To better understand the development of LGD, we introduce the institutional background of LGD in China and a two-stage accounting model of LGD with 2014 as the watershed year in the appendix.
Appendix A.2. Categories of LGD
LGD refers to debts assumed by local governments (local governments refer to the general name of the governmental organization that manages administrative affairs of a country). Its full name is local people’s government. In China, it refers to people’s governments at all levels relative to the central people’s government, including the people’s governments established by provinces, municipalities directly under the Central Government, counties, cities, municipal districts, townships, ethnic townships and towns at all levels of government as debtors. Zhong and Lu [
54] categorized LGD into “broad-sense LGD” and “narrow-sense LGD” according to the subject scope. Narrow-sense LGD refers to debt borrowed directly by the local government and backed by the “full faith and credit” of the local government as part of local government on-budget liabilities to perform its functions and meet the needs of local economic and social development. Broad-sense LGD refers to debts assumed by local governments as public entities, in addition to traditional legitimate or contract-binding loans and bonds, including debts of local governments and institutions at all levels, local state-owned enterprises and implicit debts, such as pensions. Broad-sense LGD constitutes off-budget borrowing and mainly includes bank loans, BT (build-and-transfer), bond loans, trust loans, borrowing from other organizations and individuals, and other types of borrowing.
Local government-backed debt refers to debts directly borrowed, defaulted on, or supported with guarantees, buybacks or other credit by local governments (including government departments and agencies), government-subsidized institutions, public utilities, LGFVs, etc., for public welfare projects. According to the Audit Results of Nationwide Governmental Debts released by the National Audit Office of China at the end of 2013, local government-backed debt is categorized into three types: governmental responsibility for debt payment, governmental guarantee responsibility and governmental rescue responsibility. All three types are required to be incorporated into budget management, and it is clear that “government-backed debts” do not include implicit debt.
The term “implicit LGD” first appeared at a Central Political Bureau meeting held on 24 July 2017. On paper, so-called “implicit LGD” is not part of local government-backed debt but rather a product of noncompliant operations (e.g., guarantees, issuance of commitment letters, etc.) or disguised debt (pseudo-public–private partnership, debts packaged as government purchases, etc.). At present, there is no uniform standard or defining criteria for implicit LGD, and it is unclear how to dispose of it in the future and whether it can be transformed into explicit LGD through a new round of screening.
LGBs are bonds issued by local governments. Specifically, they refer to bonds issued and repaid by the central government on behalf of local governments between 2009 and 2014 (there are also some pilot programs where bonds were issued by local governments themselves and repaid by either the central government or by themselves) and bonds issued and repaid by local governments themselves since 2015. LGBs have gone through three stages, as shown in
Table A1.
Table A1.
Three stages of LGBs.
Table A1.
Three stages of LGBs.
Stage | Issuing Scope | Issuer | Obligor |
---|
1 | Provincial governments (including the governments of municipalities listed separately in the state plan) | Ministry of Finance | Ministry of Finance |
2 | Six pilot regions: Shanghai, Guangdong, Zhejiang, Shenzhen, Jiangsu and Shandong | The six pilot regions | Ministry of Finance |
3 | Ten pilot regions: Shanghai, Beijing, Guangdong, Jiangsu, Shandong, Zhejiang, Jiangxi, Ningxia, Shenzhen and Qingdao | The 10 pilot regions | The 10 pilot regions |
Municipal corporate bonds (MCBs) refer to debt financing instruments issued by qualified (i.e., eligible for standardized business) LGFVs. They include corporate bonds, debt financing instruments for nonfinancial enterprises in the interbank bond market (medium-term notes, short-term financing, asset-backed notes, principal protected notes, etc.), private placement bonds and asset securitization. As the data of MCBs are openly available (e.g., from the Wind database), the term is frequently used in LGD studies.
The new Budget Law explicitly categorizes LGBs into general obligation (GO) bonds and revenue bonds. GO bonds are issued by local governments to relieve financial constraints or address temporary funding shortfalls. Usually, they are secured by the region’s fiscal revenue, so defaults are rare. The funds raised are often used to build highways, airports, parks, municipal facilities and other public welfare projects, which generally do not generate revenue. GO bonds are payable from and managed under the general public budget (that is, revenue mainly collected from taxes and spent on social, security and local institutional improvements).
Revenue bonds are issued by the governments of provinces, autonomous regions, and municipalities directly under the central government (including the governments of municipalities listed separately in the state plan) for public welfare projects with specific revenue streams. Revenue bonds are payable from earmarked government funds or proceeds from the bonds. Revenue bonds are managed under the government’s fund budget. The Notice on the Pilot Local Government Revenue Bonds with Self-balancing Revenue and Financing, issued in 2017, stipulates that pilot revenue bonds are to be repaid by earmarked government funds or fees collected from the users of the services associated with the project financed through the bond issue. The Notice specifies the sources of funds for debt servicing of the projects. It also explores the “closed” operation and management of different types of local government revenue bonds, which is conducive to locking the risk of revenue bonds and effectively protecting the legitimate rights and interests of investors.
Public–private partnership (PPP) is a project operation model involving collaboration between a government agency and a private-sector company that can be used to finance public infrastructure. PPP was introduced in China in 2013. Over the years, it has achieved remarkable results in strengthening weak links, improving quality and efficiency in the public sector, bridging the investment and financing gap in the infrastructure sector, and encouraging the development of intensive and innovative industries. The central government of China requires that the operating subsidies of PPP projects be fully linked to an evaluation of their performance. The government shall not be an “unconditional obligor” of PPP debts, and standardized PPP contracts signed according to the law will not increase LGD. If the government were to fail to fulfill its expenditure responsibility, in part or in whole, then this would constitute a default of government expenditure responsibility; however, this is not an implicit LGD. However, if the government has no extra financial resources, then fulfilling the expenditure responsibility of a new PPP poses a threat to financial sustainability and the government’s credibility. Under such circumstances, the government would not have the ability to fulfill the PPP contract and would not meet the legal attributes of the contracted expenditure responsibility; therefore, such a case would constitute implicit LGD. In addition, if the total amount of PPP projects were to get out of control or the expenditure responsibility fail to match the current financial capacity leading to delayed payment or default and PPP project failure, then the government would have to bail the project out. Such cases would add to implicit LGD [
24]. In summary, this paper defines “implicit LGD caused by PPPs” as being the result of government default due to the mismatch between expenditure responsibility and current financial resources.
Many local governments set up LGFVs to raise funds, largely because the reform of the tax-sharing system and the restrictions on LGDs imposed by the former Budget Law limited local governments’ financial resources. The bonds issued by LGFVs in the name of corporate bonds add to implicit LGD. To control the scale of implicit LGD and prevent systemic risks, the central government issued details in the No. 43 Document, which for the first time proposed to “repair the open channel, block the back channel, and give local governments the authority to borrow in accordance with the law”. The No. 43 Document specified that to “distinguish the responsibilities of the government and the business, local governments shall not borrow via LGFVs, and corporate debt shall not be repaid by local governments. He who borrows shall repay”. Since the No. 43 Document was issued, a series of policies have been adopted to “open the front door” and “block the back door”. In addition to putting strict controls on implicit LGD in place to avoid irrational borrowing, the Chinese government has also stepped up its countercyclical adjustment efforts to draw a clear line between the government and the market, encourage market-based financing in accordance with the law, increase effective investment, promote a virtuous cycle for economic growth, and enhance the quality and sustainability of economic and social development.
Figure A1 presents the impact of the changes introduced by the No. 43 Document on the accounting of LGD. The nature of the LGD entirely changed over the five years to 2014. Before 2009, only the “back door” was open, and LGD was mainly borrowed through LGFVs, which included debts for which local governments had repayment responsibilities and debts for which they had guarantee and rescue responsibilities. From 2009 to 2014, both the “front door” and the “back door” were open; while pilot LGBs were extensively issued, corporate bonds issued by LGFVs were increasing rapidly. After 2014, the “front door” remained open, while the “back door” was gradually closed. The issuance of the No. 43 Document, therefore, made 2014 a watershed year.
Figure A1.
Schematic diagram of the accounting basis for LGD under different institutions.
Figure A1.
Schematic diagram of the accounting basis for LGD under different institutions.
This overview of the institutional changes and categories of LGD provides theoretical support for a comprehensive and deep understanding of the LGD issue and for scientific calculation of LGD in China. However, for a long time, local governments in China did not have legitimate debt raising claims and could not explicitly incorporate financial deficits, so accurate statistics were not available (Zhong and Lu, 2015) [
54]. Existing studies are mainly based on estimates or substitute indicators; this is insufficient for accurately understanding and managing LGD and does not provide a solid scientific basis for future research. We need accurate and authoritative data to inform studies of LGD.