ insolvency would support ex-ante regulations by deterring irresponsible behavior by local governments and lenders.
- International experience suggests a strict no-bailout principle is difficult to implement; a conditional bailout principle could be more applicable to China.
- Burden sharing with lenders would help prevent moral hazard by lenders; requiring commercial banks to share the consequences of defaults is likely to reduce moral hazard.
- During the RMB 4 trillion fiscal stimulus package in early 2008:
  - RMB 1.18 trillion was planned to come from central government and the remainder from other sources, including funding raised by local governments.
  - The overall budget deficit increased by only RMB 614 billion.
  - The MOF raised RMB 200 billion on behalf of local governments by issuing bonds.
  - Most of the funding needs were met through LGFPs’ borrowing from commercial banks, with guidance by the PBC and CBRC; the central government needs to take responsibility for this portion of LGFPs’ borrowing.

### Allowing creditworthy local governments to issue bonds
- Setting up a municipal bond market would allow creditworthy local governments to access capital markets for long-term projects and have bond prices determined by the market.
- Pilot projects have been undertaken in Guangdong, Shanghai, Shenzhen, and Zhejiang.
- To reduce moral hazard, the central government should make clear that it will not provide any guarantees on bonds issued by local governments.

### Ensuring sustainability of land capitalization
- China still has a large amount of land available for construction; China’s available construction land can provide 100 square meters per person, even if only urban construction land is used (CICC, 2010).
- The current land management system is strongly linked to fiscal gap and housing prices:
  - Less land supply reduces land sales and can increase fiscal gaps (negative relationship between land supply and fiscal gap).
  - Local governments and developers have incentives to hold back land release to benefit from land price increases, which can raise housing prices and deter timely housing construction.
- Completion rate of planned land supply was 55 percent at the national level in 2009.
  - Chongqing: completion rate in 2009 was 81 percent.
  - Shanghai: completion rate in 2009 was 48 percent.
- Under assumptions cited (total land value RMB 44.3 trillion at 2010; land prices increase at the same speed as in 2010; land sales revenue grows at the speed of the past couple of years), a rough estimate shows land may be fully sold by around 2021, implying:
  - End of land capitalization could mean local fiscal gaps can no longer be met through land sales revenue, a sharp slowdown in local investments and economic growth, and rising non-performing loans in the banking sector.
- Managing the amount and speed of land supply in a transparent and sustainable way would help provide sustainable resources and reduce incentives to hold back supply.

### Developing local government bonds into safe assets
- Safe assets serve as a reliable store of value and as liquid, stable collateral in repo agreements and derivatives markets.
- China could benefit from a larger supply of domestically-produced safe assets.
- Potential benefits of developing central and local government bonds into domestic or global safe assets:
  - Besides RMB 1.1 trillion of central government bonds that could be first developed into safe assets, Chinese local governments could provide another $3 trillion (about RMB 20 trillion) in bonds for domestic and global investors; this sum is more than the accumulated land sales revenue and roughly equal to accumulated financing gaps between local fiscal revenues and expenditures between 1998 and 2011.
  - Reducing financing costs: a decline of one percentage point in the interest rate for the $3 trillion local government bonds would save RMB 200 billion in interest expenditure for local governments.
  - Standardized review alongside issuance of local government bonds will improve transparency and market discipline in collateralizing and using land, making the land capitalization process more sustainable and providing additional leeway for fiscal reforms.

### Conclusion: risks and comprehensive policy response
- Rapid development of LGFPs over the past four years reflects:
  - An economic growth model reliant on investment;
  - Growing fiscal gaps in local governments;
  - Limited financing capacities and instruments at the local government level;
  - Heavy reliance on land sales revenue;
  - Unconstrained provision of loans driven by incomplete commercialization of banks.
- Main risks associated with LGFPs arise from:
  - (i) credit risk leading to inability for banks to collect loans;
  - (ii) potential fiscal risk in Chinese provinces;
  - (iii) future collateral loss related to potential declines in land prices, which may create contagion across local governments, the banking sector, the real estate sector, and the central government.
- Policies required to address LGFP risks include:
  - (i) transforming the growth pattern from export- and investment-driven to consumption-driven;
  - (ii) matching local fiscal revenue and expenditure;
  - (iii) encouraging qualified local governments to issue bonds;
  - (iv) managing the amount and speed of land release in a transparent and sustainable way.
- Issuing and promoting local government debt as global safe assets requires further reforms:
  - Increasing depth of China’s bond market by encouraging local governments with robust fiscal revenue and state-owned assets to issue more bonds;
  - Promoting financial market depth by enlarging securitization of LGFPs’ loans and land;
  - Continuing exchange rate liberalization and capital account liberalization to facilitate foreign investment in domestic local government bonds.
- Summary judgement: LGFPs represent a current risk to China’s economy, but with comprehensive policy implementation they could contribute to economic development and financial stability.

### Annex: Four broad categories of regulation and supervision on local government borrowing
- Market-based discipline:
  - Relies on capital markets to control local government borrowing; central government does not set limits.
  - Conditions for effective market discipline include open and free markets, accessible information on local debt and repayment capacity, no assumption of central government bailout, and institutional structures ensuring policy responsiveness.
- Cooperative arrangement:
  - Negotiated borrowing limits between central and local governments; local governments involved in macro objectives and fiscal parameters.
  - Advantages: coordination and dialog; weaknesses: may soften budget constraints, undermine central leadership, promote bargaining on transfers, and weaken coordination if poorly implemented.
- Rule-based controls:
  - Central government imposes quantitative rules or qualitative constraints (examples provided by country practices).
  - Quantitative examples: restrictions on overall debt amount, expenditure ceilings, indicators of debt-servicing capacity, budget deficits, operating budget deficits.
  - Qualitative examples: “golden rules” limiting borrowing to investment purposes, restricting access to some financing sources, requiring medium-term fiscal frameworks and transparent budget processes.

*Source: IMF staff analysis in the supplied content.*

### 6.      Rule-based controls are attractive but are likely to promote evasive behavior.

### 6.      Rule-based controls are attractive but are likely to promote evasive behavior.

### Rule-based controls: advantages and trade-offs
- Advantages:
  - Clear, transparent, and impartial.
  - Avoid extensive negotiations between central and local governments.
- Key trade-off:
  - Effectiveness depends on the balance between ensuring compliance and preserving flexibility.
  - Lack of flexibility could ultimately promote evasive behavior and practices.
  - Flexible rules with escape clauses lack credibility and encourage rule circumvention.

### Forms of evasive behavior (examples)
- Restrictions on borrowing for current expenditure in favor of borrowing for capital expenditure (i.e., golden rules) could lead to classifying current expenditure as capital expenditure.
- If restrictions only apply to budget items, local government will create off-balance sheet items and SOEs with extra-budgetary statutes to circumvent the restrictions.
- These SOEs could be used to borrow money for purposes that should be funded by the local government budgets.
- Accumulating “hidden” off-budget debts or using sale-and-lease-back operations are also ways to circumvent borrowing limits.

### D.   Administrative Approach

### Nature of the administrative approach
- Among the four approaches, the administrative approach is the strictest way to control local government borrowing.
- The central government retains the power for exercising direct control over local government borrowing.
- Implementation forms include:
  - Setting the annual or semiannual individual local government debt ceiling (Lithuania).
  - Reviewing and authorizing individual borrowing operations (India and Bolivia).
  - Centralizing all government borrowing with on-lending to local governments (Latvia and Indonesia).

### Benefits and limitations
- Benefits:
  - Often seen in constitutionally centralized countries.
  - Ensures some level of coordination of the borrowing activities for a nation as a whole.
- Limitations:
  - Introduces implicit or explicit guarantees of local government debt.
  - Effectiveness could be limited by the central government having imperfect information on local government projects.
  - Projects with low quality or high risk may be selected due to information constraints.

*Source: _wp13243 - 6.      Rule-based controls are attractive but are likely to promote evasive behavior.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp13243.pdf_