Rating companies say the risk of defaults in China has risen as Premier Li Keqiang pares implicit guarantees for local-government financing vehicles.
The yield premium over the sovereign for three-year AA corporate bonds, the most common grade for LGFVs, widened 21 basis points from last month’s four-year low to 198 basis points on Oct. 9. The State Council said Oct. 2 that the finance arms can no longer raise funds for local authorities, and that the governments have no obligation to repay debt that wasn’t raised to fund public projects. China International Capital Corp. predicts higher yields for new sales, while China Lianhe Credit Rating Co., a Fitch Ratings joint venture, says it can’t rule out defaults.
“The market is entering a new era,” said Chen Jianheng, a Beijing-based fixed-income analyst at CICC. “The time when everybody bought LGFV bonds for high returns without considering credit risks are gone. For any sales in the future, investors will apply a different set of criteria.”
Premier Li has accelerated budget reforms in the past year as a borrowing spree which started after the 2008 global financial crisis prompted economists including those at JPMorgan Chase & Co. to compare it to debt surges that tipped Asian nations into repayment troubles in the late 1990s. Local government liabilities, equivalent to 30 percent of the nation’s gross domestic product by a Fitch estimate, grew 67 percent from the end of 2010 to 17.9 trillion yuan ($2.9 trillion) as of June last year, according to a state audit.
Creditors and debtors should work together to identify existing LGFV bonds which governments have repayment obligations on, according to the State Council statement posted on the central government website. Such debt will be included in local budgets and can be replaced by new issuance with lower costs, while the rest is subject to repayment failure, it said. Apart from public projects, the funding vehicles also raise money for the private sector.
LGFVs issued 1.7 trillion yuan of debt this year, exceeding the 1.16 trillion yuan of 2013, data compiled by Bloomberg show. Repayments will amount to 250 billion yuan a year in 2014-15, and may rise to 350 billion-400 billion yuan in 2016-17, according to Lianhe Credit Rating estimates.
“LGFVs’ profitability is weak and, given the huge repayment pressure, there’s the possibility that certain bonds are likely to default on a lack of government endorsement,” Liu Xiaoping, director of credit rating at Lianhe, wrote in a report on Oct. 8.
Fiscal and tax reforms came into focus after the Communist Party’s Third Plenum in November 2013, which promised to give markets a “decisive” role. This August, lawmakers passed an amendment to the budget law to clear legal hurdles for local governments to issue bonds directly. A ban on such borrowings in a 1994 version led to the establishment of thousands of financing companies to fund the building of sewers, roads and bridges. The World Bank estimated that regional administrations are responsible for about 80 percent of spending while receiving only 40 percent of tax revenue.
In an effort to streamline the process and clear the muddle caused by LGFVS which don’t publish their accounts, the finance ministry expanded a trial of municipal note sales to 10 provinces and cities this year from six in 2013, and regulators approved the issuance of revenue bonds that are linked to specific projects.
“These steps show the central government is really serious about handling the debt,” said Zhang Yingjie, Beijing-based deputy general manager of research at China Chengxin International Credit Rating Co., a Moody’s Investors Service joint venture.“Sovereign credit was overdrawn in an opaque financing system, but from now on the responsible parties will be clearly stated.”
China’s economy will grow 7.3 percent this year, the slowest pace in 24 years, according to a Bloomberg survey. The yield on the nation’s 10-year sovereign debt fell for three quarters in a row, declining to 3.98 percent on Sept. 30 from 4.56 percent on Dec. 31. The yuan has fallen 1.3 percent this year to 6.1309 per dollar in Shanghai last week.
“While the State Council guidelines emphasized that the central government won’t bear responsibilities for local liabilities, it also said the bottom line is to prevent regional and systemic risks,” said Xu Hanfei, an analyst at Guotai Junan Securities Co. in Shanghai. “So we don’t expect any large-scale refinancing difficulties.”
Shanghai Chaori Solar Energy Science & Technology Co. (002506), which in March became the first company to default in China’s onshore bond market, received a guarantee from China Great Wall Asset Management Corp. to help make repayments, according to an exchange filing on Oct. 7.
Given the fact that even Chaori’s investors were bailed out, the impact of any LGFV debt rollover difficulties will be controlled, said CICC’s Chen. “Still, there is almost no doubt that some LGFV bonds will be marginalized.”
The yield on Zhenjiang City Construction Investment Co.’s notes due 2021 climbed to a three-week high of 6.50 percent last week, while that on Jining City Construction Investment Co.’s bonds due 2021 rose to 6.25 percent, the highest since Sept. 22.
“The real impact will surface probably not until next year, when the amended Budget Law takes effect,” said Song Qiuhong, an analyst at Shunde Rural Commercial Bank Co. in Guangdong province. “For a very limited number of bonds, it’s possible that holders will find it difficult to sell.”