THE pressure on LGFVs is rising as they are subject to uncertainty over government support, refinancing risk and liquidity risk. However, behind every dark cloud is a silver lining, as defaults in the LGFV space could help bring about credit differentiation and be good for the long-term health of the corporate bond market.
In the past five years onshore LGFV bond issuance continued to rise. As of the end of last year, more than 1,000 LGFVs issued outstanding bonds totaling 6.8 trillion yuan (approx. US$1.05 trillion), according to Wind Information. This represents 37% of China’s total outstanding corporate bond issuance in 2017.
When asked about the possibility of LGFV defaults, Zhi Wei Feng, the head of China corporate credit research at Standard Chartered, says: “I wouldn’t be surprised, because they (LGFVs) are from so many different places and I think it’s very hard for the local government, even if they want to, to bail out every single name.”
Moreover, Moody’s, Fitch and Standard & Poor’s have all made statements about the possibility of a bond default in the space in 2018. “The risk of LGFVs defaulting on their bonds has increased, which is why we may well see the first LGFV default in the bond market,” says a Standard & Poor’s report released in late January.
LGFVs traditionally raised money from the bond or loan market with the support of local governments acting as guarantors or providing collateral. However, since 2014 the central government has launched several policies to prohibit local and regional governments from providing support to LGFVs. They have also diverted the funding needs of the local government away from LGFVs to the local government bond market, and have opened other avenues to issue debt, such as land reserve bonds, metro bonds and toll road bonds.
The central government’s aim is to prevent the local government from being exposed to debt obligations in LGFVs which will result in contingent liabilities. However, most LGFVs currently have quite a substantial debt burden and require refinancing in the market. The government’s move makes it difficult for LGFVs to refinance or even service their debt because investors are changing their perceptions.
“In the past LGFVs were largely based upon implicit government support, but now we see that the implicit government support is getting a bit more and more remote from a policy perspective,” says Ivan Chung, associate managing director at Moody’s, speaking at a roundtable on January 31 2018.
In addition, the funding environment is unfavourable given the rising onshore interest rates. There is also less investor participation from banks. “Now there is tighter supervision on financial institutions, which means they can no longer do as much leveraged bond investment as in the past,” Chung adds.
Alternate funding avenues are also becoming more remote. Previously, when LGFVs had difficulty raising funds from the bond or bank market they would go to the trust market – a destination for investors in search of higher yields. “Given the government’s tough stance and supervisory measures on shadow banking products, this market is also shutting down for LGFVs,” says Chung.
Yunnan State-Owned Capital Operation Company is one example of an LGFV that defaulted on two trust loans in mid-December. Even though they later obtained financing to repay the loans, this was the first known default of off-balance sheet debt by a local government.
Considering the recent deleveraging measures, the onshore government might well allow LGFV defaults to occur, which will cause both a repricing of these bonds and a drop in market liquidity. Access to foreign borrowing might also drop off.
Yet there may be a silver lining. By allowing defaults the authorities are giving rise to a maturing corporate bond market which will lead to greater credit differentiation.
“Today’s LGFVs are similar to China property say 10 years ago. Only after so many years do investors realize they are different,” says Feng. “They have different geographical focuses, sizes and target markets, although they’re all called China property. Eventually LGFVs will have all these tiers – the differential will be a lot bigger.”
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