China in infrastructure drive via local govt bonds
China is turning to tailor-made local government debt to fund infrastructure projects and support the economy, but investors tempted by such bonds should be wary of putting their money to work in overly crowded sectors.
Local governments have to meet an issuing quota set by central government for these special-purpose bonds each year. Although directly sourced figures are hard to come by, Fitch Ratings and Chinese media reports indicate that this quota has risen to Rmb1.35 trillion ($196 billion) this year from just Rmb100 billion in 2015 and Rmb800 billion last year.
Trouble is, only Rmb150 billion of new special-purpose bonds were issued in the first seven months of this year, estimates Fitch Ratings, in what appears to be an unforeseen consequence of the deleveraging drive stressed by the central government late last year.
So China's Ministry of Finance, keen to offset some of the downward pressure put upon the Chinese economy by the US trade conflict, ordered local governments on Tuesday to issue no less than 80% of their assigned annual quota in August and September, with the remainder done in October.
That's some Rmb930 billion ($135 billion) of new bonds expected to hit the market in just two months.
It’s a pre-emptive measure to counter the ongoing trade war, Iris Pang, Greater China economist at ING Bank, told AsianInvestor on Friday. But it could also lead to further excess capacity if these funds are misallocated, she warned, singling out infrastructure projects aimed at protecting the environment and countering pollution.
It is difficult to estimate the effectiveness of environmental projects and "overinvestments" will easily happen, she said.
REPLACING LGFV?
The special-purpose bonds are backed directly by local government, so default rates have tended to be very low. As Terry Gao, senior director for international public finance at Fitch Ratings, told AsianInvestor on Thursday, "they are backed by local governments’ fiscal reserves and are in nature with higher credit quality.”
As such, he is confident that the accelerated sales drive will be met since state-owned Chinese commercial banks, insurers and funds will want to demonstrate their solidarity with central government policy to buy the bonds. Ping An Asset Management, for example, has already told AsianInvestor that it plans to invest more in local infrastructure debt.
The National Development and Reform Commission, the country’s top economic planner, said on Wednesday that Beijing wanted to boost investment in infrastructure projects and alleviate the financing pressure on local governments. It also cited the ongoing trade dispute with the US.
Curiously, the Ministry of Finance statement followed news of a default on a local government financing vehicle (LGFV) in the western province of Xinjiang. The Shanghai Clearing House announced on August 13 that the company had failed to pay principal and interest on its Rmb500 million, 270-day bond.
As the fourth case so far this year of a local government-related entity defaulting on its debt obligations, and the first involving a bond, that is likely to have dented broader investor sentiment.
Even so, there are a thousand-plus LGFVs in existence that will still be favoured by the central government, Gao of Fitch Ratings said, not least while China leans on both them and special-purpose bonds to shore up the economy as export and internal consumption weakens.
Whether that generates a degree of moral hazard in the context of hybrid planned economy is a moot point, but the yields on the special-purpose bonds are around 40 to 50 basis points higher than on Chinese government bonds, while bonds issued by LGFVs pay 4.5% to 6% on average.
ING’s Pang believes special-pupose bonds issued by local governments will gradually play a bigger role in driving infrastructure investment than LGFVs, partly because they are more transparent.
In many cases little is known about whether a LGFV is investing in local government projects, public-private partnership or other assets. In contrast, local government bonds are very transparent and investors can better evaluate the risk and return, she said.
Local governments also have no obligation to bail out LGFVs in case of of default, although there is a widespread perception that they would.
New issuance of LGFV bonds in 2017 dropped by 30% year-on-year to Rmb 1.7 trillion, while net issuance -- new issuance minus maturing debt -- fell last year to its lowest level in seven years, according to a report in March by Guotai Junan.
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