In Depth: As China’s Hidden Local Debts Shrink, a New Challenge Emerges

As mid-2026 approaches, the clock is ticking on one of the most ambitious and high-stakes financial cleanups in China’s recent history.

In late 2024, Beijing rolled out a sweeping 12 trillion yuan ($1.7 trillion) package of policies to resolve a significant portion of the country’s officially recognized hidden local government debt, amassed during decades of credit-fueled infrastructure-building.

The campaign to eliminate the hidden debt is largely on track to meet the government’s mid-2027 deadline, thanks to a massive bond-swap program that has shifted these liabilities onto local government balance sheets.

But the arguably more difficult task of tackling the murkier, more sprawling world of operational debt held by thousands of local government financing vehicles (LGFVs) is running into complications, partly in the form of a tangle of high-interest, noncompliant debt that banks are reluctant to touch.

This stalemate is contributing to a growing liquidity strain for LGFVs, which can roll over their principal but are increasingly struggling to pay the interest, raising concerns about a buildup of default risks.

The easy part first

The primary goal of the debt resolution plan was clear: eliminate all hidden debts and remove the thousands of LGFVs from a centrally managed list by the end of June 2027. The main tool was the 12 trillion yuan package, including special-purpose bonds (SPBs) issued by local governments to swap out their high-cost hidden liabilities for lower-interest, longer-term official debt.

From the central government’s perspective, progress has been made. Finance Minister Lan Fo’an said the outstanding balance of hidden debt fell by 3.8 trillion yuan from the end of 2023 to 10.5 trillion yuan by the end of 2024. The number of LGFVs on the official list — estimated to be around 18,000 initially — also plummeted, shrinking by 71% from March 2023 to September 2025, according to official data.

With at least about 4 trillion yuan in SPB funds still available before 2028, market watchers are confident that Beijing will be able to declare victory on schedule in its hidden debt campaign.

The tougher challenge

The more intractable problem is operational debt owed by LGFVs to financial institutions, which People’s Bank of China Governor Pan Gongsheng put at 14.8 trillion yuan at the end of 2024. This category consists of loans and other liabilities that are not officially classified as hidden government debt, but still carry local government repayment responsibilities.

According to a veteran local debt researcher, these operational debts generally fall into three categories. The first is debt with no corresponding asset, such as cases where cash flow is so poor that the LGFV can only borrow new funds to pay old debt. The second is debt tied to assets that don’t generate cash flow. The third is debt tied to cash-generating assets that can be rolled over on market terms.

The more difficult part of the problem lies with high-interest, non-standard loans. To facilitate financing, many local governments pushed LGFVs to borrow through such instruments, which often involved opaque underlying assets and were used simply to move funds around rather than for specific project construction.

Currently, all LGFV operational debts that can be replaced have been replaced, said a source close to policymakers. For the rest, even if banks can offer interest rate reductions, they still face compliance requirements. And banks are unlikely to take on compliance risks to restructure debt as policy requires that any swapped debt be tied to a clear, financially sustainable project.

The interest payment problem

The resolution of hidden debt has had a paradoxical effect. While it has lowered LGFVs’ borrowing costs, it has also transferred an immense amount of debt onto local governments’ official balance sheets, causing their statutory debt to balloon from 40.7 trillion yuan at the end of 2023 to 54.8 trillion yuan two years later. Interest payments on this official debt are soaring, while the land sales revenue — a crucial source of local fiscal revenue — has collapsed.

For LGFVs, the situation is also dire. While the principal on their debt can generally be rolled over, the strict curbs on new financing have cut off their main source of cash for paying interest.

This liquidity squeeze is pushing them into a corner. Last year, many LGFVs borrowed new funds just to repay old bonds.

There was once a proposal to consider suspending interest payments and capitalizing them to deal with operational debts over a longer period. Caixin has learned from people with knowledge of the matter that government departments studied this idea at the end of last year and concluded that it had too many drawbacks.

Some are resorting to desperate measures. Several LGFVs in Central China’s Henan province have issued offshore bonds with real interest costs reaching the double digits, while some in Shandong have issued non-standard products with rates above 6%.

Revitalizing assets

With financing squeezed, local governments are turning to a new strategy: revitalizing state-owned resources, assets and funds. Championed by provinces like Hubei and Hunan, the idea is to turn all possible state-owned resources into assets, securitize all possible state-owned assets, and leverage all possible state-owned funds.

In practice, this means identifying and packaging things from data to reservoir silt to the space under bridges, and then selling or securitizing them to raise cash. Central China’s Hubei province, for example, identified 21.8 trillion yuan of such resources, assets and funds and revitalized over 300 billion yuan of them last year. The hope is to turn dormant assets into revenue streams that can be used to pay down debt.

However, this approach is fraught with challenges. Many of these assets have ambiguous ownership and are difficult to value, as no mature market for them exists. This creates the risk of either selling state assets too cheaply or failing to attract investors.

Furthermore, a source from China Chengxin International Credit Rating Co. Ltd. warned that securitization and leveraging can monetize future cash flow, postponing debt risk.

Liu Ran contributed to this story.

Contact editors Michael Bellart (michaelbellart@caixin.com) and Lin Jinbing (jinbinglin@caixin.com)