Muni Bonds Can't Kill Financing Vehicles as China Chases Growth

  • Funding falls short as most sales used to swap local debt
  • Local officials still relying on finance arms, Nomura says

China’s local-government financing vehicles, seen as a dying breed not so long ago, are staging a comeback as authorities scrounge for financing to combat an economic slowdown.

LGFVs have sold 561 billion yuan ($88 billion) of bonds this year, close to the 521 billion yuan annual average of the five years through 2013. Issuance surged to a record 1.8 trillion yuan last year when there was a rush to raise funds before curbs on the units took effect. Although regional authorities were allowed to directly sell 3.8 trillion yuan of municipal debt in 2015, it did little to meet new funding needs because most of the sales involved swapping out financing vehicle notes.

Premier Li Keqiang is facing a precarious balancing act as he eases fiscal policy to meet a target of 6.5 percent annual economic growth for the next five years, while reining in a debt pile that is estimated to be already more than twice the size of the world’s second-largest economy. The LGFV issuance comes after the State Council said in October last year that it plans to bar regional authorities from taking on additional borrowings through financing vehicles, which were set up to bypass a previous ban on direct debt sales.

“The huge size of the debt swap program doesn’t necessarily mean it can meet local authorities’ financing demand,” said Guan Fei, an analyst at China Chengxin International Rating Co.’s government and public finance ratings department. “The first and foremost factor in deciding the progress of changing the function of LGFVs is whether local governments’ financing needs can be met.”

This year’s municipal bond sales included 3.2 trillion yuan that was used to convert high-cost regional debt into cheaper municipal notes, leaving only 600 billion yuan for new infrastructure projects such as roads, bridges and subways. Finance Minister Lou Jiwei said it will take about three years to convert all the existing of LGFV debt that is classified as being on government books. The remaining debt will be considered corporate bonds without local authority liability.

Regional officials set up thousands of the funding units after a 1994 budget law barred them from issuing notes directly, with offerings accelerating as part of stimulus following the global financial crisis. The often-opaque fundraising by LGFVs contributed to a more than doubling of liabilities from the end of 2010 to 24 trillion yuan at the end of last year, prompting Premier Li to try and phase them out.

Moody’s Investors Service said Dec. 1 that the 2016 outlook for local governments is negative as the economy slows. China’s total debt as a percentage of gross domestic product was close to 220 percent at the end of last year, the rating company estimates.

Slowing Economy

While China last October said authorities have no obligation to repay debt that wasn’t raised for public works, the slowing economy prompted the State Council to ease restrictions on financing for projects under construction. Some companies, including LGFVs, may be eligible to issue more bonds to repay maturing debt, people familiar with the matter said on June 24, citing a National Development and Reform Commission document.

Haian Urban Demolition & Reconstruction Co. issued 1.15 billion yuan of seven-year notes at a coupon of 5.08 percent last month, and Qingdao City Construction Investment Group Co. sold 2 billion yuan of one-year debt at 3.43 percent. Similar-maturity sovereign bonds are trading at yields of 3.03 percent and 2.54 percent, respectively.

LGFVs’ bond issuance will rise next year as their funding costs are low and the government has relaxed the approval process of debt sales, said Nicholas Zhu, a Beijing-based senior analyst at Moody’s Investors Service.

Tax Revenue

“Slower economic growth would lower the tax revenue for the local governments,” said Zhu. “Secondly, land sales have been a very important source of funding for local governments, so with the cooling of the real-estate market, local governments are not selling as much land, or not at the price they would like.”

A gauge of manufacturing activity fell to the weakest level in more than three years last month, and this year’s 7 percent economic expansion target is at risk despite six central bank interest-rate cuts since November 2014. Economists forecast gross domestic product growth this year will be 6.9 percent, the least in a quarter century. Investment in fixed-assets in the first 10 months of 2015 expanded at the slowest pace in 15 years, while that on property grew at the slowest pace in more than five years.

“The debt swap scheme can solve the problem of the existing debt, but to stabilize economic growth, or at least to offset the headwinds from the real-estate sector, you need some incremental money put into infrastructure building,” said Zhao Yang, an economist at Nomura Holdings Inc. in Hong Kong. “That means the local governments still need to rely on LGFVs.”

— With assistance by Justina Lee, and Helen Sun

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