Some of China’s local government financing vehicles (LGFVs) are increasingly likely to default on their public debts, but foreign investors can breathe a sigh of relief—any debt collapses will most likely impact lower-tier bonds that are mostly held by local buyers. 

However, the likelihood of defaults of government-linked borrowers underlines the increased risk of investing into Chinese bonds, and the need for foreign investors to do their due diligence in the absence of international rating agencies. 

Fitch Ratings said in a report on September 24 that the LGFVs most likely to default consist mostly of lower-tier, or non-provincial LGFVs. The rating agency added that the timing of the initial defaults are uncertain. 

Some other experts think that bonds across all rating levels in China face increasing default risks. The country’s overall debt continue to mount, which has led Bejing to be less concerned with defaults.

That is forcing China’s financial system to grapple with the trade-off between risk and reward, after years of assuming government-linked debt was essentially default risk-free. 

"The government is becoming more comforable with investors sharing the pain. Historically there had been more intervention [by Beijing to bail out troubled issuers]," Keith Pogson, a senior partner for Asia-Pacific financial services at consultancy EY, told AsianInvestor.

Addressing debt growth

Fitch warned that stressed LGFVs are likely to see selective defaults as Chinese authorities aim to address indiscriminate debt growth by some of the vehicles and attempt to instill greater market discipline.

It noted that onshore LGFV bond issuance skyrocketed from Rmb35 billion via 17 issuers in 2005 to Rmb2.31 trillion through 1,135 issuers in 2016, marking a 46% compound annual growth rate. 

The agency estimates that LGFVs still have Rmb4 trillion in outstanding debt that has been issued since 2015, equivalent to 5.4% of China’s GDP. It warned that this debt accumulation is likely to have involved at least pockets of excessive risk taking and debt hiding.

LGFV borrowers are particularly vulnerable if they mixed commercial activities with policy work, such combining residential projects with urban development, Fitch's report warned, adding that the vast majority of LGFVs possessing a Fitch rating are connected with high-ranking local governments, so are not likely to be affected.

They are riskier, because of higher debt level in the building projects. Also, the economic model is more exposed to economic cycles and more subject to uncertainty, Nicolas Painvin, head of criteria, credit and research for global public and infrastructure finance at Fitch Ratings, told AsianInvestor in an emailed reply.

These entities have borrowed to develop facilities which are supposed to be paid by future economic development, not by taxes, he said. Fitch rates about 50 Chinese LGFVs, of over 7,000 operating in China, according to sources familiar with the organistions.   

A domestic dilemma

Initial LGFV defaults appear most likely to impact local investors. Terry Gao, senior director of international public finance at Fitch Ratings told AsianInvestor in emailed comments that foreign investors have focused on investment-grade LGFV bonds, while the high-yield ones are mainly bought by locals.  

However, Gao noted that it is sometimes hard to distinguish domestic investors from foreign ones. He noted that a foreign fund could be financed by Chinese investors and invest according to the mandate set by these local accounts.

One likely impact of local LGFV defaults is that they will trigger a repricing of the bond market, although Fitch demurred to estimate the likely changes in bond prices and yields that could occur.

"We envisage from a purely logical standpoint and empirically observed precedents that a change in the risk discrimination may entail a change in pricing,” Fitch's Painvin said.

While defaults are likely to rise, Fitch’s report said widespread LGFV defaults remain relatively unlikely. It noted that the authorities continue to rely on local government investment, which are supported by LGFVs, to hit economic growth targets. Plus, local and municipal governments have a broad spectrum of policy tools to limit default contagion, it added.

China’s central authorities have been making efforts to separate LGFVs from public-sector balance sheets as part of a broader drive to contain risks associated with the rapid growth of municipal bonds. The Fitch report noted that Beijing has introduced debt ceilings and debt swaps to facilitate the conversion of LGFV obligations into explicit local government debt.

Downgrade concerns

Fitch’s warning on LGFVs comes days after Standard & Poor’s downgraded China’s sovereign credit rating from AA- to A+.  

This is unlikely to directly lead to LGFV rating drops as well, according to Bank of America Merrill Lynch. It said in a report released on September 22 that while the credit profile of local governments is closely linked to the central government, the LGFVs rated by S&P have a stable outlook and are thus unlikely to be downgraded in the near-term. 

However, some offshore LGFV bonds may face technical default risk as they may not be able to meet debt obligations because of increases to China’s capital controls, Harry Hu, director of financial institutions at S&P Global Ratings, told AsianInvestor.

“Institutions need the approval of Safe (the State Administration of Foreign Exchange) to get money out [of the country]. The approval time is now longer than before,” he said.

Low-grade LGFV bonds may have higher default risk because the issuers of them tend to have poorer liquidity management, he added. Unfortunately, the ability of rating agencies like Fitch and S&P to warn about the risk of local Chinese bonds is very limited, because they lack the requisite licences to rate them, Hu added.

This is a problem at a time when China is trying to encourage more investment into its bond market. Without the ability to use international rating agencies to gauge domestic default risks, international investors may well limit their exposure to the country’s bonds.