LGFVs: The Path Forward
LGFVs: The Path Forward
Restructuring and reform considerations
We head into the home stretch on this ongoing series of deep dives into local government financing vehicles (“LGFVs”) in China and related themes:
The previous essay took a detour to examine the case study of Korean chaebols from the 1990s and how a currency and liquidity crisis (the Asian Financial Crisis, or “AFC”) provided them impetus to force major corporate governance reforms on the conglomerates that ultimately led to a “leveling up” of the economy over the following two decades.
In a similar way, LGFVs today are currently in a slow-motion version of the AFC, one that was — unlike the exogeneous currency crisis — largely self-induced by the impact of the financial regulator’s tightening on the real estate sector in August 2020. Looking at the Chinese economy holistically, in a previous essay I highlighted how LGFV assets tend to sit at the “bottom of the barrel”, meaning that the private sector and national state-owned enterprises (“SOEs”) are relatively healthy with strong balance sheets, current malaise notwithstanding.
In this essay, we will discuss the path forward for the local government sector, first by defining the problems that it faces and then discussing potential solution approaches. Let’s start by first talking about how the role of local governments itself will likely evolve in the coming decades.
The “Mayor Economy” and the evolution of the role of local governments over the next decade
For the last two-plus decades, local governments have played a critical role as the gatekeeper in the development of land, part of what has been arguably the most significant development trend for the Chinese economy: urbanization. As Keyu Jin describes the “Mayor Economy” in her recently published book The China Playbook:
“Pioneering local government officials have rushed at a frenetic pace to expand their local economies, transforming former fishing villages and farmland to technology hubs and industrial centers. These officials vie with each other for primacy in everything from economic growth to foreign investment, from the number of industrial, trade and horticultural exhibitions to the size of cultural events like concerts and film festival.”
We know from past precedents that rapid urbanization eventually ends. But how do we know how much urbanization is left for China? One way is to look at the experiences of South Korea and Taiwan, as they are probably the two “cleanest” and most comparable historical examples of this for China.
China’s rapid urbanization phase started about three to four decades after South Korea and Taiwan. Both South Korea and Taiwan urbanized rapidly, growing near-linearly at an average of 1.7% and 1.4%, respectively, in the roughly two decades after they reached 36%. After reaching betwen 75-80% urbanization rates, urbanization growth rates slowed considerably, averaging <0.5% per year in the subsequent two decades.
This would suggest that China has about another decade left of rural-to-urban migration until it reaches around 75%. This means another 150-200 million people will still be moving into urban areas at a pace of around 15-20 million people per year which is moderately slower than the pace of the last three decades1. 2021 and 2022 were impacted by the pandemic and the “Three Red Lines” liquidity tightening in August 2020. Based on historical precedents, we can expect a moderate decline in the pace of urbanization for the next decade — and there probably will be some pent-up demand that manifests over the next couple years as regulators loosen up after almost three years of tightening.
Infrastructure is the other large multi-decade trend that has involved land-finance and local governments. Similar to urbanization, there is still at least another decade left of historically elevated construction and corresponding gross capital formation. For example, the current plan for the high-speed rail network is to increase from the current 43,000 kilometers to 70,000 kilometers by 20352. In recent years, the pace of investment in urban metros and regional rail systems has been even more intense than HSR.
As we enter the 2030s, the pace of land-centric construction activity will fall off and the role of the local government will have to evolve. In mature economies, local governments typically focus mainly on local activities like schools, hospitals, safety and city services. Land-related activities (e.g. zoning) will continue to be a responsibility, just much smaller.
I expect local governments in China to also naturally evolve in this direction. This would inevitably change the composition of local government finances and the eventual reduction in the scope of LGFVs as well as long-discussed changes in the hukou system. We can speculate about the pace and timing of such a transition but these end goals are fairly clear.
Solvency vs. Liquidity
Timing is one thing, but can China afford to make this transition? In the first essay of the series, I threw out two critical questions that needed to be answered out of this exercise:
Is this a solvency or liquidity issue?
Who pays for the social costs?
The tongue-in-cheek response to the first question is a resounding “yes”. If you examine at the asset or project level, the majority of LGFV assets appear to be financially impaired, which would suggest a solvency issue. The degree of impairment matters — when your equity cushion is 38%3, there is a significant difference between assets being impaired 15% and 50%. But on this question of degree, I do not presently have a good answer for you because I do not have access to the underlying data needed to make this assessment. The only way to precisely determine this answer is to perform an exhaustive set of “fresh look” assessments on trillions of dollars worth of assets.
Zooming out and examining it from a national perspective, it is very clear that this is not a solvency issue. The national SOEs are large, well-run with market values that generally exceed the recorded book values of their assets ($30 trillion). Even in an extreme scenario4 where local government assets of $23 trillion5 were impaired by 50%, between the national and local governments, you still have sufficient asset coverage on $9 trillion in LGFV debt.
Ultimately, the crux of the matter revolves around the second question concerning the losses — it is not a question of whether the losses can or will be covered but how. The central government has the resources and local governments need financial support — this has been the way the administrative system has functioned since the 1990s. Resolution hinges on the dynamics and cooperation between the central government and local authorities.
One (admittedly imperfect) analogy to conceptualize the Chinese bureacracy is as vast and decentralized conglomerate where Corporate (the central government) manages far-flung branch offices (local governments). Borrowing from one of my all-time favorite shows, The Office, there is an adversarial relationship between corporate and the branch offices with corporate playing the role of the responsible adult (David Wallace) and the branch offices playing the roles of the entreprenuerial, less-dicisplined children (Michael Scott).
“How?” is a much more complicated question and requires looking into the problems at an individual level. Each asset, particularly those dealing with financial problems, needs to be assessed or audited. Coming out of this analysis should be a plan on how to deal with the assets, if necessary. And by looking for patterns across thousands of these assets, policymakers and reforms will be able to figure out what went wrong and how to address these in the next round of local government reforms.
“Fresh Look” assessment on $23 trillion worth of assets
Much of the commentary I have seen on local government (or broad Chinese economic) issues exists at too high a level to be useful in formulating practical solutions. What does it actually mean in practice to “unshackle the economy and stimulate consumption”? That type of high-level commentary is not helpful to policymakers that need to figure out detailed, practical solutions to very specific real-world issues.
Instead, issues need to be identified at a deeper level than just “there’s too much investment and debt”. It needs to recognize that there have been a variety of assets created with a range of outcomes from the good to the mierda. Policymakers need the right frameworks to guide the restructuring and reform process and ultimately tailored approaches with assets at the individual project level.
Different asset types require differentiated restructuring solutions. Dealing with real estate assets that are stuck in work-in-progress construction requires a different approach from real estate assets that are intended to be held on the balance sheet. Dealing with an infrastructure asset like an under-performing highway is very different from managing an eco-tourism development or amusement park.
In a previous essay in this series, we discussed the use of “Economic RoI” to determine one measure of asset and project performance. There we started from a high level and successively applied the framework at deeper levels. At the individual project level, the framework would be applied by evaluating its individual performance in a “fresh look” analysis and then diagnosing the reasons for project success or failure.
In private equity, these “fresh look” assessments are a common way of managing a portfolio of assets and similar, modified approach can be used for this massive portfolio of LGFV assets. The key difference is that these projects need to be evaluated based on both financial and social factors vs. private equity where the primary stakeholder is the equity owner. In the context of economic development, the stakeholders include the entire spectrum of society.
This is what a summary of such “fresh look” analysis might look like at the project level:
The above is the summary of a project assessment (illustrative only) of the Guiyang-Guangzhou HSR project (“GuiGuang HSR”). A detailed assessment would look more like this World Bank implementation report from 2017. The GuiGuang HSR project happened to be one of the more successful HSR projects. A less-successful project in another sector (e.g. a failed real estate development) would look different and generate a different set of recommendations.
Multiply this assessment across tens of thousands of projects6 and one can start accumulating a nice catalog of case studies of all the problems that need to be fixed. This is the type of work that is currently ongoing, undertaken by Chinese creditor banks, auditors and teams from the policymaking bodies. I expect that many of the issues that arise are typical of those that we find in conglomerates around the world.
LGFVs are conglomerates and deal with typical conglomerate issues
Imagine, if you will, that all of the LGFVs were grouped together under one organization as a large conglomerate. To a certain degree this reflects reality:
LGFVs are all affiliates of one another by virtue of being state entities
LGFVs draw on implicit guarantees from the state to raise financing
LGFVs often lend and borrow from each other and co-invest together on projects and operating ventures
If one were to combine the balance sheets of all the LGFVs, this is what it might look like:
On the righthand side, I have annotated the balance sheet with descriptions of the major asset categories that sit within LGFVs. In the “LGFV conglomerate” think of each asset category as a focused division. Each division will have to formulate its own operational improvement strategy.
Restructuring and reform
In the last essay, I described some of the longitudinal problems that Korean chaebols faced in the 1990s and how LGFVs face similar problems today. The experience of the chaebols can serve as a guidepost for LGFV reform. Capital efficiency can be improved by:
Re-structuring: Re-organizing the existing assets that have been created to be better managed
Reform: Improving the capital and resource allocation decision-making process going forward
Re-structuring and reform are related. For example, re-organizing assets into more discrete categories will also create new market players that can be utilized to improve capital allocation going forward. Financial sector reform, particularly the use of newer types of specialized financing mechanisms like REIT-like structures, will help in the re-structuring process by providing fresh capital to unlock liquidity.
Restructuring: the over-arching need for greater focus
History (e.g. Korean chaebols in the 1990s) has shown that as conglomerates get larger, their economic advantages are eroded away by the burden of managing an increasingly diverse array of assets. A key goal for reform will be introduce greater focus around differentiated business models.
The business model groupings above provide guidelines, with different operational improvement approaches for different types of assets:
Financial intermediary / investment holdings — Similar to a bank or financial institution, this grouping represents assets primarily listed under “Financial and Other” on the aggregate LGFV balance sheet above that are net off against associated liabilities on the debt side7. Ideally LGFVs should not be in the business of acting like unregulated banks: lending and borrowing money, holding a portfolio of investments and assets using public money. This activity can be done more effectively by the formal banking system or dedicated investment funds. Regulations need to be tightened up to clarify this type of financing activity at LGFVs (more on this below under “Reform: working capital”).
Structured asset-backed warehousing — This division represents the role that local governments play as a gatekeeper on land development. While there is still another decade of rapid urbanization, this responsibility should eventually wind down. As China’s economy matures, the role of the local government as a formal gatekeeper to land will shrink significantly as other priorities take precedence. In the meantime there may be some interesting financial sector reforms that can improve the way this division finances its activities (more on this below under “Reform: financial sector”).
Real estate asset management — LGFVs hold large portfolios of real estate assets “on the books”. These include many properties in new planning districts, government buildings, tourist sites, etc. In my view, the local government should not be in the business of real estate asset management and these assets represent trapped capital for many cash-strapped local governments. These assets should be liquidated over time and transferred to private sector entities like real estate management firms that specialize in operating and managing real estate assets. Select properties, like government building and schools, may be retained.
Infrastructure — LGFVs hold large portfolios of infrastructure assets such as highways, joint ventures in rail assets and airports. In my view, local governments should not be in the direct infrastructure management business. These assets could be consolidated under larger, dedicated infrastucture management companies, with a mix of state-owned and private ownership. Introducing private ownership could help with liquidity and management but also requires putting clear rules in place for how natural monopoly infrastructure assets like tollroads and bridges are operated.
Other operating assets — LGFVs also own a potpourri of other operating assets. Local officials partnered with local entrepreneurs to build a variety of operating businesses spanning from construction companies to amusement parks to tourist sites. Going along with the theme of focus, there are opportunities to consolidate operating assets under a larger, dedicated entity. For example, a dedicated operator could acquire a number of amusement parks that were built to create a Walt Disney Parks and Resorts equivalent that is dedicated to operating amusement and theme parks. A local government that contributes its local amusement park into the operation could receive equity in the larger entity. The key is to allow competent and focused operators that have the right combination of skills and incentives to run these businesses at larger scale, more efficiently. Increased clarity and separation between the board of directors and management would reduce risk of misaligned incentives and blurred lines between local government and private sector. A new generation of focused enterprises could arise out of this diversified blend of assets.
These approaches will help deal with the $23 trillion or so worth of assets that have been created in LGFVs to date. Greater focus will also improve the capital and resources allocation process going forward. Creation of more focused enterprises that specialize in specific asset categories are also natural partners for local governments on future projects.
Restructuring: Disciplining through financial support
As mentioned earlier, nobody — not even the central government — really quite knows exactly how large of an impairment LGFVs will have to collectively take on the $23 trillion in assets that have been created to date. This will not be fully known until auditors have had a chance to comb through a large representative sample of the assets.
While the size of the impairment is meaningful, arguably equally important are the reasons for the impairments. There are “good” reasons and there are “bad” reasons.
As discussed in Project Finance with Kweichow Characteristics, some of the impairments may be due to infrastructure projects that had specific poverty alleviation mandates. These are examples of “good reasons” — the local governments were fulfilling national policy mandates that were handed down to them by the central government policymakers and the projects should understandably not be evaluated purely on its financial metrics. To the extent the projects were executed well (cost-efficient, no/low corruption, achieved social goals) but are still struggling financially, the right thing to do would be to get continued financial support.
There are also “bad reasons”. If a project was underwritten and executed poorly, or riddled with corruption, those responsible should be held accountable. Provinces and municipalities where there was more bad execution might just need to clean up the mess themselves and not expect significant support from the central or provincial governments, respectively.
The reality is that every project will have its own individual assessment and its performance will be explained by multiple factors, ranging from “good” to “bad” to plain luck and chance. Each asset should have its own tailored plan. Good assets might become consolidators in the industry, with their managers rewarded with more responsibilities, including scaling up by acquiring other assets or being put in charge (with funding support) of dealing with troubled assets. Bad assets might need to be restructured and dealt with in various ways.
Reform: Privatization and transparency
With the prospect of significant re-organization of LGFV assets, improvements in the asset transfer mechanisms like auctions would help accelerate this process. Enlisting the support of the private sector and its capital increases the urgency to implement transparency.
There have been improvements in the asset sale process in recent years but greater transparency is required when it comes to public assets that are potentially being privatized. For example, there were rumors around the the sale of certain operating rights to manage the famous Leshan Giant Buddha in Sichuan for ¥1.7 billion. As David Fishman (Crossing the River) describes here, in this case it looks like it was merely the transfer of rights from one LGFV to another, but if there is to be widescale privatization involving private capital, transparency is of paramount importance.
In the last cycle of significant SOE privatization in the 1990s, things were not transparent at all. Many public assets were stripped from the state by insiders. In retrospect, the massive gains from introducing private capital far outweighed the losses from proto-crony capitalism — leading to significant net gains in overall capital efficiency. But the China of today is very different from three decades ago and the low-hanging fruits of market reform have already been picked. It gets harder from here.
Reform: Incorporating “lessons learnt”
Optimizing and re-organizing $23 trillion worth of assets is a big task. But trillions more worth of new assets will be created in the coming years and it is just as important that the process of underwriting new projects be improved going forward.
In private equity, one of the most important outcomes of “fresh look” analyses is figuring out what went wrong and using these lessons to improve the investment and portfolio management process. In a similar way, the aggregate output of thousands of “fresh look” case studies will be evaluated and analyzed to inform policymakers on the next round of reforms aimed at improving capital allocation processes going forward.
Much of the responsibility for this evaluation work will be with the National Development and Reform Commission (NDRC), an umbrella organization that works with other governmental bodies and is responsible for much of China’s long-term economic planning. One of its main responsibilities is drafting the Five-Year plans and no doubt many of the lessons learned from the LGFVs will be incorporated into the strategic planning cycle. Currently, China is in the third year of the 14th Five-Year Plan spanning (2021-2025). Research should be starting next year for the 15th Five-Year Plan (2026-2030) but this does not preclude reforms from being implemented within the current plan.
Reform: Corporate governance
As shown in the Korean chaebol experience, re-organizing assets held in diversified conglomerates into more focused operating entities should be paired with improvements to corporate governance affecting capital allocation decision-making in all of the major asset categories that LGFVs play in.
Management of LGFV assets will benefit from greater clarification and separation in the roles and responsibilities of the board of directors (representing the investors) and management responsible for day-to-day operation. Today, the lines are too often blurred between local officials and the folks in charge of managing the assets sitting on LGFV balance sheets. These blurred lines result in greater opportunities for corruption, misaligned incentives and lower operational performance and capital efficiency.
Reform: Working capital
When most people think of capital, they think of buildings or factory machinery. However, another significant and poorly understood component of capital are working capital items like receivables and inventory. One way to think about working capital is the amount of time a business takes to receive cash from the time they start working on a product or service that they are selling, also known as the cash conversion cycle8.
China has unusually long working capital cycles, which means it has more capital tied up in working capital than other economies. The average payment delay is almost twice as long as Japan’s and also higher than Australia, Hong Kong and Taiwan. SOEs are especially notorious for stretching out payments, which increases working capital requirements for upstream suppliers. While payment delays do not show up in the income statement, they do affect cash flows and businesses ultimately run on cash inflows and outflows, not profit accruals.
Referring back to the “aggegate LGFV balance sheet”, you can see the working capital intensity in the size of the Receivables category, which at ¥18 trillion at the end of 2020 was over 60% of the entire Infrastructure fixed assets category (¥29 trillion). The “Inventories” category is comprised mainly of real estate, some of which is owned “on the balance sheet” but another large portion of which is essentially long-dated working capital tied up in work-in-progress construction projects that have yet to be completed or sold.
Elevated working capital levels reduce the capital efficiency of the economy as they increase the amount of total capital required in an economy and reduce the velocity of money and corresponding economic activity. Significant reforms in this area would improve the capital efficiency throughout the economy and particularly with LGFVs. J.P. Morgan estimates that ¥2.3 trillion ($335 billion) tied up in working capital can be released with improvements in the cash conversion cycle and used for more productive purposes.
Reform: Financial sector — loosening (short-term)
A recurring theme in this essay series is the idea that the Chinese financial system is by mature economy standards still quite basic, conservative and unsophisticated. This has given rise to informal lending and investing that has undoubtedly created risk in the financial system through increased credit intermediation.
This is part of the cycle of regulatory tightening and loosening where entrepreneurial forces are tacitly encouraged to experiment outside the formal system for a period of time before regulators step in. In the case of LGFVs, the key date of tightening was August 2020 when financial regulators stepped in with the “Three Red Lines” guidelines that limited indebtedness and curtailed access to liquidity for mny LGFVs. If this cycle follows past financial sector reform cycles, financial regulators should step in with a slate of new regulations to usher in a new era of growth and experimentation.
China’s post-pandemic recovery has been relatively tepid because capital is simply not flowing as smoothly through the system as it has in the past. The formal banking system, while basic and conservative, fit well with two of the main growth engines of the Chinese economy — residential real estate and infrastructure. It was efficient at re-deploying cash deposited in the banks by savers into loans for projects, a large portion of which went back into the pockets of wage-earners, which would then flow back into the economy and eventually find its way back into cash deposits, starting the cycle all over again.
But with liquidity tightening and general lack of confidence in the economy, this once-smooth cycle has slowed down. Households, which had been driving new urban household formation, have been tentative to make such large financial commitments. While household incomes have continued to rise, instead of saving it in the form of residential real estate, they have been saving it in the form of cash and liquid reserves. Banks are flush with cash but there is stagnant demand for loans — the balance sheets of LGFVs and private sector developers are stretched and the private sector is still tentative. Significant capital is stuck in the system and not being put to work. This has dampened momentum in the post-pandemic recovery.
In the short to medium-term, getting out of this liquidity trap is to a large extent about restoring confidence in households and private sector businesses. The lack of confidence is caused by lack of visibility in the future outlook and greater uncertainty. Part of restoring confidence will be simply loosening as part of the natural tightening and loosening cycle described above.
But this needs to be done in moderation. Urban household formation peaked in the 2015-19 period and completions of floorspace in the 2012-17 period. Infrastructure is also likely at or approaching its peak intensity. While regulators may have tightened too early or let it linger too long, they also need to be mindful that a return to 2010s decade would not be prudent in light of where China is in the back-end of its multi-decade urbanization super-cycle. A “goldilocks” approach with respect to the tightening/loosening cycle is warranted here.
Reforms: Financial sector — more sophisticated financing tools, role of private capital (long-term)
In the long-term, financial sector reform are important to enable the economy to reach the next level of capital efficiency. Part and parcel with greater focus and a move away from diversified conglomerate approach of LGFVs are more sophisticated financing tools that align with the asset categories they are financing.
For example, China has been experimenting with REIT-like structures as a way to diversify financing options for real estate and infrastructure projects away from plain-vanilla bank lending and bond markets. Since June 2021, approximately ¥90 billion was raised for over two dozen projects — a drop in the bucket compared to the total pool of real estate and infrastructure assets but China’s securities regulator recently released guidelines to expand both the size and scope of this financing method.
REITs would strengthen the alignment between investors, management and the assets they hold, a more dynamic mechanism to enforce capital discipline and improve the resource allocation process. They would also bring new sources of liquidity into the sector by diversifying its sources of capital to private investment funds and household investors.
Another area of financial sector reform would be to formalize many of the informal financing activities that have been undertaken by LGFVs. This includes investing, lending and borrowing operations between LGFVs mentioned earlier but also the role that LGFVs play in warehousing work-in-progress construction projects on their balance sheets before liquidating by selling to the household end buyers (in the case of residential real estate projects). There are more specialized and sophisticated structured asset financing vehicles that can be used to finance this process more efficiently.
Ultimately, the primary goal of introducing more sophisticated financial tools is to better align investors with management and the assets that they manage. Private capital and capital markets can introduce capital discipline more dynamically and responsively than the “brute force” disciplining approach undertaken under China’s adversarial administrative system and conservative, unsophisticated banks. By diversifying sources of financing, it also mitigates future risk of liquidity traps.
There is major precedent for this in China’s recent history. One of the biggest reasons why Chinese economic efficiency boomed in the 2000s was from the introduction of private capital and entepreneurs to formerly state-owned assets that were “let go” in the major SOE reforms in the 1990s. Similarly, private capital played a significant role in improving capital efficiency in Korea in the aftermath of the Asian Financial Crisis. Figuring out how to better harness these forces should be an important theme in the next cycle of reforms.
“Life is old there, older than the trees,
Younger than the mountains, growin' like a breeze
Country roads, take me home
To the place I belong” — John Denver
“Country Roads, Take Me Home (to Guizhou)”
Economic development is driven by a continuous series of reforms. In the coming months and years we are likely to see a steady stream of news and announcements related to local governments, LGFVs, and this large pool of assets they have spawned. The goal of this series of essays was not to predict everything that is to come but to provide perspective and frameworks on how to place changes as they arrive.
While this topic has been mostly about abstract concepts like economic development, it is always important to ground ourselves in the human impacts, often hidden behind all the numbers and charts. Whether American or Chinese, West Virginian or 贵州人, no matter where we are in the world, “going home” is something we can all relate to. This essay series began in Guizhou and I think it is fitting that we end it there as well.
Regardless of what happens with Guizhou province, its LGFVs and the assets they hold, there is no doubt that there has been tremendous change and the long-term impact of the past two decades will continue to echo into the future, often in ways that nobody could have predicted at the outset. But even through such tremendous change, home will always be home.
When I began writing this series of essays, I knew very little of Guizhou and the 39 million people that call it home. While reading and research can barely scratch the surface, I now know a little more about this corner of the world and I hope you do too as well.
Just one last tidbit on Guizhou: I recently read this interesting article from Baiguan about the budding trend of “Village Super Leagues” (村超) where a grassroots effort by locals that are passionate about football has grown into a national phenomenon:
“We invite you to explore captivating stories of individuals who, driven by their unwavering love for the sport, are keeping the football spirit alive in their rural local communities in the mountainous, historically underdeveloped province of Guizhou. Through personal tales of dedication to the sport, this examination of China’s Village Super Leagues presents a new, hopeful side of the nation's relationship with ‘the beautiful game’”
China’s urbanization rate also overstates how fully urbanized the cities are as nearly a third of current urban residents do not hold urban hukous. The majority of this population are migrant laborers that are working, often living within company-provided housing. They represent additional future demand for new, permanent urban housing units.
42k km were built in the first 19 years of HSR construction, averaging approximately 2,200 km per year. 42k to 70k km by 2035 would be an average of 2,150 km per year.
Source: IMF, “Local Government Financing Vehicles Revisited” (2020)
One of the key points emphasized was how asset-backed debt is different from typical government financing backed by fiscal revenue collected through taxes and other means.
Total assets of ¥123 trillion ($20 trillion) as of the end of 2020. I have grossed this number up to match the updated debt figure of ¥66 trillion ($9.3 trillion) from the recent Bloomberg article.
Full audits do not need to be conducted on every single asset sitting in a LGFV. Performing assets that do not have any financial issues can be assessed but naturally it will be the non-performing assets that are having financial difficulties that are prioritized. This still represents a very large number of assets, with an estimated 77% of LGFVs found by the IMF to not be generating enough operating earnings to cover interest expenses for three consecutive years.
A typical transaction might be when LGFV-1 lends money to LGFV-2 because it can access capital at lower interest rates, perhaps through an unsecured promissory note. The promissory note would show up as an asset on LGFV-1’s balance sheet and a liability on LGFV-2’s balance sheet. On the Aggregate LGFV balance sheet, both the asset and the liability form of the same promissory note would be counted.
If all the LGFVs were grouped together under aggregate nationwide LGFV, the promissory note would be considered an inter-company transaction and be netted out during the accounting consolidation process. We are actually dealing with less than $23 trillion worth of real assets because many such financial instruments sit on both the asset and liability side and should be netted out.
As part of the restructuring and reform process, these inter-LGFV transactions will ideally be untangled and moved over to the formal banking system that has improved its processes and underwriting capabilities to accommodate LGFV financing demand.
For example, imagine you owned a widget factory. The working capital cycle would be:
Purchase $1,000 in upstream widget components from my suppliers (payment terms: 30 days)
Add $700 of labor and out-of-pocket factory inputs. Another $300 of factory overhead. It takes another 15 days to build the product. Total inventory cost for this batch of widgets is $2,000.
The widgets are sold wholesale to retailers for $3,500, so a total gross profit of $1,500. Retailers have 60 days to pay your factory.
It takes about 75 days from the moment you kick off this batch of widgets until receiving cash. You are allowed to pay your own suppliers in 30 days. So your net working capital cycle is around 45 days. During this time, you need to carry around $2,000 of inventory. As long as you are running the business, your capital will be “stuck” in this inventory in the same way that capital is “stuck” in factory equipment.
I predict that the asset side of China's local government recovery ledger will be stronger than expected.
Big state assets, like the HSR system, return a steady 6%-8%, and standouts like the Three Gorges return 200%-300% annually. Older projects like the Dujiang Water Diversion return 100% daily. The Chinese are good with money, remember.
As to 'China’s post-pandemic recovery has been relatively tepid,' I tremble to think what 'hot' would look like.
No other country has ever grown as fast as China is growing this year, by $1.5 Tn.
No other country's wages have grown as fast as China's, an indicator of real economic growth.
Hi Glen,
Is it possible that I may have the documents for your model of the electrification of China's vehicle fleet?
You mentioned on Twitter a little while ago that your model predicted that 47% of China's cars would be EVs in 2030.