Debt-fuelled growth in China and local government indebtedness: The consequences of an unbalanced economic growth model

The Chinese economy has experienced strong economic growth for more than four decades since the implementation of the Open Door Policy in 1978. The local governments of the Chinese provinces played a decisive role in implementing the ambitious development goals envisioned by the central government. In particular during economic crises, local governments were responsible for turning the massive monetary and fiscal stimuli into economic growth. Indeed, they were quite successful in steering the Chinese economy during the Asian Financial Crisis in the late 1990s and the Great Financial Crisis (GFC) in the late 2000s by maintaining strong economic growth. To counter economic downturns, the Chinese leadership and local governments heavily relied on large-scale public and industrial infrastructure projects as well as on the booming real estate sector. This decades-long lasting growth miracle was heavily financed by debt. By the end of 2024, the debtto-GDP ratio of the Chinese economy had reached a staggering 290 percent. Especially the debt accumulated by local governments and their implicit debt hidden in so-called local government financing vehicles (LGFVs) have proven to be problematic. Since the 1994 budget law and tax-sharing reforms, the financial leeway for local governments to acquire funds for their extensive public expenditures had been severely limited. The legislation curtailed the fiscal revenue streams for local governments and prohibited them from issuing bonds and from running any deficit. Therefore, local governments established LGFVs, which enabled local governments to fund their public expenditures aside from their official balance-sheets. The number of LGFVs and their associated debts blew up ever since the Great Financial Crisis in 2008. The Covid pandemic then marked the breaking point for the debt-fuelled Chinese growth model and revealed the vulnerability of the LGFV system. Consumer confidence and private consumption eroded, the booming real estate sector imploded and land sales revenues for local governments plummeted. In consequence, the financial backbone of LGFVs and their debts became fragile raising concerns about financial stability. These worries are particularly pronounced given the staggering scale of both on- and off-balance local government debt. By the end of 2024, official local government debt had reached close to 48 trillion RMB and LGFV debt was estimated at more than 60 trillion RMB. The current local government debt crisis is the legacy of an in parts failed growth model focused on infrastructure development. It calls for a shift towards a more balanced growth model with a heightened role for domestic private consumption in the Chinese economy. Now, the Chinese leadership must manage the risks for financial stability originating from local government and in particular LGFV debt. In the near future, it must then set the course for an overhaul of the economic growth model by implementing a range of structural reforms improving the coverage of and the access to public social services such as a gradual liberalization of the hukou system and a basic social security coverage. Additional relevant measures include an improved provision of financial instruments suitable for private social security.