Mounting hidden local government debt is one of China’s pressing challenges. Held by local government financing vehicles (LGFVs) and estimated between US$8-10 trillion, this off-the-books debt originates from a long-running tug-of-war over tax revenue between China’s central government and the localities. In the years before COVID-19, LGFVs controlled their debt by drawing on steady non-tax revenues. In summer 2020, however, approximately six months after the pandemic broke out in Wuhan, the hidden debt held by LGFVs began rising dramatically. Today, many of them are nearing default, and local governments are increasingly going broke.

​​Why did hidden LGFV debt rise so much during COVID?

A recent study, published in The China Journal, sheds light on this question. The study’s co-authors – including Jean Oi, the William Haas Professor of Chinese Politics, a senior fellow at the Freeman Spogli Institute for International Studies, and director of the China Program at APARC – use quantitative data to show how China’s central government’s regulatory crackdowns on income tied to the real estate sector during the pandemic disrupted the revenue sources LGFVs and their local governments relied on to service their debts. These policy changes “interacted with the zero-COVID policy to create a perfect storm, pushing hidden local government debt to new highs,” they write. 

Their study draws on a wide array of quantitative data, tracking information on factors ranging from COVID shocks (including confirmed cases and deaths) to, among others, government medical responses, special treasury bonds and their allocation, local debt, land purchases, and business activities. Using these sources, the co-authors built a province-level dataset covering all 31 of China’s provincial units from 2018 to 2022, allowing comparative analyses before and after China’s COVID shocks. They organized the data into three categories: (1) the impact of COVID on small and medium enterprises; (2) government fiscal responses and COVID expenditures during the pandemic; and (3) local government finances and debts.

Sign up for APARC newsletters to receive our scholars’ research updates >

The Pre-COVID Era: The Grand Bargain That Failed

China’s local debt problem traces back to the 1994 fiscal reforms, which recentralized tax revenues in Beijing and left local governments with chronic budget shortfalls. To bridge the gap, the central government struck a “grand bargain”: while claiming a larger share of tax income, localities could generate new non-tax revenues through special-purpose vehicles, namely, local government financing vehicles. These LGFVs were set up as state-owned enterprises to incur and hold debt off-the-books, yet not illegally, on behalf of local governments.

The workaround fueled rapid development for years but laid the groundwork for today’s mounting hidden debt crisis.

“The success of LGFVs hinged largely on revenue generated through land finance,” explain Oi and her co-authors. “Local governments provided LGFVs with cheap land as collateral for bank loans and bonds. Further revenue was generated from preparing and selling land to real estate developers.”

Thus, LGFVs powered over a decade of rapid growth in China, driving infrastructure booms and urbanization that made the real estate sector a cornerstone of the economy. The model appeared mutually beneficial: the central government gained more tax revenue as the economy grew, while local governments used land sales and debt to fund development. But this growth depended on a continuous flow of non-tax income, making the system increasingly fragile.

After the 2008 global financial crisis, Beijing launched a sustained push to rein in local government hidden debt, focusing heavily on LGFVs. By 2017, officials labeled the risk a “gray rhino.” Yet this drive for fiscal discipline ground to a halt with the onset of COVID.

A Perfect Storm of Policy and Pandemic

The pandemic’s impact was swift and severe. Small and medium-sized businesses, especially in the hardest-hit regions like Hubei Province, saw their incomes collapse by up to 90%. In response, Beijing provided a massive fiscal support package to localities, including one trillion yuan in special COVID bonds to offset the costs from the initial onslaught of the pandemic. Crucial for LGFVs, these bonds cushioned the impact of the pandemic on land sales.

By summer 2020, however, as China was still locked away from the rest of the world and COVID was under control, Beijing resumed its policy agenda to enforce fiscal discipline and curb local government debt. The central government’s most consequential measure was the “three red lines” policy, which dealt a major blow to China’s real estate sector by sharply restricting developers’ ability to borrow once debt thresholds were crossed. The policy, expanded from 12 pilot firms in 2020 to cover the entire sector by 2021, disrupted the “borrow-to-grow” model and triggered a liquidity crisis. Evergrande, China’s second-biggest property developer, was among the first groups affected.

As borrowing dried up, firms struggled to repay debt, halted construction, and stopped buying land, slashing local government revenues. Land sales plummeted across provinces, with national revenue growth from land transfers plunging into negative territory by 2022. The crisis deepened when unfinished housing projects led to mortgage boycotts by frustrated home buyers, prompting more state intervention.

For local governments, the shift came at a steep cost. They were ordered to step in, using LGFVs to purchase land and inject cash into public budgets. As a result, even wealthier provinces like Shanghai and Guangdong saw sharp increases in LGFV debt.

“The call for LGFVs to buy land to create revenue for local governments made matters worse, turning land from a key source of revenue into a source of new debt and forcing LGFVs further to increase borrowing, all of which caused soaring increases in LGFV debt, without any alternative revenue source to service or pay that debt,” explain Oi and her co-authors.

A Fiscal Reform Imperative

The study shows how China’s shifts in central government policies during the pandemic – especially the three red lines and the directive for LGFVs to buy up unwanted land — exacerbated long-standing vulnerabilities in local public finance. What had been a delicate balancing act quickly became unsustainable.

“At the root of China’s continuing crisis of LGFVs' debt is China’s flawed fiscal system,” the co-authors emphasize. Before the pandemic, the system masked deficits by relying on LGFVs to generate off-the-books revenues, primarily through land sales fueled by a booming real estate market. This arrangement allowed Beijing to capture the bulk of tax revenue while localities chased growth. But when COVID struck and the property sector collapsed, the facade crumbled.

The fallout exposed how deeply local governments had come to depend on land finance – an unstable, non-institutionalized revenue stream. With the real estate sector once accounting for over 20 percent of GDP, its collapse left localities and their financing vehicles adrift. “In the context of a crisis such as COVID, the weakness of the fiscal system and LGFVs was exposed as policy instability added to the volatility of the economic situation,” Oi and her co-authors note.

The local government debt problem might not trigger a financial crisis in China, “but LGFVs and their local governments remain in dire straits,” they write. More worrying, the economy has not rebounded in the post-COVID years as hoped, and “as long as the real estate sector remains depressed, land finance will not be able to make local government budgets whole as it once did. The grand bargain can’t work.”

Rather than assume the debt, Beijing is extending lifelines: urging banks to offer LGFVs 25-year loans with temporary interest relief, approving debt swaps into longer maturity municipal bonds, and allowing new issuances of special-purpose bonds. But these are stopgaps, not solutions.

Hidden debt will keep resurfacing unless China overhauls the fiscal system born out of the 1994 reforms, Oi and her co-authors conclude. Institutionalized, dependable, alternative revenue streams for local governments are needed, or the crisis will persist. “It may be time for Chinese leadership to stop kicking the can down the road and undertake institutional reforms of the fiscal system. This may be painful, but there is no other sustainable solution.”