Moody’s Sees Local Default as $21 Billion Matures: China CreditKyoungwha Kim and Yanping Li
Local-government financing vehicles need to repay a record amount of debt this year, prompting Moody’s Investors Service to warn Premier Li Keqiang may set an example by allowing China’s first onshore bond default.
Some 127 billion yuan ($21 billion) of so-called LGFV notes expire in the second half, according to Everbright Securities Co., the most in its data going back to 2000 and more than double the 62.7 billion yuan that matured in the first six months. The yield premium over top-rated notes for one-year AA debt, the most common rating for LGFVs, widened to 67 basis points yesterday, the highest level since Jan. 16, Chinabond data show. The comparable gap in India is 47.
“With bonds approaching maturity, the weaker ones will have some problems as cash flows that they generate are very weak,” said Christine Kuo, a Moody’s analyst in Hong Kong. “I wouldn’t rule out the possibility of the government showcasing some companies to go under.”
Refinancing will be a challenge after corporate bond sales slumped to a two-year low in the second quarter and policy makers cracked down on shadow banking activities that bypass regulatory limits on lending. Premier Li is seeking to shift the focus of the world’s second-largest economy away from government-led investment and China this month cut taxes for small businesses and eased controls on bank lending rates.
Next year, 208.8 billion yuan of LGFV debt comes due, up 10 percent from this year and 122 percent than in 2012, according to Shanghai-based Everbright. Guotai Junan Securities Co., which uses a different classification system, estimates a record 160 billion yuan of the debt matures both this year and next, up from 110 billion yuan in 2012.
The investment arms in the city of Ordos, Inner Mongolia have amassed 240 billion yuan of debt and some district governments there are struggling to repay debt and pay workers, according to a magazine published by the Xinhua News Agency this month.
Local governments set up more than 10,000 LGFVs to fund the construction of roads, sewage plants and subways after they were barred from directly issuing bonds under a 1994 budget law. A 4 trillion yuan stimulus plan during the 2008-09 financial crisis swelled loans to the companies, which they have been rolling over or refinancing with new note sales.
LGFVs may hold more than 20 trillion yuan of debt, former Finance Minister Xiang Huaicheng said in April. That’s double the figure given by the National Audit Office in 2011. The government must be on “high alert” to the dangers of their rising borrowings, Vice Finance Minister Zhu Guangyao warned on July 5, after central bank Governor Zhou Xiaochuan said in March that about 20 percent of the debt is risky.
The yield on one-year securities rated AA surged 112 basis points last month in an interbank cash squeeze, the most on record, to 5.54 percent and was 5.59 percent yesterday. The benchmark one-year treasury yield increased three basis points this month to 3.51 percent after a 61 basis-point jump in June.
“We remain bearish on AA-or-below-rated LGFV notes as they heavily depend on borrowings to repay debts,” said Zhao Bowen, a credit analyst at Shenyin & Wanguo Securities Co. in Beijing. “Should the government remain tight on sales, LGFVs face a greater risk of default. Once one goes broke, the fall could lead to a domino effect among the weaker LGFVs and cause a systemic risk.”
To limit the fallout, he forecast the government will help approve bond sales for selected companies. China will support local governments in raising funds for shantytown redevelopment, the Finance Ministry said this week. Policy makers also expanded a trial that allows regional authorities to directly sell bonds to include Jiangsu and Shandong provinces earlier this month.
Zhao said the average yield of AA-rated LGFV notes may climb to 7 percent this quarter from the current range of 6.3 percent to 6.5 percent. Most LGFV bonds are rated AA and above, according to Bank of America Corp.
The yield on Lishui City Construction Investment Co.’s notes due May 2020 climbed 25 basis points this month to 6.26 percent yesterday, China Interbank Funding Center prices show. Liaoyang City Assets Operation & Management Co.’s November 2019 bonds yielded 7.53 percent, 73 basis points more than at the end of June, according to Shanghai Stock Exchange prices.
Rising borrowing costs for LGFVs reflect uncertainty that the central government will bail them out in case of distress, said Bin Gao, BOA’s head of Asia-Pacific rates research in Hong Kong. “The government has more willingness to allow some kind of restructuring or default to reduce moral hazard,” he said.
Premier Li described reform as the “biggest dividend for China” in his first press conference on March 17 and said that cutting the government’s power was a “self-imposed revolution,” that would “be very painful and even feel like cutting one’s wrist.” Policy makers refrained from adding cash to the banking system, sending interbank money rates to a record last month. Total financing, the broadest measure of credit, slid to 1.04 trillion yuan in June, the least since April 2012, as policy makers curbed unregulated lending.
The authorities are focusing instead on financial reforms to revive the economy after growth slowed to 7.5 percent last quarter. China scrapped a floor for banks’ lending rates on July 19, raised the limit for foreign investment in capital markets on July 12 and is planning to set up a pilot free-trade zone in Shanghai. The State Council approved tax breaks for small companies this week and said railway construction will be accelerated to support the economy.
Corporate bond sales fell to 219 billion yuan in the last three months, the least since the third quarter of 2011, data compiled by Bloomberg show. LGFVs’ issuance slipped to 53.5 billion yuan in June from 93.5 billion yuan in May, according to data from Everbright Securities. The decline came after the National Development and Reform Commission restricted bond-sale applications from LGFVs in April.
Li Qing, a credit analyst at Guotai Junan in Shanghai, predicted issuance by LGFVs will remain around or below 50 billion yuan a month in the second half, while Zhao at Shenyin & Wanguo forecast a rebound from this quarter onwards.
There have been no defaults in the publicly traded domestic debt market since the central bank started regulating it in 1997, according to Moody’s.
The possibility of the first is making it more expensive to insure Chinese bond holdings using credit-default swaps. Five-year contracts on sovereign debt rose 45 basis points this year to 112 in New York, according to CMA prices. They reached 147 last month, the highest since January 2012. The yuan weakened 0.17 percent since reaching a 19-year high of 6.1210 per dollar on May 27 in Shanghai. The rate was at 6.1326 today.
“The amount of bonds set to mature is getting bigger while the financial situation of LGFVs is getting worse and worse,” Bank of Amercia’s Gao said. “We do think there’s a higher chance for some LGFV bonds not to be paid back.”