China may finally be ready to cut the cord when it comes to the country’s troubled local government financing vehicles. Beijing’s deleveraging drive has seen rules impacting LGFV debt refinancing tightened, spurring a slump in issuance by the vehicles, which owe about 5.6 trillion yuan ($818 billion) to bondholders and are seen by some as the poster children for China’s post-financial crisis debt woes. Signs the authorities may be taking a less sympathetic view of the sector has ratings companies flagging the possibility that 2017 could see the first ever default by a local financing vehicle.
A Ministry of Finance circular dated April 26 barred municipal governments from giving ownership of public assets or land to their local financing companies and prohibited the use of revenue from land sales to help the vehicles repay their debt. This move “effectively closed the door” on Beijing’s support for the vehicles, as this was a key way for them to bolster their repayment abilities, said Ivan Chung, head of Greater China credit research at Moody’s Investors Service. “The central government might need an LGFV default to send a clear signal to the market that it won’t always bail them out.”
Allowing one of the vehicles to default would be a shift for Beijing, whose support for local financing vehicles has been taken for granted by investors as a symbol of the lengths the authorities will go to to bubble wrap China’s economic recovery. In 2015, officials created a new budget law and bond swap program to ease the debt burden of LGFVs, which were used by municipal governments after 2008 as a way of raising cash to meet funding shortfalls when local bodies themselves were prohibited from issuing debt on their own. Since then, provincial-level governments have been allowed to sell bonds of their own accord with the finance ministry setting a cap on outstanding debt each year.
Notoriously immune to negative news flow in the past, local financing vehicle yields have spiked this year as traders speculate about the central government’s support. China saw the first ever credit downgrade of an LGFV by an international ratings agency in April, and Moody’s flagged the sector as a source of increasing contingent liabilities when it reduced the Chinese sovereign’s rating last month. While LGFVs face a record amount of maturing debt this year, the finance ministry’s curbs saw sales slide 70 percent in May from the previous month to 50 billion yuan. This is down from an all-time high of 2.1 trillion yuan in onshore sales last year, and the $12.7 billion of debt raised offshore. The implicit guarantee that had been provided by the local financing vehicles’ municipal parents had encouraged borrowing.
The ministry has also asked for a nationwide check of debt guarantees by local governments by July 31. “LGFVs will face a tougher second half,” S&P analyst Gloria Lu wrote in a research note in May. “The pressure to weaken their ties with local governments and market liquidity stress are likely to result in the credit crunch. The first LGFV default may emerge.”
For China Lianhe Credit Rating Co. — a Beijing-based agency 49-percent owned by Fitch Ratings — the appeal of local financing vehicle bonds has been the result of “excessive optimism” as investors scrambled for high yields. “The companies’ credit qualities vary greatly, so defaults will certainly occur,” Lianhe said in an email in response to questions. Investors are already demanding additional returns, with the premium on AA rated five-year LGFV notes over sovereign debt climbing earlier this month to the most since July 2015, ChinaBond data show.
“Going forward, investors will pay more attention to the underlying credit quality and differentiate higher quality credits and lower ones more than before,” said Raymond Gui, who helps oversee $1.7 billion at Income Partners Asset Management (HK) Ltd.