Understanding the Risk of China's Local Government Debts and its Linkage with Property Markets

Abstract

Unlike local governments in western countries, local Chinese governments are prevented from directly issuing debt to fund mandated capital projects. As a result of recent fiscal stresses and restrictions placed on local governments, China has developed a unique funding source, known as Local Government-Backed Investment Units (LGBIUs), that allow local governments to obtain capital necessary to fund large-scale infrastructure investments. However, unlike traditional municipal debt in western countries, the Chinese investment units are not able to use tax revenues to fund coupon or principal payments. Thus, local governments tap into the growing housing market by selling public land to fund the investment units coupon and principal payments. As a result of this unique mixing of local governmental fiscal policies with local housing markets, a substantial drop in housing or land prices may increase the risk level of local government debt, or even trigger a systematic default. We present an analysis of the risk associated with these bonds and demonstrate that local housing price risk is priced in the bond yield spreads.

Keywords: China municipal bonds, fixed-income securities, house prices, China development

JEL Classification: G12, G15, G18, H54, H7, R5