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Chinese LGFVs: Polarising credit profiles amid an improved liquidity and policy environment

Local-government financing vehicles have been one of the fastest growing sectors for G3 bonds. Fitch Ratings’ international public finance team’s Terry Gao, Samuel Kwok and Ark Huang reveal their outlook for this sector in 2019.

Local-government financing vehicles (LGFVs) issued by Chinese companies for G3 bonds have shown dynamic growth over the past three years. While government policies have improved liquidity and increased transparency, Fitch Ratings (Fitch) believes these government related entities (GREs) face headwinds in the year ahead.

Q: What is Fitch’s definition of LGFVs? Are all entities rated under Fitch’s top down approach classified as LGFVs?

Fitch adopts a wide definition of LGFVs and treats them as a segment of GREs. LGFVs are entities set up by local governments that carry policy missions including urban development, rail transit and transportation.

Under Fitch’s GRE criteria, we assess GREs on the strength of linkages with the government sponsor, and on the government sponsor’s incentive to support the GREs. Within Fitch’s portfolio, the majority of GREs are rated under a top down approach.

Fitch views these functional GREs’ debt to be indirect liabilities of the government sponsor. For more commercially driven entities with less functional roles, Fitch has rated them under a bottom up approach.

Q: What is the outlook for Chinese LGFVs in 2019?

The ongoing effort by central authorities to increase the transparency of local governments’ (LG) budget and debt management has made some progress. The current performance indicator has given local officials more incentive to balance economic growth and local debt management, as well as reining in the growth of indirect LG debts. Sanctions imposed on several LG officials incurring illegitimate LG financing in the past year further demonstrated Beijing’s determination to ensure proper and transparent funding for LGs.

Fitch believes these measures will improve the supervision of local governments’ indebtedness, enable authorities to better manage potential systemic risks arising from LG debt, and put LG financing on a more sustainable long-term path.

Q: What challenges does the LGFVs sector face?

The credit quality of LGs is constrained by the indirect liability burden from their satellite state-owned entities, especially the LGFVs. The authorities’ deleveraging policies amid China’s economic rebalancing, government fee and tax reduction initiatives and Sino-US trade tension could add more pressure to LGs’ fiscal budgets in the medium term.

Moreover, headwinds also arise from the volatility in the property market. This particularly applies to third and fourth tier LGs whose budgets rely more heavily on land sales. Given the challenging external environment, we expect government policies to swing between boosting economic growth and deleveraging, and to see more policies potentially with competing objectives and implementation schedules. This will also create more uncertainty in the sector.

Although the authorities have set a clearer boundary between LGs and their financing vehicles from a legal and regulatory perspective, Fitch expects LGFVs will continue to play a critical role in rolling out local infrastructure investment and public expenditure. LGFVs will continue to undertake socio-economic policy mandates and support local economic development – owing to the structural mismatches between LGs' revenue and expenditure. 

We believe LGFVs will gradually transform into local state-owned asset management and investment companies, and government service providers. As such, there may be several rounds of sector consolidation resulting in the polarisation of LGFVs. Those having strong policy mandates are likely to benefit, while others with weak policy mandates will eventually be sidelined and closed.

Q: How’s the pipeline for LGFV bond issuance in 2019?

The liquidity and policy condition of LGFVs has largely improved since July 2018 when central authorities issued a policy statement to “ensure the proper funding needs of LGFVs”.

The interest rate spread of LGFV bonds between onshore and offshore market has narrowed or even reversed – i.e. onshore funding cost is lower than offshore, especially for those with a credit profile above average. As such, we expect there will be less offshore issuance for this type of issuers.

For those with weak credits, Fitch expects their liquidity will still be quite tight in both onshore and offshore markets.

Q: Several LGFVs have issued green bonds. How are green bonds developing in this sector? 

There is no doubt that the growth of green bonds has gained real momentum in the Asia-Pacific region (APAC). Chinese authorities have made a top down effort to encourage this asset class. By issuance volume, China has become the largest green bond market in APAC and the second-largest globally, just behind the US.

China’s railway and metro companies are frequent issuers of green bonds due to the environmentally friendly nature of massive transit systems. Fitch has rated the offshore green bonds issued by Wuhan Metro Group (A/Stable) and Tianjin Rail Transit Group (A/Stable) in 2018, and these notes have been well received by the investors.

Urban developers could also become green bond issuers for developing the energy efficient and ecological friendly infrastructure facilities and buildings. Increasingly, LGFVs are starting to realise that being a green bond issuer could make them better aligned with the demands of regulators, investors, internal and external stakeholders. 

Q: It seems Chinese LGFVs are unique. Are there similar entities in other counties?

LG funding via its satellite companies is a common practice around the world. We have observed and rated thousands of these entities from Europe (e.g. France and Italy), as well as in Asia-Pacific nations (e.g. New Zealand, India and China). Some smaller LGs want to collectively set up a financing vehicle to achieve a better funding cost – one example is the New Zealand Local Government Funding Agency Limited (AA/Stable).

Others might do so for better project management and higher efficiency, e.g. India’s Kerala Infrastructure Investment Fund Board (BB/Stable) and SEMAPA (AA-/Stable) in France.

Although these LGFVs might carry different purposes and legal setups, they normally have close operational and financial links with their sponsors and their defaults will also potentially cause significant social, political and financial impact to their sponsors. As such, Fitch assesses the creditability of these LGFVs by using our unified GRE criteria globally.  

Q: Does fundamental analysis matter for LGFVs’ credit profile?

Fitch assesses the stand-alone credit profile of GREs, i.e. excluding potential extraordinary support from the government.

The majority of the GREs have a weak credit profile, with a likely rating in the ‘B Category’. For typical urban developers, they tend to have limited profitability and high leverage with a net debt to EBITDA in double digits. The revenue of these entities is primarily derived from contracted works with the government, with substantial receivables due from the government.

Part of the debts of LGFVs will be settled via the repayment of these receivable or LGs’ capital injection. These debt repayment sources might not be captured by the conventional profit and loss credit metrics. Such LGFV debts are therefore consolidated in the analysis of the LG indebtedness. The standalone credit profile of the LGFVs may have very limited value, explaining why those entities are rated top down from their “parent”.

Fitch Ratings’ Credit Outlooks 2019 is available here

Fitch video: 2019 Outlook - China Credit Outlook Roundtable

More insightful commentaries about the Asia-Pacific region are available here

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