INFOGRAPHIC: China’s local governments start to feel pinch

Rising onshore borrowing costs leads to a rising risk of bond defaults by local-government financing vehicles

China’s local-government financing vehicles (LGFVs) will face refinancing pressure this year due to their rising funding costs onshore.

Economists and credit analysts expect China’s government bond yields to continue to rise, which will translate into a higher interest burden for the government-linked borrowers.

The 10-year bond yield, a key metric of borrowing cost for LGFVs, rose to 4% in November last year, the highest level in three years, before moderating to about 3.7% as of April 19.

Most of LGFVs’ debt is relatively short term, in the three to five year tenor range, and this is also rising. According to data provider Wind, a LGFV bond pays about 6.5% over a three-year period, up from 4.5% in the end of 2016 over the same maturity.

“We expect some weak LGFVs may default this year due to access to refinancing becoming more difficult,” Christopher Lee, a Hong Kong-based analyst at credit rating agency Standard & Poor’s, told FinanceAsia.

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LGFVs are funding vehicles created by regional governments to finance key generators of growth in the world’s second-largest economy, local construction and infrastructure projects.

LGFV bonds represent about 40% of China’s Rmb 18.3 trillion corporate debt market. LGFV debt including bank loans surpassed the central government debt for the first time at the end of last year, Wind data showed.

A key concern among investors contacted by FinanceAsia is that the rampant growth in LGFV debt has created a moral hazard, since GDP-obsessed officials are desperate to keep up with their growth-oriented targets. In China, promotion of government officials is mainly based on their merits in boosting local economic output.

China’s Ministry of Finance threw cold water on this cycle in March. It issued a statement to dissuade state-owned lenders from providing further credit to local governments, in a move to control the growth of debt and prevent systemic risk.

Chinese commercial banks are the biggest buyers of onshore LGFV debt, a Rmb 7 trillion market.

The ministry also said local governments should not provide any guarantees to creditors, who hold an unrealistic belief that the central government is willing to bail out failing companies in the event of default.

The Ministry of Finance’s ruling is the latest blow to LGFV’s financing, coming on the back of a broader deleveraging campaign that has impacted local government’s ability to refinance their debt.

S&P’s Lee noted that there are large maturities coming due and government policies are become increasingly tougher for these issuers to continue to rely on raising new funding to repay old debt.

According to S&P’s estimate, there will be Rmb1 trillion of maturing bonds for each year between 2018 and 2019, and the remaining Rmb5 trillion will mature after 2020.

China’s deleveraging campaign is already starting to have an impact according to credit analysts at broker Guotai Junan showed new issuance of LGFV bonds in 2017 dropped 30% year-on-year to Rmb 1.7 trillion, and net issuance, the sum of new issuance minus maturing debt, of 2017 fell to the lowest level in seven years.

To be sure, there has not been a bond default in the country’s wider public sector yet, but credit analysts are expecting it to happen soon and there are signs of distress in the economy.
In January last year, a government-linked entity called Yunnan State-Owned Capital Operation technically defaulted on two trust loans totaling Rmb1.5 billion, but the company was ultimately saved by the local government of Yunnan, which provided about Rmb 2billion of new equity to the company.

For investors, the most critical part of the credit analysis of LGFVs is the financial health of local governments, which don’t usually make their fiscal spending public. In many cases, the data provided by local governments is patchy.

“There have not been any public bond defaults by LGFVs, but there are cases of defaults in bank loans and trusts,” Ivan Chung, an analyst at credit rating agency Moody’s told FinanceAsia. “The bank loans and trust markets are not transparent and the default information is sometimes not publicly available and can hardly be verified.”

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