Why are local government financing vehicles (LGFVs) increasingly looking offshore to raise funds?
The offshore bond market provides LGFVs with a deeper pool of liquidity and efficient means to raise funds. For example, Beijing Infrastructure Investment launched a medium-term notes program in 2014 to facilitate overseas fund-raising, and lifted the program size to $6 billion (from an initial $2 billion) in June 2015.
Domestic fund-raising has become increasingly restrictive for LGFVs. Under regulations introduced in October 2014, the vehicles have been unable to raise funds on behalf of their local governments at the same time that conditions have tightened for LGFV-related bond issues. The result has been a sharp drop in funding levels. The LGFVs had previously relied on bank loans and local bond markets to raise low-cost funds, partly secured by implicit guarantees from local governments through the expectation of support, or "comfort letters."
On the other hand, the central government appears less concerned about local state-owned enterprises borrowing offshore, possibly because China is more capable of managing external debt risks and the government places great importance on enabling robust investment and economic growth.
How important is local government support to LGFVs in China?
The primary objective of many LGFVs is to execute the government policy mandates in investing, constructing, and operating important infrastructure and social facilities, hence their activities are not commercially driven. Their debt-servicing ability relies on the support from local governments to a large extent. Therefore, our assessment of the credit profiles of local governments and their willingness to support LGFVs is very important.
How does the credit profile of provincial governments vary across the country?
Most provincial governments in eastern China -- the most developed area in the country -- have investment-grade credit features. Compared with inland peers, eastern provinces generally have a higher level of wealth, greater physical and human capital, better governance and fiscal management, and financially stronger state-owned enterprises. The credit profiles of other provincial governments may fall in the investment-grade or speculative-grade categories, subject to our review of their individual fiscal transparency, budgetary performance, and liquidity position.
What's behind the high leverage of the financing vehicles rated by Standard & Poor’s?
S&P currently rates three LGFVs: Beijing Infrastructure Investment, Qingdao City Construction Investment, and Tianjin Binhai New Area Construction & Investment Group, which are all highly leveraged because of their large capital expenditure (capex) and the low profitability of their businesses. They have primarily used bank loans and domestic bonds to finance their sizable expenditure or investments. The vehicles still have significant capex plans to fulfill the local government's goals of constructing or investing in infrastructure or social projects. On the other hand, the companies have volatile operating cash flows because of their small business scale, low profitability, and lumpy cash flows that are tied to the progress of projects under construction.
The LGFVs' funds from operations (FFO) further dampened because of high interest expenses associated with significant debt; the expenses include capitalized interest for funding construction projects. In our base-case forecasts, FFO after deducting interest expenses for all three companies is likely to remain negative or neutral over the next two years, and FFO interest coverage should be less than 1x. We expect the three rated LGFVs to continue to rely on the support of Chinese banks due to their strong links to governments and meaningful economic and policy role to meet interest, principal repayments, expansion costs, and capex.
Can these companies or other LGFVs improve their leverage and profitability?
It will be tough. We expect the high leverage and weak profitability of the three rated LGFVs to continue over the next two to five years, given that their business mix and policy mandate won't change materially in this period and the companies still have large capex planned.
In our view, the business models of LGFVs are likely to undergo an important transformation over time, which may affect profitability over the longer term. The central government has been promoting a public-private-partnership (PPP) model for the investment and operation of projects for urban infrastructure and public services. Under the PPP framework, the LGFVs may set up project companies independently or with the LRGs.
Although the project companies will be running on a stand-alone basis, they expect to receive stable cash flow from products and services on a fair pricing basis, or government subsidies, which are based on contractually agreed terms by the LRGs. This model is more likely to help LGFVs to control the increase in leverage that would occur if PPPs were not available.
What are the implications of debt swaps between Local Regional Governments (LRGs) and LGFVs?
We view the debt swaps as a positive development for reducing the near-term refinancing risk of the LGFVs. As a part of the debt swap program this year, the LRGs issue bonds to refinance LGFV debt that has been classified as government debt as of June 2013 and is maturing in 2015. Two batches of LRG bonds totaling RMB2 trillion (about US$320 billion) have been rolled out so far in 2015. LGFVs benefit from having part of their short-term debt repaid through the debt swaps. But the governments don't assume all of the LGFV debt.
On top of the debt swap program for LRGs, the regulator relaxed requirements on LGFVs issuing bonds for certain purposes, which will give them an additional buffer to refinance their debt if it is not covered by the debt swap plan. The ability of LGFVs to continue to refinance their maturities and access the capital markets with the support of the regulator should ensure they can effectively manage their liquidity positions.
This article is authored by Gloria Lu, Standard & Poor’s Senior Director of Corporate Ratings.
