What is the role played by the local governments in China’s property eco-system, and how should investors think about the risks posed by China’s local governments as the property market weakens? The local governments have indeed dramatically increased their liabilities in the past decade: total liabilities owed by the local governments are around 54 percent of GDP, compared to China’s sovereign debt of only 22 percent of GDP. There were political and economic reasons behind the sharp rise in local debt in recent years. In any case, the dominance of the property cycle in China’s economy has led to local governments having become reliant on land sales. A cooling off in this sector has exposed the imbalances and vulnerabilities in the local governments’ fiscal positions. Contrary to popular presumption, we believe the problems facing the local governments can be resolved, even if the solution is not simple and will entail major changes in the way the local governments are run. Of the 30 percent GDP worth of problematic debt associated with the property sector, it is possible that half of that, we guesstimate, will eventually end up being fiscalised. But a 15 percent GDP increase in China’s public debt would be on par with the step increases in the debt-to-GDP ratios of both the EU and the US in recent years, and not comparable to what Japan sustained in the years following the bursting of its property bubble in 1990. We believe this fiscal setback is manageable for China and could inspire a wholesale improvement in how the local governments operate. For the local governments, the slowdown in the property markets in China is not a crisis but an opportunity, in our view.

The full report contains the following sections:

• What is the size of local government debt (LGD)?
• Why have local governments issued LGFVs?
• Who are the creditors of LGDs and LGFVs?
• Why are LGFVs a problem now?
• What is the relationship between China’s central and local governments?
• Is there a wide variance between the various local governments?
• What is the source of revenues for the local governments?
• What might happen if land sales can no longer support local governments’ budgets?
• What remedial policies might the central government take to address the issue of local government debts?
• How much assets do the local governments have?
• Might the fiscal challenges of the local governments undermine the effectiveness of the policies of the central government?
• Bottom line

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