Markets

Christopher Langner is a markets columnist for Bloomberg Gadfly. He previously covered corporate finance for Bloomberg News, and has written for Reuters/IFR, Forbes, the Wall Street Journal and Mergermarket.

A very local problem in China is being exported at an alarming rate.

Debt from special-purpose vehicles linked to municipal and provincial governments -- leverage that central authorities are trying (unsuccessfully) to extinguish -- is becoming more common in overseas markets. What's worse, lately it's been the weakest cities and provinces panhandling to international investors.

Since June, as many as six local government financing vehicles  have sold dollar bonds, bringing the total issued by such entities to at least $4 billion this year, just shy of the record $4.1 billion logged in all of 2015. Three offerings were scored below investment grade by Fitch, whereas prior to 2016, only one junk security of its kind had surfaced internationally.

Junk Pile
In just two months, bonds graded BB+ by Fitch Ratings went from the fewest to the third most common among dollar notes sold by Chinese local government funding vehicles
Source: Bloomberg

Investors should ask why these localities are going abroad when all their revenue is onshore. Could it be that they're having a harder time raising funds domestically?

That wasn't always the case.

After a 1994 law banned regional authorities from issuing bonds directly, LGFVs were set up in their thousands in China to fund infrastructure projects like roads and bridges. Beijing lost track of how big the liabilities were and deployed about 50,000 auditors across the country in 2014. That crackdown culminated in authorities' decision last year to open the municipal debt spigots and use funds raised that way to repay local governments' off-balance-sheet debt.

As a result, provincial and municipal governments issued an unprecedented 3.8 trillion yuan ($567 billion) directly last year, Bloomberg-compiled data show, and may sell as much as 5 trillion yuan this year.

That Didn't Work
Issuance of bonds via off-balance-sheet LGFVs has dropped. But cities and provinces have increased the amount of debt they're taking on directly via municipal notes
Source: Bloomberg

But now, local investor appetite looks to be fading, and Fitch said in March it expects more low-rated LGFVs will seek alternative sources of funding faced with borrowing restrictions at home.

Cue money managers in New York, London and Singapore, who hopefully have short memories and won't mind being used to mop up debt Chinese investors don't want.

It's been working a treat to date. Investors are attracted by the relatively higher yields these bonds offer, and the notion there may be some state backing. Jiangsu Hanrui Investment Holding Co., a LGFV based in Zhenjiang in China's eastern Jiangsu province, sold $300 million of bonds due 2019 with a 4.9 percent coupon on June 23. That same day, similarly rated notes from developer Greenland were yielding 4.2 percent.

However, as the yuan depreciates, the capacity for these cities and provinces to pay back international debt will deteriorate.

Returns may look decent at the moment, especially against the backdrop of negative rates from Europe to Japan, but with reward comes risk, and China has bucketloads of that.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. Special-purpose entities created solely to raise debt for a local government without burdening its balance sheet.

To contact the author of this story:
Christopher Langner in Singapore at clangner@bloomberg.net

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net