Source: Cailian Press, Minsheng Securities
Author: Tao Chuan Zhong Yumei

The financial suspense that the market has been eagerly anticipating was unveiled at the NPC Standing Committee meeting held today. Since the deployment of the "926" Politburo meeting, Minsheng Securities expects that the additional efforts in finance are likely to follow the "two-step" principle: the first step is to focus on "debt-to-equity" within the year, prioritizing reducing the burden on local governments; the second step is to look to next year to boost domestic demand and stimulate consumption. Therefore, whether it is the newly added 3-year 6 trillion or the total 10 trillion, the new debt-to-equity policy is undoubtedly the core content of the current financial policy.

However, from a short to long-term perspective, the implementation of the new round of "debt-to-equity" plan also opens up space for more powerful financial measures to be implemented in the next step. As previously mentioned by Minsheng Securities, only when local governments no longer practice subtraction on the asset-liability side, more incremental policies can achieve the effect of addition. Minsheng Securities predicts that at the Central Economic Work Conference to be held in December, guidance will be given on how to leverage central finances next year to expand domestic demand.

In response to the 10 trillion debt-to-equity policy announced today, an attempt is made to clarify the policy context behind it through five questions:

Q1: How to define the scope of implicit debts?

The category of hidden debts is not simply determined by financing channels. It is not entirely accurate to include local government financing platforms, public-private partnerships (PPP), government purchasing services, government investment funds, local commercial banks, and state-owned enterprises' unauthorized financing as hidden debts. The most important thing is to determine whether the funds are endorsed by the government and whether they belong to normative borrowing (i.e., whether they are within the legal government debt limit). Debts that are endorsed by the government and exceed the legal government debt limit constitute non-normative debts outside the legal government debt limit.

Taking PPP as an example: only non-compliant projects will be included in hidden debts. PPP projects operated in accordance with national policies do not actually fall into hidden debts with long-term fiscal expenditure. More of the hidden debts fall into the category of unauthorized borrowing and financing through methods such as build-transfer-operate, disguised debt as equity, local government commitment to guarantee or repurchase principal, where almost all risks are borne by the local government.

In addition to local government financing platforms, PPP, government investment funds, some hidden debts may be even more 'invisible and intangible.' What can easily be overlooked is that parts of the expenditures incurred by local governments due to unexpected events (such as major public events, natural disasters, difficulties in local financial institutions or state-owned enterprises' operations, etc.) may also form hidden debts, but these hidden debts are often more difficult to quantify. For example, in 2020, multiple local governments reported cases of hidden debts formed by unauthorized borrowing for reasons such as the pandemic.

In hidden debts, local government financing platforms account for nearly half. The hidden debts generated by local government financing platforms account for approximately 49.4%, while the other half of hidden debts mainly stem from PPP projects (27.8%), unauthorized debts of local state-owned enterprises (12.2%), government purchasing services (10.4%), and so on. Given that local financing platforms account for the 'lion's share' of hidden debts, the market tends to focus on urban investment platforms when analyzing the situation of hidden debts.

Q2: Which method of debt restructuring is the most effective?

How to support local government debt restructuring? The Ministry of Finance 'officially' recommends six debt restructuring methods - fiscal budget, debt restructuring, project operation, asset realization, enterprise debt transformation, bankruptcy liquidation. The first two methods mainly rely on government coordination, while the latter four methods are mainly carried out through enterprise's own operations or debt transformation.

Different debt restructuring methods may each have their own advantages. Looking at outstanding cases over the past few years that have alleviated the debt burden of local government financing platforms, most local governments have adopted a 'tailored' approach to debt restructuring. For example, debt restructuring paths such as the 'Zhenjiang Model,' 'Baijiu Debt Restructuring,' and 'Kanglv Model' all have strong local characteristics. The debt-to-equity swap used in the 'Zhenjiang Model' is based on the stronger economic power and more debt restructuring resources of Jiangsu Province; the asset realization used in the 'Baijiu Debt Restructuring' is based on the strong strength of regional state-owned enterprises. These outstanding debt restructuring cases have low replicability for regions with slightly weaker comprehensive strength.

If there are sufficient debt restructuring resources, debt restructuring may be the fastest way to see results. Looking at recent debt restructuring practices, the most commonly used debt restructuring methods by 'officials' are debt-to-equity swaps and debt extension, which make debt restructuring effective quickly by 'trading time for space.' Since 2015, the four rounds of debt restructuring have basically been 'fully rolled out' in the form of debt restructuring. Given the current situation, this round of debt restructuring may also focus mainly on debt restructuring.

Debt restructuring, which explicit debts are used? Before answering this question, let's first categorize the types of local government bonds - China's local government bonds can be classified in two ways: according to the source of funds for debt repayment, they can be divided into general bonds and special bonds; according to the use of funds, they can be divided into new bonds, replacement bonds, and refinancing bonds. These two major categories of bonds can be further paired, such as replacement bonds can be divided into replacing general bonds and replacing special bonds.

However, not all local debts can be used for debt restructuring. The three main types of local explicit debts that can be used for debt restructuring are:

First, replacement bonds (both replacing general bonds and replacing special bonds can be used to replace the general debts and special debts of local governments);

Second, special refinancing bonds (ordinary refinancing bonds are mainly used to repay the principal of maturing local government bonds, while special refinancing bonds are mainly used to repay the existing debts of local governments, which can be seen as a substitute for replacement bonds. Both special refinancing general bonds and special refinancing special bonds can be used for debt restructuring);

Third, special new special bonds (ordinary new special bonds are mainly invested in infrastructure, while starting from 2024, new special bonds began to tilt towards debt restructuring, and this part of new special bonds is referred to as special new special bonds).

From the changes in the direction of special bonds, traces of a new round of debt restructuring can also be seen. In the past, new special bonds were mainly invested in infrastructure, so the scale of new special bonds issued can roughly indicate the vitality of infrastructure in the next few months. However, since this year, the predictive role of new special bonds in infrastructure investment has been ineffective, mainly due to a breakthrough in the restrictions on the use of funds from new special bonds, leaning more towards debt restructuring. According to the content of the Standing Committee of the National People's Congress, from 2024 to 2028, 800 billion yuan of new special bonds will be added to the debt restructuring efforts each year.

Q3: How many rounds of debt restructuring have been carried out in history?

Since 2015, China has carried out a total of four rounds of debt restructuring. The first two rounds were conducted in the form of replacement bonds, the third round was in the form of special refinancing bonds, and the current round of debt restructuring is based on special refinancing bonds, adding the tool of special new special bonds for debt restructuring. Specifically:

The first round (2015.05-2018.12): After the new Budget Law, the substitution bonds took the stage of "historical drama". Since the 2008 "Four Trillion" plan, local governments started large-scale financing through urban investment platforms, laying the foundation for hidden local debts. After the introduction of the new Budget Law in 2015, local governments and their departments are not allowed to borrow or provide guarantees in any "non-official" way. At the same time, the financing platform government financing function was stripped off, officially launching the "first shot" of debt conversion. A total of 12.2 trillion yuan of substitution bonds were issued between 2015 and 2018, successfully transforming large-scale high-cost debts into government bonds with longer maturities and lower interest rates. This is also the largest scale of debt conversion by far.

The second round (2019.06-2019.12): Continuing to use the form of substitution bonds, but this time it was more "regionalized". Compared to the previous round's "comprehensive deployment", this round of debt conversion pays more attention to "point-to-face"——In 2019, the Ministry of Finance selected six provinces and adopted a competitive project approval method to select some counties and cities in these provinces for debt risk resolution pilots. Although the scale of the substitution bonds involved in this round of debt conversion is relatively small (only 0.16 trillion yuan), it has greatly eased the liquidity pressure of some rear-end regional governments.

The third round (2020.12-2022.06): Special refinancing bonds become the "substitute" for substitution bonds. As mentioned above, local governments may also generate hidden debts due to unexpected events, so the scale of hidden debts at the local level may marginally increase during public health emergencies. After the impact of the first wave of public health emergencies subsided, Jiangsu Province took the lead in action in December 2020 and became the first to issue special refinancing bonds used to repay government outstanding debts.

In this round of debt conversion, the early stage (2020.12-2021.09) focused more on expanding the pilot program for resolving hidden debts in counties and districts and assisting in debt conversion in high-risk areas; the later stage (2021.10-2022.06) focused more on implementing comprehensive pilot programs without hidden debts in first-tier cities, among which Beijing, Guangdong, and other regions successfully achieved the zero hidden debt plan in this phase of debt conversion work.

The fourth round (starting from October 2023): Special refinancing bonds make a comeback, along with the silent addition of special newly added specific bonds. Since the July 2023 Political Bureau meeting proposed to "formulate and implement a comprehensive debt conversion plan", special refinancing bonds resumed in October, and intensive issuances began. However, compared to before, the special feature of this round of debt conversion is the addition of special newly added specific bonds to the "large regiment" of debt conversion. Including the 10 trillion yuan of newly added debt conversion resources by the Standing Committee of the National People's Congress, Minsheng Securities estimates that the scale of this round of debt conversion can reach 12.1 trillion yuan.

Q4: What is the policy context of the new debt conversion policy?

What form? Debt conversion (special refinancing bonds + special newly added specific bonds) as the main approach. The Ministry of Finance has increased the local debt ceiling at the Standing Committee of the National People's Congress (2 trillion yuan per year from 2024 to 2026, totaling 6 trillion yuan), increased the amount of newly added specific bonds for debt conversion (0.8 trillion yuan per year from 2024 to 2028, totaling 4 trillion yuan), indirectly providing an answer to this issue - the new round of debt conversion is mostly carried out in the form of debt conversion. Not only because the urgency of debt conversion is increasing, and debt conversion happens to be the fastest way to see results in debt conversion; but also because the possibility of relying on local governments, local financing platforms, and local state-owned enterprises' funds to conduct debt conversion is decreasing as the local economy has not fully recovered.

How much effort? The annual progress of 2-3 trillion yuan in debt conversion is the "standard answer". Judging from the "Ten-Year Debt Conversion Plan" proposed in 2018, local government hidden debts need to be successfully resolved by 2028 at the latest. The Ministry of Finance first announced that hidden debts in 2023 amount to 14.3 trillion yuan, which means that the scale of hidden debts needing to be resolved annually in the future is approximately 2-3 trillion yuan.

What is the significance of the National People's Congress Standing Committee increasing the assets allocated for debt conversion to 10 trillion yuan? As of October, the cumulative issuance scale of special refinancing bonds and special additional special bonds was only 1.2 trillion yuan. Compared with the standardized debt issuance progress of 2-3 trillion yuan per year, it is evident that this year's debt conversion efforts are still insufficient, hence the need for more explicit debt available for debt conversion to provide support.

However, before the National People's Congress Standing Committee increased the local debt ceiling, the explicit debt available for debt conversion was insufficient. China implements quota management on the balance of local government debts (i.e., the balance must be controlled within the limit, and the difference between the limit and the balance is the limit space). The local debt limit space is the maximum amount of special refinancing bonds and special additional special bonds that can be issued.

According to calculations, before the National People's Congress Standing Committee formally raised the local debt ceiling, China's local debt limit space was about 1.6 trillion yuan. If this 1.6 trillion yuan is fully used to issue special refinancing bonds or special additional special bonds to support this year's debt conversion work, then this year's debt conversion progress would just meet the standards and would lead to a shortage of debt conversion resources in the future.

To increase the intensity of debt conversion in the future, the most important first step is to break through the 'ceiling' of explicit debt issuance available for debt conversion. This is also the main reason for the National People's Congress Standing Committee to increase the debt limit by 6 trillion yuan over three years in November. Considering that special additional special bonds already have a dedicated quota of 4 trillion yuan over five years, Minsheng Securities believes that the 6 trillion yuan limit space may be tilted more towards special refinancing bonds.

Q5: After the new debt conversion policy is implemented, what is the economic impact?

The 'benefit' to people's livelihood could largely offset the 'harm' to infrastructure. One of the main sources of funding for local government infrastructure investment is local financing platforms. Therefore, when the debt conversion cycle opens and urban investment financing is restricted, it usually leads to a weakening trend in infrastructure investment growth. The continuous lag in investment growth in key debt conversion provinces and cities since 2023 compared to the national level also indicates the negative impact of debt conversion on local project construction. However, focusing solely on infrastructure cannot outline the full picture of the economic impact of debt conversion; the impact on people's livelihood security also needs to be considered comprehensively.

For residents, after reducing the pressure of local governments to repay principal and interest, there will be more financial resources available to tilt towards people's livelihood, which can help restore residents' confidence. This also explains the 'zero-sum game' effect between debt interest expenditure on the fiscal side and expenditure on people's livelihood. For businesses, from a micro perspective, the current debt scale in the construction industry is relatively high, and the large-scale start of debt conversion work may improve the situation of enterprise debt repayment.

Risk Warning: Discrepancies may exist between estimated and actual scale of hidden debts; future debt conversion efforts may fall short of or exceed expectations; unexpected methods of debt conversion may arise in the future.

Editor / jayden