Moody’s Sees Defaults as PBOC Warns on Local RisksKyoungwha Kim and David Yong
Moody’s Investors Service said China’s local-government financing vehicles face greater risk of default, as regulators warn 20 percent of their loans are risky.
A rally in LGFV bonds may reverse, particularly should delinquencies emerge, Christine Kuo, a Moody’s analyst, wrote in an e-mailed response to questions on March 8. The average yield may rise to 7 percent by June from 6 percent now, according to Shenyin & Wanguo Securities Co., the first brokerage incorporated in China and ranked the nation’s most influential research provider by New Fortune magazine in 2010.
“I see increased risk of LGFV defaults because the financial profiles of many remain weak and heavy refinancing is needed,” Hong Kong-based Kuo said. “Regulators have asked banks to control their LGFV exposures. Some of the projects could default unless other sources of funds are found.”
People’s Bank of China Governor Zhou Xiaochuan said in a March 13 press briefing that about one-fifth of loans to the financing arms of local governments are risky. Net debt issuance by these entities surged 179 percent in 2012 to 1.132 trillion yuan ($182 billion), accounting for 50 percent of corporate bond sales, according to Bank of America Corp. data.
The China Banking Regulatory Commission warned lenders to exercise caution and limit their holdings of bonds sold by local governments’ financing arms, the 21st Century Business Herald said on March 13. Banks aren’t allowed to increase outstanding loans to LGFVs above the level as of Dec. 31, 2011, the report said. Phone calls made by Bloomberg News to the regulator’s press office went unanswered.
The yield on Jilin Construction Holding Co.’s 7.1 percent notes due March 2018 was 6.05 percent today, according to Shanghai Exchange, after touching a record low of 6.04 percent on March 15. The yield on Liaoyang City Assets Operation & Management Co.’s November 2019 bonds rose two basis points to 6.78 percent. Companies pay an average 2.6 percent for debt globally, according to a Bank of America index.
The financing units of local governments owe between 9.1 trillion yuan and 14.5 trillion yuan, or 18 to 30 percent of China’s gross domestic product, according to a BNP Paribas SA report published in January. Tighter curbs on bank loans prompted the units to scramble for funds in 2012, driving a 50 percent jump in net corporate bond sales and a 404 percent surge in trust financing, according to Bank of America.
Aggregate financing, which includes non-bank lending, climbed 914 billion yuan to a record 2.54 trillion yuan in January, official data show. China’s non-financial credit has increased by nearly 60 percent of GDP in the past five years, outstripping the rise in the U.S.’s in the five years preceding the onset of its banking crisis in 2008, BNP Paribas said.
The central government “is concerned about financial risks and will take action to contain risks in 2013,” said Zhang Zhiwei, chief China economist at Nomura Holdings Inc. in Hong Kong. “We believe policy will have to be tightened eventually, but the timing and pace of tightening remain uncertain. We continue to focus on the size of total social financing as the best indicator of potential policy change.”
CEBM Group, a Shanghai-based investment research firm, estimated last month that about 4 trillion yuan to 5 trillion yuan of credit -- including 2 trillion of bank loans, 2 trillion of trust loans and 180 billion yuan of LGFV bonds -- is set to mature this year.
The bond market has yet to show signs of concern. Most LGFV notes are rated AA and above, according to Bank of America, and the yield premium on one-year debt of that grade over AAA debt shrank by 71 basis points to 50 basis points in the year through March 15, Chinabond data show. A Feb. 22 gap of 45 basis points was the least since September 2010.
“The outperformance last year is unlikely to be repeated in 2013,” said Yu Wenlong, an analyst at Shenyin & Wanguo. “LGFV notes are now overpriced. The tightening by regulators on shadow banking will mark a turning point for the market. Authorities face tough challenges as they need to meet local governments’ funding needs, while preventing defaults.”
The biggest threats to China’s financial stability are shadow banking and loans to LGFVs, Bank of China Ltd. Chairman Xiao Gang wrote in a commentary in the China Daily on Feb. 19. China should pay special attention to such risks, the Economic Information Daily reported on Jan. 22, citing Huang Shuhe, vice chairman of State-owned Assets Supervision and Administration Commission.
The provincial debt levels in some second and third-tier cities, particularly those in western China such as Hainan and Ningxia, have increased with their debt-to-GDP ratios already exceeding 40 percent in 2010, CEBM said in a Feb. 21 report. More than 30 percent of LGFVs have insufficient operating cash flow to cover debt payments, the report said, citing CBRC estimates.
“This suggests that some local governments could potentially default,” CEBM analysts including Steve Chen wrote. “An actual default would reverberate throughout China’s commercial banking system and have a systemic impact on China’s financial system.”
China is encountering “some natural frictions” as its capital markets develop, according to Wee-Ming Ting, head of Asian Fixed Income at Pictet Asset Management, which oversees $29 billion of emerging-market debt. Pictet’s holdings include securities from China, although not LGFV notes, he said.
“Increasing debt in China is an issue to be addressed but it’s not going to cause a major problem,” said Ting, who is based in Singapore. “China is in a transition period as it shifts away from a reliance on bank loans to the bond market.”
The cost of insuring China’s sovereign notes using five-year credit-default swaps fell five basis points this year to 62 in New York, according to data provider CMA, which is owned by McGraw-Hill Cos. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent if a government fails to adhere to debt agreements.
The yuan weakened 0.03 percent to 6.2155 per dollar as of 12:53 p.m. in Shanghai today, according to China Foreign Exchange Trade System. The government’s 10-year bonds yielded 3.59 percent on March 15.
CEBM Group estimated total social financing will rise 15 percent this year to 17.5 trillion yuan, providing ample liquidity to companies and local governments. Loans to Tianjin’s LGFVs are expected to post “stable” growth this year, after 30 billion yuan was extended last year, Lin Tiegang, head of the the PBOC’s Tianjin branch said this month.
“The government will definitely continue to allow LGFV bond sales, but may restrict some high-risk or low-level local governments from selling bonds,” said Ethan Mou, a fixed-income strategist at Bank of America in Hong Kong. The yield spreads of LGFV bonds could widen in 2013, due to supply or a credit event associated with trusts, Mou said, adding that a “big sell-off” could be a good opportunity for buy-and-hold investors.