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The debt crisis at China’s local governments will be top of the agenda when China’s leaders gather in Beijing for the annual parliament next week.m (The nation’s legislators and top leaders meet from this Sunday to approve key economic targets for 2023, including a new local bond quota, the budget, and also monetary policy.)

A majority of regional governments — at least 17 out of 31 — are facing a serious funding squeeze, with outstanding borrowing exceeding 120% of income in 2022, according to Bloomberg. The outstanding local government debt exceeded 35 trillion yuan ($5 trillion) as of the end of last year. That total doesn’t include off-balance sheet borrowing via local government financing vehicles. This “hidden” debt could be more than twice as big as official local liabilities, according to Guosheng Securities told Bloomberg. Local governments repaid 3.9 trillion yuan in bond principal and interest payments last year just on their official debt. (Most of the official debt of recent years is in the form of special bonds primarily meant to pay for infrastructure investment.)

The implications are very negative for the Chinese economy. It’s unlikely that Beijing will let any local government default, the high debt level and the burden of interest payments could force some regional governments to scale back spending. Local government “infrastructure” spending is a major tool for stimulating the economy and creating new jobs. Beijing is considering setting a special bond quota of 3.8 trillion yuan this year, Bloomberg News reports, less than the actual issuance in 2022.

Any slack from local governments would push the central government to spend more. This might be a problem since the government’s deficit soared to a record in 2022. A broad measure of government income contracted last year for the first time since at least 2012 due to Covid disruptions, the property slump, and record tax breaks. One option to plug the funding gap would be for the central government to borrow more and increase its transfers to the regions, thereby reducing the need for local governments to take on extra debt. Beijing can borrow more cheaply than local authorities and its balance sheet is much healthier.

The high debt level and the huge interest burden could also prompt the People’s Bank of China to keep interest rates. Which would be good for China’s GDP growth rate, but bad for the price of the yuan. (A yuan under pressure would force Beijing to spend reserves to support the currency or risk an increase in inflation, which is already at levels that worry government financial officials.)

Lower interest rates from the People’s Bank would also cut financing costs for local governments and improve their spending power, Zhang Bin, a researcher at state-run think tank the Chinese Academy of Social Sciences. Assuming the entire government sector’s liabilities are 82 trillion yuan, every 1 percentage-point cut to policy rates could reduce interest payments by 160 billion yuan.