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Local Governments Beat Corporate Debt on Loan Ease: China Credit

Local Bonds Beat Corporates Amid Lending Reprieve
A woman passes in front of a poster featuring Communist Party leaders of China including Mao Zedong, Deng Xiaoping, Jiang Zemin and Hu Jintao in Shanghai, China. China has loosened lending curbs to small companies as Europe’s sovereign debt crisis and a slowdown in the U.S. cut demand for the nation’s exports. Photographer: Kevin Lee/Bloomberg

Bonds sold by the funding arms of China’s local governments are providing higher returns than the rest of the corporate debt market as regulators signal that they may be given more time to repay 4.5 trillion yuan ($708 billion) of debt due by the end of 2012.

Seven of the nation’s 10 best-performing corporate bonds in October are from companies set up by regional authorities to fund infrastructure projects, with Yixing City Development Investment Co. returning the most at 10 percent, according to data compiled by Bloomberg. U.S. state municipal debt lost 0.6 percent during the same period, Bank of America Merrill Lynch data show.

China’s top banking regulator indicated this week for the first time that so-called local government financing vehicles may qualify for an extension of their loan repayments, easing financial pressures after policy makers curbed credit to control inflation in the world’s fastest-growing major economy. Lending to the regional bodies may end in a wave of bad debts and prompt the nation’s third banking bailout in less than two decades, Standard Chartered Plc has said.

“If they can renew the debt, it can temporarily solve the liquidity problems,” Xu Xiaoqing, the head of fixed-income research at China International Capital Corp. said in a phone interview from Shanghai on Oct. 25. The easing of restrictions is reassuring for bond investors, he said.

Loosening Curbs

China has loosened lending curbs to small companies as Europe’s sovereign debt crisis and a slowdown in the U.S. cut demand for the nation’s exports. Premier Wen Jiabao on Oct. 25 called for more support to small businesses that have been hit by the tightening in the lending market.

Should local financing vehicles meet collateral requirements they can have a one-time extension on their loans, Zhou Mubing, the vice chairman of the China Banking Regulatory Commission, said at conference on Oct. 24 organized by internet portal, according to a transcript of his comments on the website.

The banking regulator’s local offices have been helping companies restructure debt for months, Victor Shih, a professor at Northwestern University in Evanston, Illinois who analyzes China’s regional government finances, wrote in an e-mailed response to questions. Zhou’s comments suggest that widespread restructuring of debt has now been endorsed by the central government, he said.

“Although this will help banks prevent a sharp rise in non-performing loans, rolling over debt does nothing to improve the cash flows of the debtors,” said Shih. “The long-term repayment of local-government financing vehicle debt remains problematic.”

Direct Borrowing

Local governments in China set up the financing companies to fund the construction of roads, sewage plants and subways after they were barred from issuing bonds and obtaining bank loans directly under a 1994 budget law. A June report by the National Audit Office said there were more than 6,500 entities with debt of 10.7 trillion yuan at the end of last year, 42 percent of which would fall due in 2011 and 2012.

The government will allow some local governments to issue bonds independently for the first time in a trial program, the Finance Ministry said on Oct. 20. The eastern province of Zhejiang will sell 8 billion yuan of debt this year, its fiscal department said in a faxed response to questions on Oct. 18. The cities of Shanghai and Shenzhen and the province of Guangdong will also sell debt.

Default Risk

The cost of insuring Chinese sovereign bonds against non-payment more than doubled this year as ratings companies highlighted the growing risk of loans to the financing vehicles and property developers. Five-year credit-default swaps on government notes cost 138 basis points, or 1.38 percentage point, yesterday in New York, up 71 basis points in 2011, according to data provider CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a government or company fail to adhere to its debt agreements. They’re also used to speculate on bond movements.

Government-run Central Huijin Investment Ltd., which holds stakes in most of China’s financial institutions, said this month it would boost its holdings in the nation’s four biggest state-owned commercial banks after their shares slumped amid concern that bad debts will climb.

Industrial & Commercial Bank of China Ltd. and China Construction Bank Corp., the world’s two biggest lenders by market value, have dropped 18.6 percent and 19.66 percent this year in Hong Kong.

Reserve Requirements

Policy makers may lower the reserve-requirement ratio for small- and medium-size banks before the end of 2011 and cut interest rates in the second quarter of 2012 after Premier Wen said on Oct. 25 that the government may fine-tune economic policies, according to a Guotai Junan Securities Co. report yesterday.

The central bank hasn’t raised interest rates since a 25 basis-point increase in July took benchmark one-year borrowing costs to 6.56 percent. Policy makers have boosted the amount lenders must keep in reserve on nine occasions in the past year to help tame inflation.

Consumer prices climbed 6.1 percent in September from a year earlier, exceeding the government’s full-year target of 4 percent. China’s exports rose 17.1 percent in September from a year ago, the least in seven months, customs bureau data released on Oct. 13 showed.

Government Backing

The yield on the government’s 10-year bonds reached a three-year high of 4.13 percent on Aug. 30 and was little changed at 3.79 percent yesterday, Chinabond data show. The yuan was little changed against the U.S. dollar, at 6.3534 per dollar as of 11:30 a.m. in Shanghai versus 6.3535 the previous trading day, according to the China Foreign Exchange Trade System. The currency has advanced 3.9 percent against the dollar this year, the best performance of the 25 emerging-market currencies tracked by Bloomberg.

Investors are favoring the local-government securities over corporate notes on expectations they have the government’s backing.

The yield on Shanghai Urban Construction Investment & Development Corp.’s 1 billion yuan of 2020 bonds has fallen 44 basis points to 5.63 percent as of 11:30 a.m. local time, from a record high of 6.07 percent on Oct. 12, according to Chinabond prices. Yields on Huaihua City Construction Investment Co.’s 1.3 billion yuan of 2019 bonds have dropped 134 basis points from a high of 9.87 percent on Sept. 29, according to exchange prices.

“They bounced back so quickly,” George Weisi Tan, who oversees about 300 million yuan as head of bond investments at Fortune SGAM Fund Management Co., said by phone from Shanghai on Oct. 25. “Holding the bonds is probably better than bonds issued by real-estate companies because they have an implied government warranty. This is just like religion: it’s a belief.”

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