Published: 03:05 PM, 27 August 2023
Why LGFV Debt Is a Growing Risk for China’s Economy
Cracks are showing in a pillar of China’s debt market known as local-government financing vehicles, or LGFVs. Created to fund such things as roads, airports and power infrastructure, they rarely generate enough returns to cover their obligations. That means most rely on injections of municipal funds to stay solvent. With many local authorities facing cash-flow problems due to the country’s real estate crisis, there are growing concerns about this $9 trillion market — prompting the government to take steps to effectively bail out weaker issuers and avert a credit crunch
1. How do LGFVs work?
LGFVs were originally established to skirt around a ban on municipal authorities borrowing from banks or selling bonds directly in the open market. The money they raise is usually spent directly on infrastructure like roads, bridges and water plants that can take a long time to complete and often generate low returns. While LGFVs are categorized as corporate debt, investors generally assume that local governments are held accountable for them.
2. How did they become so important?
LGFVs have been central to government efforts to ensure that infrastructure and public services expand fast enough to sustain China’s outsize economic growth. They took off after the 2008 financial crisis, when the government undertook a 4 trillion yuan ($586 billion at the time) national stimulus plan, and have grown rapidly ever since.
3. How significant are they to China’s economy?
The International Monetary Fund estimated that LGFV debts nearly doubled over the past five years to about 66 trillion yuan ($9 trillion) — equivalent to more than half of China’s annual economic output. LGFVs had about 13.5 trillion yuan of outstanding onshore bonds at the end of 2022, according to data from S&P Global Ratings — representing about 40% of China’s non-financial corporate bond market. All types of financial institutions have exposure to them: commercial banks via their wealth management units, insurers, mutual funds, securities companies and hedge funds. The overwhelming majority of their investors are local, as foreigners consider LGFVs to be opaque and hard to analyze.
4. How did they become a major risk?
A government effort in 2020 to set borrowing limits, known as three red lines, for heavily indebted developers resulted in a major property slump. That dealt a blow to local governments by depleting their income from land sales to builders. Combined with a jump in public spending in response to the Covid pandemic, that left a majority of regional governments facing a serious funding squeeze. Half of some 205 cities examined by Rhodium Group experienced difficulty in managing debt interest payments last year. Meanwhile, LGFVs were paid average government subsidies of 392 million yuan in 2022, the most in nine years, according to a report from China International Capital Corp.
5. Has any LGFV defaulted?
No. Even those local governments that are struggling the most appear to be prioritizing timely bond payments, given the potentially catastrophic signal it would send if they were unable to pay their way. But some LGFVs have been making last-minute payments, indicating debt-servicing difficulties.
6. What is the government doing about it?
At its July meeting, the Communist Party’s top decision-making body, the Politburo, fueled optimism with its pro-growth tone regarding support for local government debt and the property sector. Afterward, demand surged for shorter-term yuan bonds from LGFVs, led by lower-rated borrowers. Exemplifying the turn in investor sentiment was August’s 1.5 billion yuan note sale by an LGFV from Tianjin, one of China’s most indebted cities, which attracted overwhelming demand. In other steps:
• China will allow provincial-level governments to raise about 1 trillion yuan via bond sales to repay the debt of LGFVs and other off-balance sheet issuers, Bloomberg News reported in August. The program will in effect bail out weaker issuers, shifting the debt burden to provincial governments instead.
• China’s biggest state banks also have started providing relief, Bloomberg News reported earlier. Some of China’s biggest state banks were said to be offering loans that mature in 25 years, instead of the prevailing 10-year tenor for most corporate lending, to qualified LGFVs with high creditworthiness.
• The central bank may also set up an emergency liquidity tool with banks to provide low-cost funds with longer maturities to LGFVs, Caixin reported in August.
Past experience shows a missed payment could trigger a surge in perceived risk that would inflate borrowing costs to unaffordable levels for some state entities and state-linked companies. However, a sector bailout appears unlikely given the central government’s efforts generally to discourage reckless borrowing driven by the assumption that the state will always come to the rescue if things go wrong.
7. What are the other risks beside a default?
The concern is that many local financing authorities are reaching a point where they will be forced to rein in their borrowing — potentially stanching the flood of cash that has been a steady source of stimulus for China’s economy. If that happens, the timing could be unfortunate, with investors already worried that the country’s recovery from pandemic restrictions has lost momentum. (Analysis by Wei Zhou | Bloomberg)
>> Source: The Washington post
