Doubts over the Chinese government’s ability to cope with escalating debt are showing up in record borrowing costs for the nation’s policy banks.
The average yield premium over the sovereign for five-year debt sold by China Development Bank, Export-Import Bank of China and Agricultural Development Bank of China widened 90 basis points from an August low to 142 basis points on Jan. 17, the highest in Chinabond data going back to 2007. The gap was 138 basis points yesterday. Yields have climbed on safer assets, including CDB’s, as delays in restructuring bad loans are stretching the central government’s ability to guarantee debt, Bank of America Merrill Lynch wrote in a report this week.
The blowout in borrowing costs accelerated as a government audit estimated regional liabilities surged 67 percent from the end of 2010 to 17.9 trillion yuan ($2.96 trillion) as of June 30 while trust banks struggled to recoup soured loans to coal mines. CDB had 3.3 trillion yuan of outstanding loans to regional authorities at the end of March, then-Chief Investment Officer Zhang Xuguang said last year, Caijing reported. It also lends extensively to state-owned enterprises.
“The audit opened people’s eyes to policy banks’ lending, and it may be becoming more evident how thinly spread the government’s guarantees have become, and how much it may end up being on the hook for,” Patrick Chovanec, New York-based chief strategist at Silvercrest Asset Management, said in an e-mail yesterday. “Policy banks have an implicit guarantee from the central government, but it’s also backing a host of other entities, from local governments to banks to SOEs to trusts.”
Regional authorities set up more than 10,000 local government financing vehicles to fund construction projects after they were barred from directly issuing bonds under a 1994 budget law. A 4 trillion yuan stimulus plan during the 2008-2009 financial crisis swelled loans to the companies, which they have been rolling over or refinancing with new note sales.
CDB, the biggest of the three policy banks, pioneered a model of lending to LGFVs in which the authorities can sell land for repayment, according to Chovanec, a former associate professor at Tsinghua University in Beijing. About 80 percent of government spending occurs at the local level and 40 percent of tax revenue, leaving a funding hole, the World Bank estimates.
CDB “was frequently the seed investor for projects that were financed this way,” he said. “Recent news that local government debt has exploded far beyond what many people realized may have opened people’s eyes to risks in the model.”
The bank’s press office didn’t immediately respond to a telephone call and an e-mail seeking comment.
The audit, released on Dec. 30, was followed two weeks later by a People’s Bank of China pledge to clean up LGFVs, identifying those with “poor trustworthiness, unclear functions and unsustainable financial conditions.” The vehicles must repay a record 299.5 billion yuan of bonds this year, according to Everbright Securities Co.
“Over the medium- to long-term, banks’ exposure to LGFVs may go sour if the situation doesn’t change fundamentally,” Hu Bin, a Hong Kong-based analyst at Moody’s Investors Service, said in a Jan. 13 phone interview. “In the short-term, there’s no pressure because the government now has tools to refinance.”
Fortune SG Fund Management Co. is buying policy bank notes, which are relatively safe and offer “decent” yields amid higher corporate risk, Rui Hai Wang, Shanghai-based head of fixed income, said in a Jan. 15 interview.
The spread of five-year AA securities, the most common grade for LGFV debt, over the sovereign widened to 325 basis points yesterday, the most since February 2012.
Resolving the debt pile has been complicated by growth in less-transparent shadow banking. Conventional loans to local governments dropped to 57 percent of direct and contingent liabilities as of June 30 from 79 percent at the end of 2010, while bonds rose to 10 percent from 7 percent, National Audit Office data show. Trust financing surged to 8 percent from zero, while other channels that sidestep loan curbs accounted for the remaining 25 percent.
Irregularities in the trust industry are coming to light as China faces a default on high-yielding investments at the end of this month, when a troubled 3 billion yuan trust product sold to raise funds for a collapsed coal miner matures. Industrial and Commercial Bank of China, its distributor, has rejected calls to assume responsibility.
The central government should allow defaults because mispriced risks and the worsening “implicit guarantee” are pushing up borrowing costs for the sovereign as well as for policy banks, Bank of America Merrill Lynch economists Ting Lu, Xiaojia Zhi and Sylvia Sheng wrote in a Jan. 20 note.
Ten-year sovereign bond yields surged 104 basis points in the second half of last year, touching a record in November, as liquidity tightened and the government signaled it will liberalize interest rates. The benchmark seven-day repurchase rate jumped to a record 10.77 percent on June 20 and averaged 4.09 percent last year, from 3.50 percent in the previous year.
During the cash crunch, all three policy banks delayed or downsized debt offerings. They sold 2 trillion yuan of bonds in 2013, down from 2.1 trillion yuan in the previous year. Commercial banks held 81 percent of total policy bonds as of the end of December, Chinabond data show. CDB postponed a bond sale and canceled another in November.
“With less liquidity in the system, when commercial banks have limited funds to allocate on their balance sheets, they tend to pursue higher-yielding products,” said Hu at Moody’s.
Policy lenders enjoy an advantage as the regulator allows a zero-risk weighting for their debt, bolstering demand. Moody’s gives the three banks the same rating as it does the sovereign, citing their high level of dependence on the government.
Costlier funding may hamper the superbanks’ capacity to support policy initiatives such as Premier Li Keqiang’s urbanization push to house 260 million migrant workers, according to Qiu Xinhong, a Guangzhou-based fund manager at Golden Eagle Asset Management, which oversees about 10 billion yuan in assets.
“It’s very hard to raise lending rates or lower borrowing costs, so their margins are narrowing and a loss is becoming more likely,” Qiu said Jan. 20. “With the name of a policy bank, they can’t charge high interest rates, so if they can’t transfer the costs to borrowers, they’ll just downsize the scale of the projects.”
Premier Li has called urbanization a “huge engine” for growth as policy makers announced plans to map out city clusters across the nation. CDB plans to direct at least 60 percent of its annual loans to the initiative starting this year, Chairman Hu Huaibang said in December.
Government projects aren’t always the most profitable, said Hu at Moody’s. In the shipbuilding industry, for example, state-directed lending in the past few years fueled a boom until orders slumped. China Rongsheng Heavy Industries Group Holdings Ltd. (1101), the biggest private firm in the field, saw its assets jump sevenfold between 2007 and 2012, before it was forced to seek a government bailout in 2013.
CDB has also lent at least 7.08 billion yuan this month to develop solar power, an industry in which a supply glut prompted authorities to cap production last year, data compiled by Bloomberg show. The debt of all listed companies excluding financial firms has doubled since 2009 to some $1.9 trillion.
“Investment in government-led projects or state-owned enterprises tend to be less efficient, and there may be overcapacity because of government intervention,” said Hu.