China’s local debt bomb fuse starts offshore

Huishang Bank

21/02/2023 02:36

(The author is a Reuters Breakingviews columnist.  The opinions
expressed are her own.)
    By Yawen Chen
       HONG KONG, Feb 21 (Reuters Breakingviews) - China’s next
asset bubble looks primed to deflate, and this one could pop
with a bang. Local government financing vehicles, or LGFVs, were
the main drivers of China’s infrastructure boom, and have become
big bond issuers overseas - just like the property developers
that set off a wave of defaults starting in 2021. With overall
outstanding debts estimated around 65 trillion yuan, or $9
trillion - roughly equivalent to half of national economic
output - some of them are struggling to make payments, and
Beijing is further tightening the offshore funding channel,
making it harder to refinance. A bailout would be expensive and
bad for domestic banks; letting them default threatens the
creditworthiness of the Chinese state.
    The LGFVs share dangerous similarities with developers. They
are supposed to support regional economic development, but many
have borrowed recklessly. In addition to building vanity
projects or roads to nowhere, they have got heavily involved in
property, stepping in to buy and develop land as real estate
firms run out of cash. The fiscal condition of their municipal
backers has rapidly weakened through the pandemic too. Beijing
is fretting and in 2021 introduced curbs on LGFV leverage in a
document known as Circular 15, reminiscent of the “three red
lines” policy applied to developers in 2020, which set off the
current real estate crisis. 
    Struggling to finance themselves at home thanks to the
circular, the LGFVs increasingly went offshore, and bond
issuance there hit a record in 2022, bringing the outstanding
amount to $95 billion, per S&P Global analysts, with smaller
entities driving the surge. In absolute terms that is dwarfed by
their onshore obligations, but risks are concentrated overseas
as financially weaker entities from poorer regions have become
more dependent on hard-currency markets. In the north-eastern
rustbelt province of Liaoning, for example, dollar bonds
accounted for 22% of its total issuance maturing last year,
according to Founder Securities analysts. 
    For offshore investors that are predominantly Chinese banks’
overseas subsidiaries, these LGFV bonds look like a safe bet.
They offer better returns than the domestic issues, with less
default risk than property disasters like China Evergrande
 3333.HK . Given implicit government backing, most LGFV credit
is either rated investment grade or priced as if it is, despite
weak cash flows and questionable fundamentals. S&P estimates
their coupons averaged 4.6% last year, only slightly above
corporate financing costs for bank loans onshore, whereas
offshore developers had to offer double-digit yields. 
    That means any crash in their values could be bloodier than
developers suffered. So far there have been occasional late
payments, but official defaults have been avoided. In January
Zunyi Road and Bridge Construction, an LGFV in Guizhou province,
restructured $2.3 billion of onshore bank loans and deferred
payment  for two decades but vowed to honour offshore
obligations. It may help that so many of the bondholders are
Chinese state-owned banks. Markets are worried but not panicked.
For example, yields have risen sharply on a $300 million dollar
bond maturing in November 2023 issued by Gansu Provincial
Highway Aviation Tourism Investment Group, an LGFV in China’s
hinterland, but it still trades at 95 cents per dollar,
Refinitiv data shows. A comparable Evergrande note trades at 9
cents.
    However, the largest, best-capitalised lenders have
retreated from the market, leaving the offshore subsidiaries of
mid-sized institutions like Industrial Bank  601166.SS  as major
underwriters and investors. Peers like Huishang Bank  3698.HK 
also supported one-third of LGFV issues by providing stand-by
letters of credit as guarantees, per an analysis by Pengyuan
credit rating agency, which means they will be on the hook to
honour those debts if the LGFVs cannot. Even so, some Chinese
banks may not be able to bear the financial weight. There is the
risk of an offshore default triggering early redemptions of all
obligations offshore or even those onshore, depending on the
covenants, which could drag in even more investors. China’s
capital controls also make it harder for companies to move money
out of the country to make payments.
    New LGFV offshore bond issues halved to $6 billion in the
quarter ending in December from a peak in April-June, S&P data
shows, as the state economic planning agency instituted a
lengthier approval process. As with real estate, policymakers
are walking a tightrope, trying to rein in risk without
triggering a crash. 
    Follow @ywchen1 on Twitter
    CONTEXT NEWS
    China's new home prices rose in January for the first time
in a year, official data showed on Feb. 16, as the end of the
zero-Covid regime, favourable property policies and market
expectations for more stimulus measures boosted demand.
    Fiscal revenue rose 0.6% in 2022 from a year earlier,
slowing sharply from a 10.7% increase in 2021 due to huge tax
rebates for businesses to support the Covid-ravaged economy,
data from the Ministry of Finance showed on Jan. 30. Separately,
land sales fell 23% last year to 6.7 trillion yuan ($972
billion).
    On the same day, the ministry said it will curb “new hidden
government debt” and standardise the management of local
government financial vehicles. 
 (Editing by Pete Sweeney and Thomas Shum)
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