Guanghua Thought Leadership
Local Government Implicit Debt and the Pricing of LGFV Bonds

Laura Xiaolei Liu  Yuanzhen Lyu  Fan Yu


The increasing level of Chinese local government debt has led regulators and investors to pay closer attention to local government credit risk. According to the National Government Debt Audit Report issued by the National Audit Office in 2013, the total outstanding debt of local governments has reached RMB 10.89 trillion as of June 2013. In addition, guaranteed debt (for which governments act as guarantors) and implicit debt (in which governments may bail out the issuer in the event of financial trouble) amounted to RMB 2.67 trillion and RMB 4.34 trillion, respectively. Nevertheless, there is still a lack of systematic measure of local government indebtedness, especially at municipal government level where implicit debt is predominant. On the other hand, the local government financing vehicle (LGFV) bond, a financial instrument that possesses both features of corporate and municipal bonds, has a few unique properties. Chinese local governments have issued a large number of LGFV bonds since the promulgation of the Budget Law in 1994, according to which local governments were prohibited from raising debt on their own. Although LGFV bonds are perceived to be implicitly backed by governments, there has been no consensus on which level of government is expected to bail out the issuer in the event of financial distress.


This paper examines how local government implicit debt affects the pricing of LGFV bonds and further explores the variations in implicit guarantors that are recognized by the market. We follow the following steps to measure government implicit indebtedness. First, based on the public disclosures of bond-issuing firms, we create a proxy for municipal implicit debt in a prefecture-level city by summing up the interest-bearing debt of all LGFVs owned by it. We use this approach because the debt of LGFV accounts for a large proportion of the implicit debt of municipal governments but the official audit report does not provide relevant details for prefecture-level cities. Second, we divide the municipal debt amount by three variables that measure the financial capacity of a local government: general budget revenue, local GDP, and local fixed asset investment. The statistics show that local government’s total implicit debt is on average 3.02 times its annual general budget revenue, 32.91% of local GDP, and 56.23% of local fixed asset investment.


If the market perceives that the price of LGFV bonds carries implicit guarantee from local governments, the credit spread of LGFV bonds should be related to the implicit debt ratios of local governments. Consistent with this hypothesis, the empirical results suggest that the higher the implicit local government debt ratios, the higher the credit spread of LGFV bonds. This result holds in both the primary and secondary markets from May 2008 to April 2018 whenever issuer fixed effect is controlled or not.


Furthermore, this paper conducts time-series analysis to examine whether default events in the market and changes in government policies have brought about changes in investors’ identification of the implicit guarantor. The results show that investors’ view on the level of government that provides implicit guarantee shifts over time, from the central government to municipal governments, and then to both municipal and provincial governments.  


In April 2011, Yunnan Highway, a provincial LGFV in the Yunnan Province, notified its creditor bank that it would default on its loan repayment. Although this crisis was finally resolved with government intervention and no default actually occurred in the end, it had a significantly impact on investors’ perception of LGFV bonds’ risk. The empirical results show that a prefecture-level city’ implicit debt ratios do not have significantly pricing effect on LGFV bonds in early years, but they became significant after the Yunnan Highway default. This implies that, before the default event, soft budget constraints of local governments made investors less sensitive to the heterogeneity in the financial risks of local governments. Investors generally believed that the central government offered the implicit guarantee for LGFV debt. After the default, investors began to take local government indebtedness into consideration, and the implicit guarantor began to shift from the central government to municipal governments.


The shifting is likely to happen again in October 2014 when the State Council issued the Guidelines on The Improvement of Local Government Debt Management (hereafter “Directive No. 43”). This document proposed a stricter financial management system which aims to regulate the “borrowing, use, and repayment” of debt by local governments. Directive No. 43 aims at clarifying the relationship between LGFV and local governments, and in the meanwhile, it officially stipulated debt replacement, where provincial governments are encouraged to issue government bonds to replace high-yield LGFV debts. This action transferred a proportion of LGFV debts into the balance sheets of provincial governments. Therefore, provincial governments’ implicit debt ratios began to have significant impacts on LGFV bond spreads since then.


In August 2021, six ministries and the State Council jointly issued the Guidelines on Promoting Quality Reform and Opening-Up in the Corporate Credit Bond Market, which noted the importance of “improved bond market efficiency and a risk-based pricing system that fully reflects credit stratification”. The transition of local government financing from implicit to explicit channels is one of the major targets in this reform. As implicit guarantee is based on investors’ expectations and is sensitive to policy changes, frequent changes in such expectations will unnecessarily increase price volatility. To the contrary, government bonds with explicit government guarantee exhibit much lower cost and higher price stability. This transition can help improve market efficiency and promote the quality development of Chinese credit market.