Commentary on Political Economy

Wednesday, 18 November 2020


China’s Next Default Pressure Point Comes Closer

Beijing wants to keep troubled local debt vehicles at arm’s length. This determination will be put to the test.

Beijing won’t let local governments use Covid-19 to excuse poor risk management. Above: Wuhan returns to normal.
Beijing won’t let local governments use Covid-19 to excuse poor risk management. Above: Wuhan returns to normal. Photographer: AFP/Getty

As Beijing reins in its largesse and credit stresses rise in China amid a wave of defaults, investors should wonder where the ructions will appear next. 

Going by the numbers, local government financing vehicles – with trillions of yuan outstanding – seem primed to come under pressure. Their debt is meant to help raise capital for infrastructure and other public projects. Issuance in the first seven months of the year totaled 2.5 trillion yuan ($381 billion), up 32% over the same period in 2019.

These debts come under the oversight of provincial governments through special purpose vehicles, but aren’t always on their balance sheets. They’ve long been considered secure and quasi-fiscal entities. The yield difference between weak and strong borrowers is typically narrower than for similar corporate ones. LGFVs are also the largest issuers in corporate bond markets, having surpassed state-owned enterprises at the end of 2018, accounting for almost 35% of the issuance. Investors clearly assumed they were safer. Net financing for weaker provinces surpassed their higher-rated peers, suggesting that credit differentiation hasn’t been front of mind.

Trouble is, it’s no longer just about their ability to pay back creditors; it has now become a question of willingness. And that’s harder to assess. After two provinces, Qinghai and Guizhou, ran into trouble last year, investors pulled away and started assessing the risks around various provincial borrowers – geography, wealth, fiscal flows, lucrative industries (or lack thereof). Yet between May and July, net financing for weaker AA or below issuers in the domestic market was higher than for local government financing vehicles rated AAA, according to Moody’s Investors Service. Buyers were willing to be compensated for the risk. Sell-side analysts talked up their confidence in these assets.

These vehicles were created to kick-start financing and growth after the global financial crisis, essentially as state-backed companies with clean balance sheets to help stimulus flow through the economy. Many no longer serve that purpose. Part of the problem is that over half of the issuance in the second quarter was used to refinance old debt, not to boost capital expenditure or even investment. Across most provinces, capex spending isn’t growing this year compared to 2019, according to a Rhodium Group analysis.

Now, maturities are looming. Over the next three months, around 750 billion yuan of debt comes due. The picture is similar through next year. Meanwhile, more than $3 billion of offshore or dollar-denominated bonds from local government financing vehicles — held primarily by international investors or Chinese buyers looking for foreign currency exposure – will be up for repayment or refinancing in December. 

At this point, whether Beijing shows up to protect creditors is a guessing game. The central government has long maintained that municipalities need to deal with their own liabilities. State planners made a push in 2017 to commercialize the financing vehicles and keep them at arm’s length. In June, China’s finance minister said that local governments shouldn’t be using the Covid-19 turmoil as an excuse for not managing their debt risks. Provincial treasury officials are being taken to task as borrowing restrictions are enforced.

It isn’t clear how many local debt vehicles are commercially viable, and that’s what investors need to start looking for. Beijing has attempted to push for cleaner borrowing away from shadow channels, and the pressures of transparency are building. The central government’s ability to use fiscal policy to fund infrastructure increasingly looks fractured.

“This is the flipside of the credit cycle, where the lack of transparency hurts you rather than helps you,” says Logan Wright of the Rhodium Group.

How many of these vehicles will go under or default is hard to know. But there’s already enough precedent to say that the probability is rising. Even if Beijing allows debts to roll over so it doesn’t have several hard-up provincial borrowers on its hands, some of their interest costs are punishingly high.

If investors don’t have clarity, they’ll start withdrawing across the board. That will put pressure on credit conditions, far too many borrowers, and funding channels. Then we’ll see how far Beijing will really stand back. 

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