In a recent report, we have analyzed the current debt repayment capability of China’s corporate sector1. In this note, we attempt to piece together the available evidence on the evolution of China’s local government cash flow, as local governments are another segment that is commonly perceived to be more financially vulnerable in China.

Overall local government cash flow may have improved since 2016 given the evidence of faster local fiscal income growth, significantly lower financial expenses and rising local government savings.

Overall local government revenue growth has picked up in 2016. Overall local government revenue growth bottomed in 1Q15 – fiscal income growth started to pick up in 2Q15 in the more developed provinces and municipal cities with stronger land sales revenue, while provinces with a higher reliance on heavy industries started to see incremental improvement in fiscal income in 2H15. Total local government revenue growth has accelerated to 10.8% YoY in 1H16 from 9.4% YoY in 2015 (and both remained higher than nominal GDP growth).

The funding costs for local governments have declined significantly since 4Q14, especially since the launch of the local government bond-swap program in May 2015. Prior to the bond swap, local governments mainly raised debt indirectly through the Local Government Financial Vehicles (LGFV), whose liabilities include bank loans, trust financing, urban construction bonds, etc. Funding costs via all these channels were significantly higher before 2015 – e.g., the LGFV bid up the marginal cost of trust loans to 8~10%p.a. prior to the launch of the bond swap. Backed by the implicit government guarantee and helped by the preferential tax treatment and banks’ provision requirement, the local government bond yield came in 300~500bp lower than all the preceding funding channels for local governments. Furthermore, benchmark rate cuts, sizable local government bond swaps and the clarification on the debt repayment responsibilities (by the state) has also helped reduce the cost of other funding channels, including trust loan interest rates and the urban construction bond yield. Significantly lower funding costs have greatly reduced the fixed financial burden of local governments.

Local government deposits growth may be accelerating, especially their demand deposits. Despite the common perception of deteriorating local government fiscal positions, local government and public organization deposits continue to grow faster than the nominal GDP and overall local fiscal income. A moderate recovery in fiscal revenue growth and some retained local government bond issuance proceeds (before LGFV loans repayment) may have contributed to rising local government deposits.

While the fiscal standing continues to diverge among local governments, the “laggard provinces” have shown incremental improvement in 2016. Some cities/provinces have recorded outstanding fiscal revenue growth in 2016, including the coastal provinces, municipal cities, and provinces that benefit the most from the expansion of the tier-1 city “metropolitan area.” On the other hand, fiscal income growth in provinces that rely heavily on commodity and resource industries continues to lag. However, all of the 4 “laggard provinces” have shown stabilization or incremental improvement in their fiscal income growth since 2016, especially Liaoning and Shanxi.

In the near term, property market recovery, the ongoing economic reflation and the local government bond-swap program have all helped reduce the vulnerability of local government balance sheet. In most of the provinces where data is available, tax income growth has recovered in 2016, consistent with the acceleration of nominal GDP growth. On the other hand, the recovery of the property market and pick up in land sales may have been a more important contributor to the revenue growth pick-up of the local government. Land transfer income growth has rebounded from <-40% YoY a year ago to +10% YoY by mid-2016. Furthermore, the rapid expansion of the new low-cost funding channel for local governments – local government bonds, has greatly reduced their cash flow pressure. More specifically, a total of Rmb7.8trn of low-cost local government bonds has been issued since May 2015, among which Rmb6trn was used to swap out the high-cost LGFV loans.

In the long run, however, a more sustainable solution to balance the book and smooth out the “income volatility” of local governments is to broaden their tax base, as well as to better align the fiscal income and responsibilities among the central and local governments. Our analysis shows that although some of the “laggard provinces” may still face difficulties in debt repayment and cash flow management, the overall cash flow pressure may have eased for local governments. However, there remain blatant structural issues with the stability and sustainability of China’s local government finance – local government income, especially those with weaker economic fundamentals, still heavily relies on land sales, while ironically, the more developed regions with stronger tax income and housing demand are less incentivized to provide residential land. Furthermore, the income and expenditure mismatch continues to require large annual fiscal transfer (~30% of total tax income) from central to local governments with hefty embedded efficiency loss (among other problems).