Chinese investors are gradually accepting a new reality: the government is reducing support for the local funding units as it tries to curb their massive borrowings.
China’s cities, towns and counties are facing surging borrowing costs as investors anticipate landmark defaults. A local government financing vehicle in the country’s east was recently forced to pay a coupon on a bond that matched a record. Average financing costs in credit markets for the units that finance roads, bridges and sewers have jumped, with yields for some borrowers surging the most in six years. Chinese investors are gradually accepting a new reality: the government is reducing support for the local funding units as it tries to curb their massive borrowings. In August, a builder of social welfare housing in the southern province of Hunan said it will change from a government financing arm to a regular state-owned company, fueling concern it will lose financial support from regional authorities. At least 40 other LGFVs across China announced similar plans from 2015.
“Investors’ faith in the government’s implicit guarantee for LGFVs is weakening,” said Wang Ming, chief operating officer in Shanghai at Shanghai Yaozhi Asset Management Co. “The pricing of LGFV bonds is more and more reflecting their own credit fundamentals, which aren’t good. Default risks of weaker LGFV bonds are rising.” Those broader concerns spelled higher debt costs recently for Jiangsu Hanrui Investment Holding Co., based in Zhenjiang in the Yangtze River delta. The builder of an economic development zone in the city in the eastern province of Jiangsu sold 1 billion yuan ($153 million) of 270-day bills last week to yield 6.8 percent. That matched the highest coupon on record for similar-maturity LGFV notes.
In secondary trading, notes from the nation’s local funding units are also losing luster. The average yield on seven-year AA- rated LGFV bonds has risen 108 basis points this year, set for the sharpest increase since 2011. At 6.45 percent, it’s near a two-year high marked in June. Despite the shift in the market, there are still some investors who believe the government won’t allow defaults among the financing vehicles that support construction throughout the nation. “If any LGFV runs into repayment trouble, local government won’t stand aside,” said Qiu Xinhong, a Shenzhen-based money manager at First State Cinda Fund Management Co. “Otherwise, it would cause systemic risk.”
But there are warning signs. Just as the market reassesses local credit risks, lower-rated LGFVs face rising bond repayments next quarter. Financing arms must repay a record 21 billion yuan of notes rated AA or lower in the period, the highest amount on record, according to Bloomberg-compiled data. Hanrui illustrates the bigger trend of the local units piling on borrowing. It has sold 8.5 billion yuan this year in the onshore market, almost double all of 2016, the data show. All of the securities sold mature in a year or less.
China’s Golden Credit Rating International Co. rated Hanrui AA+, equivalent to investment grade locally, while Fitch Ratings gave the issuer a junk rating of BB+. An operator at Hanrui declined to transfer Bloomberg’s call seeking a comment on the coupon rate. “It’s hard to define LGFVs’ risk profile under current circumstances,” said Chen Qi, chief strategist at private fund management company Shanghai Silver Leaf Investment Co. “The government is trying to let LGFVs operate as regular enterprises but LGFVs still have connections with the government in many aspects so it can’t totally withdraw the support.”