The People's Bank of China in Beijing (©Kyodo)
On December 5, rating agency Moody's downgraded China's credit rating. Moody's also downgraded the credit ratings of Hong Kong, Macau, and numerous Chinese state-owned enterprises, banks, and insurers. This move was prompted by the collapse of the real estate bubble and potential local government debt crises in China. Moody's assessment highlights widespread concern that China's local debt could be the next major economic crisis.
But when exactly might this debt explode? In this essay, I take an in-depth look at the precarious financial situation in the People's Republic of China. According to at least one Chinese economist, the outlook is grim, and collapse is near.
Tracking a Bursting Bubble
Recently, a Chinese economist named Lao Man tackled the billion-dollar question of when China's local debt problem will explode. His approach is deceptively simple. Lao gathered all data on bonds issued by local governments. These data include the annual amount issued, interest rates, maturity dates, and the total principal and interest due at maturity. Using this information, Lao created a mathematical model to predict future bond repayments and funding gaps.
Compiling this data and calculating the future debt repayment burden reveals a clearer picture of when the debt bubble might burst.
However, this task is daunting. In 2016 alone, Chinese local governments issued 1,159 local government bonds. With no official total figure available, one must gather and compile all these figures for the calculation. This is an enormous task for any individual.
Lao Man's solution was to randomly select a 5% sample for his calculations. He confirmed the method's accuracy, finding only a 1.5% margin of error for formal local government debts and 10% for urban construction investment debts. Consequently, the conclusions based on this methodology are highly precise. Using Lao's figures, we can come closer to understanding when China's local debt bubble will burst.
Getting Deeper Into the Numbers
Let us review some key figures and critical projections from Lao Man's work.
The figures in Table 1 above provide a glimpse into the magnitude of local debt in China. Bear in mind that the numbers are ultimately sourced from the official data of China's Ministry of Finance. Table 1 illustrates a consistent fiscal gap in local governments' budgets. This gap stubbornly remains even after local governments received "transfer payments" (as indicated in the second column from the right) from the central government. Under China's tax-sharing system, the central government collects the majority of tax revenues. So, these "transfer payments" act as subsidies to local governments.
In 2016, the absolute deficit in local government revenues versus expenditures was nearly ¥1.5 trillion CNY (about $210 billion USD). By 2022, this figure had escalated to almost ¥5.7 trillion CNY ($800 billion USD). The shortfall nearly tripled (280%) in just six years.
In the first three quarters of 2023 alone, the absolute deficit in local finances already hit ¥3.6 trillion CNY ($510 billion USD). The annual fiscal deficit is projected to be around ¥5 trillion CNY ($703 billion USD).
A critical point to note about this table is that the expenditure data does not include principal repayments on various debts of local governments. Table 1 accounts only for interest payment expenditures. Consequently, this ¥5 trillion CNY gap must be addressed by issuing local government debt.
Understanding Local Government Debt in China
In China, local government debt falls into two categories. First is the relatively well-regulated official local government bonds. Second is the less structured urban construction investment bonds.
Table 2 presents data on official local government bonds. As of the end of September 2023, the total local government bond debt stood at ¥38.9 trillion CNY ($5.41 trillion USD).
In 2023, debt repayment pressure is anticipated to be as high as ¥5.1 trillion CNY ($710 billion USD). However, the refinancing bonds issued in the first three quarters of 2023 amount to only about ¥3 trillion CNY ($420 billion USD). This implies that an additional ¥2 trillion CNY ($280 billion USD) or so in local government bonds needs to be issued in the fourth quarter solely to meet the debt repayment requirements of local governments.
Additionally, as previously mentioned, local governments are facing a revenue/expenditure deficit of ¥5 trillion CNY this year. This also needs to be covered by issuing new bonds.
That means that a total of ¥3 trillion CNY in bonds must be issued in the fourth quarter alone. This translates to about ¥1 trillion CNY ($140 billion USD) per month, just to keep local finances afloat. In turn, this turn translates to significant debt repayment pressure.
On October 3, 2023, China's overnight borrowing rate soared to an annualized rate of over 50%. This was due to a liquidity crunch in the interbank lending market. The high rate signals a severe liquidity crisis in the market. China's local governments need to borrow money, but they will be facing enormous interest rates and severe competition for scarce funds.
Central Bank Collapse on the Horizon?
Look at the fourth column from the left in Table 2, headed "Refinancing Bond." Over the next two years, the amount of local debt due for repayment will still be around ¥4 trillion CNY ($560 billion USD). So, when the ¥5 trillion CNY ($700 billion USD) net revenue/expenditure deficit is factored in, the total annual bond issuance requirement will remain as high as ¥9 trillion CNY ($1.25 trillion USD).
The rollover debt in 2030 and 2033 is projected to reach ¥5 trillion CNY and ¥7 trillion CNY ($970 billion USD), respectively. Even at those future dates, the 5 trillion net revenue/expenditure deficit is projected to remain.
Considering the difficulties already faced this year in issuing local government bonds, it's hard to envisage how the government will manage the escalating debt repayment pressures.
Lao Man concludes that, unless the central bank, the People's Bank of China, resorts to unrestrained money printing, the Chinese financial system will struggle to survive through 2024 and 2025. Even if the central bank manages to get through 2025 and 2030 by printing money and inducing inflation, the situation in 2033 will be exceedingly challenging to handle.
According to Lao Man, it's unlikely that the central bank can sustain itself until 2033. According to Lao's calculations, 2030 is the theoretical deadline for the collapse of the People's Bank of China.
Urban Construction Funding in Chaos
However, Lao Man's analysis covers only official local government debt. What happens when we factor in the chaotic urban construction investment bonds?
Let us examine Table 3 for data on urban construction investment bonds.
The stock scale of urban construction investment bonds in 2014 was ¥4.86 trillion CNY ($680 billion USD). By September of 2023, that figure had escalated to ¥16.71 trillion CNY ($2.35 trillion USD). This represents a 2.4-fold increase over just nine years.
Table 4 provides projected future figures for urban investment bonds.
Although Lao Man's projections extend to 2040, he emphasizes that there's no need to look beyond 2024. His reasoning is that the urban investment bond model will become unsustainable by 2024.
Unsustainable Illiquidity
Why does Lao Man take such a pessimistic view? In the first three quarters of 2023, total urban investment bonds exceeded ¥4.5 trillion CNY ($630 billion USD). To manage the impending principal and interest repayments, nearly ¥7 trillion CNY ($970 billion USD) had to be issued in 2023. This indicates that an additional ¥2 trillion-plus CNY ($280 billion USD) must be issued in the fourth quarter.
However, in October, only ¥370 billion CNY ($50 billion USD) was issued due to increased auditing challenges. This placed a significant strain on local governments. Nearly ¥2 trillion CNY ($280 billion USD) remained to be issued in November and December, requiring an average monthly issuance of just under ¥1 trillion CNY.
The real difficulty will begin in 2024. That year will witness the large-scale maturity of previously issued urban investment bonds and the maturation of short-term bonds from 2023. The principal repayment scale of these bonds will enter China's financial system into an extremely hard phase. Repayment amounts are expected to exceed ¥8 trillion CNY ($1.13 trillion USD) in 2024 and surpass ¥10 trillion CNY ($1.41 trillion USD) in 2026.
This is why Lao Man asserts there's no need to project further out than 2024. Local governments will undoubtedly struggle to generate the required funds. The financial system overall lacks the liquidity to withstand this level of pressure. Something will have to give.
A Chinese Economy Drowning in Un-Repayable Debt
Table 5 merges data from both urban investment bonds and local government bonds.
For the first three quarters of 2023, as shown in the fourth row (labeled "2023.9"), the combined issuance of local debts has already reached about ¥11.7 trillion CNY ($1.65 trillion USD). This nearly matched the annual total of 2022.
However, to just barely meet 2023's requirements, a total of ¥17 trillion CNY ($2.39 trillion USD) must be issued by the end of the year. This severe debt repayment pressure will continue annually until 2030, escalating to approximately ¥18 trillion CNY ($2.53 trillion USD) by then.
This means that around ¥5.4 trillion CNY ($760 billion USD) still needs to be issued in the fourth quarter of 2023 alone. In October, a combined total of ¥1.6 trillion CNY ($220 billion USD) in local bonds and urban investment bonds was issued. Additionally, the central government issued ¥1 trillion CNY ($140 billion USD) in special national debt to address the shortfall in local finances, totaling ¥2.6 trillion CNY ($370 billion USD). However, this is still insufficient. An extra ¥2.8 trillion CNY ($390 billion USD) is required to navigate the immediate crisis and tide the bond market over through the end of 2023.
Even if this crisis is temporarily resolved, the system is unlikely to withstand the pressure in 2024. That year, the combined principal repayment pressure will surge to ¥12 trillion CNY ($1.69 trillion USD). This intense pressure will persist every year until 2030, increasing to around ¥18 trillion CNY ($2.53 trillion USD).
The Impossible 'Solution' of Rampant Inflation
The only feasible solution to China's financial trouble seems to be the central bank's printing money. Suppose China's central bank prints ¥10 trillion CNY ($1.41 trillion USD) of base money annually to assist local governments with debt repayment. With only a 4× money multiplier, this would result in over ¥40 trillion CNY ($5.63 trillion USD) of circulating money.
As of the end of September 2023, China's total money supply, M2, stood at only ¥290 trillion CNY ($40.75 trillion USD). Injecting more than ¥40 trillion CNY into this money pool within a year would have big consequences. Within less than two years, the renminbi could face destruction by the central bank itself due to rampant inflation caused by reckless money-printing.
Through meticulous calculations by Lao Man, the conclusion is that without urban investment bonds, China might struggle through the next three years. It would be a bare survival level, though, with China limping along on money printed from thin air. This situation could potentially last until 2030, which is viewed as the ultimate deadline for collapse.
'No Hope of Rescue'
However, the dilemma posed by urban investment bonds is like a noose around the Chinese economy's neck, capable of asphyxiating the system at any moment. No matter what the central bank does, 2024 looms as the most probable year for collapse.
Lao Man suggests some solutions. Elevating private enterprises to the same status as state-owned enterprises is one. He also suggests empowering the public to participate in and oversee government actions. But neither of these scenarios is likely to occur. If the Chinese Communist Party were to open the door to either capitalist innovation or public accountability, its very reason for existence would evaporate. All that remains, it would seem, therefore, is to quietly await the inevitable.
Lao Man's final conclusion was stark: "Fortunately, the wait won't be long. Local government debt will definitely explode within the next year, with no hope of rescue."
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Author: Jennifer Zeng
Find articles by Jennifer Zeng on JAPAN Forward. Follow her on X (formerly Twitter) and on her blog page, Jennifer's World.
