A Perfect Storm: Fiscal Discipline, COVID, and Local Government Debt in China

After the abrupt end of China's zero-COVID policy at the end of 2022, the debt held by local government financing vehicles (LGFVs) on behalf of their local governments had soared to at least US$8 trillion. Some local governments are now cutting public services due to a lack of funds. The mountains of LGFV debt cannot be explained by COVID public health expenditures, but the impact of COVID determined policy changes that led to the crisis of hidden debt. Paradoxically, China's success in combatting the first wave of COVID triggered policies that ultimately upended LGFVs. Using quantitative data, we show that changing central government policies during the pandemic created debt and undermined the operation of LGFVs. The three red lines policy instituted against the real estate sector in the middle of the pandemic interacted with the zero-COVID policy to create a perfect storm, pushing hidden local government debt to new highs when the revenue that LGFVs needed to service their debt dried up. COVID exposed the inherent vulnerability of LGFVs and their local governments relying on a noninstitutionalized source of revenue-namely, income tied to the real estate sector-to fill their annual fiscal gaps and underscored the need for systemic fiscal reform.