China Balance-Sheet Trick Fuels Debt as Letters of Credit Surge

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As debt balloons and defaults spread, China is relying more on a tried and tested way of ensuring the weakest get money -- the letter of credit.

State-owned lenders have thrown their weight behind $9 billion of offshore bonds over the past 18 months, pledging to step in should a borrower fail to make a coupon payment or repay principal. That accounts for a record 83 percent of notes with attached standby letters of credit sold in the period, data compiled by Bloomberg show.

“From the bank’s perspective it’s concerning because these SBLCs are not fully reflected in the books and are typically recorded as contingent liabilities, which don’t affect leverage metrics,” said Raymond Chia, the head of credit research for Asia ex-Japan at Schroder Investment Management Ltd., which has $497.7 billion in assets. SBLCs are so prevalent, he said, they may as well stand for “slowly building leverage in China.”

Bond guarantees are only a small part of China’s potential offshore liabilities as the amount of unhedged foreign debt in the nation surges to $1 trillion. By using letters of credit for sales abroad, China is effectively exporting the debt of its riskiest companies to international investors. Their use has the potential to impair the credit profile of China’s banks, already grappling with bad debts that rose on average 38 percent last year.

Face Time

Companies using standby letters of credit range from brokerage Haitong Securities Co. to shipbuilder China Cosco Holdings Co., which reported a 362.5 million yuan ($58.4 million) profit in 2014 after losing 29.7 billion yuan between the start of 2011 and December 2013.

China ZhengTong Auto Services Holdings Ltd., a luxury car dealer, tried unsuccessfully to sell bonds on its own in May 2012 despite offering a coupon of more than 11 percent. Moody’s Investors Service rates the company Ba3, three levels below investment grade.

The following year, ZhengTong Auto sold $335 million of debentures due 2018 with a 4.5 percent coupon and backed by a standby letter of credit from Bank of China Ltd. The notes are yielding 2.8 percent versus 3.2 percent at the start of 2015.

The most recent sale was from China Minsheng Investment Corp., which raised $300 million via 3.25 percent notes last week. It plans to use the proceeds for overseas projects.

“Letters of credit give some of these issuers an opportunity to meet international investors who otherwise may not have given them the face time,” said Thomas Drissner, a Singapore-based investment manager at Aberdeen Asset Management Plc, which managed $514.8 billion as of March 31.

Risk Reward

Bank of China was the first to grant a standby letter of credit to a Chinese company planning to raise funds in the international market with Zijin Mining Group Co.’s $480 million sale in 2011. A press officer for the lender in Beijing declined to comment.

Industrial & Commercial Bank of China Ltd., China Construction Bank Corp. and Agricultural Bank of China Ltd. have also guaranteed offerings. Press officers for ICBC and CCB declined to comment and while corporate communications officials at the latter didn’t immediately respond to e-mails and telephone calls seeking comment.

Chinese banks, encouraged by Premier Li Keqiang’s “going-out” strategy, are rocketing up the international bond arranging league tables in Asia, helped by their ability to issue letters of credit. ICBC jumped four spots from the end of last year to no. 11 in the region outside Japan as of June 30, while Bank of China ranked sixth.

“From Chinese banks’ point of view, providing SBLCs to issuers offers good risk-reward,” said Hong Kong-based Wesley Kong, the head of fixed income, currencies and commodities at Haitong International Securities Co. “A SBLC isn’t a direct loan, but banks can get a fee from providing the service without consuming as much capital.”

Their allure is clear in the issuance data. In four years, the total amount of SBLC-backed offshore bonds outstanding from Chinese borrowers has risen to $12.9 billion, more than what companies from the U.S. have sold in the past decade.

“As an investor, it’s a concern on both the company and bank’s point of view,” Chia said. “It is building leverage in China no matter how we slice and dice it.”

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