Photographer: Qilai Shen/Bloomberg

China Cities Face End of Fairy Tale as Default Risks Rise

  • Onshore note sales by financing vehicles fell 18% last quarter
  • ‘No absolute guarantee’ LGFVs won’t default: HuaAn’s Cheng

Finance firms that help keep cash flowing to China’s towns, cities and provinces face rising risks of landmark bond defaults just as they turn to global markets for funds.

China’s economic slowdown is weighing on revenue at regional governments, hampering their ability to support the 5.3 trillion yuan ($789 billion) of outstanding onshore notes from local-government financing vehicles, which have yet to suffer nonpayments. Such issuance fell 18 percent last quarter as regulators curbed sales, forcing some to seek funds overseas. Financing units in provinces including Hunan, Jiangsu, Hubei and Sichuan are considering or planning U.S. currency notes, people familiar with the matters have said.

Warning signs are spreading. In the nation’s northeast, Changchun Urban Development & Investment Holdings Group was downgraded by Fitch Ratings last month. In the once-booming coal town of Ordos in Inner Mongolia, Yijinhuoluoqi Hongtai City Construction Investment & Development Co. had 189.5 million yuan of borrowings overdue as of March 31, according to Pengyuan Credit Rating Co., which downgraded it to A+ from AA- in May.

“I don’t believe in the fairy tale that no LGFV will default,” said Terence Cheng, chief investment officer in at HuaAn Asset Management in Hong Kong. “Even China’s state-owned enterprises have been allowed to default. There is no absolute guarantee that an LGFV will not default.”

Two calls to Changchun Urban’s general line went unanswered. Two calls to Yijinhuoluoqi Hongtai went unanswered.

The discount LGFVs enjoy over regular companies when raising funds in the local bond market for seven years has shrunk by about half in the past six months to 23 basis points.

Non-operating revenue -- which usually includes subsidies -- has fallen relative to operating income for the nation’s local financing vehicles and this may indicate a reduction in support by regional authorities, according to China Investment Securities Co. The ratio between the two dropped to 87 percent in the first six months of 2016, compared with 110 percent two years earlier, the firm said.

While changes may take years, authorities are becoming more selective, according to Anthony Leung, a credit analyst at Nomura Holdings Inc. in Hong Kong. “For the weaker ones, the government may deem them zombies and eventually let go of them,” he said.

Repayment Problems

The Shanghai Stock Exchange has stipulated that financing vehicles generating more than half their revenue from local governments will no longer be allowed to issue corporate bonds, which could lead to increased refinancing risks for lower-tier governments’ platforms, S&P Global Ratings said in a report on Sept. 8.

“We have heard of some LGFV bonds which are running into trouble for repayment,” said Edmund Goh, a Kuala Lumpur-based investment manager at Aberdeen Asset Management. “We do expect some to default in the future as there’s been strong growth in LGFV debt and some weaker ones will be expected to fail.”

In the medium term, China may allow some non-systemic LGFVs to default, a policy that would be in line with the government’s actions on state-owned enterprises, according to BNP Paribas Investment Partners UK’s Jean-Charles Sambor.

The central government has allowed regional authorities to cut costs by directly issuing municipal notes for non-commercial businesses. That has heartened some observers.

Positive Changes

“All the reforms China is engaging in are credit positive for LGFVs in the medium-to-long term,” said Leo Hu, an emerging market debt portfolio manager at NN Investment Partners in Singapore. “The debt swap program for local governments allows local governments to lower funding costs, extend maturity and improve the transparency of their debt profiles.”

LGFVs below the provincial level may not benefit from these kind of replacements, according to Moody’s Investors Service.

“City governments have weaker ability to support LGFVs than provincial governments,” said Ivan Chung, head of Greater China credit research at Moody’s in Hong Kong. “Also these LGFVs are facing higher refinancing risks because their debt may not be included in the debt swap program.”

— With assistance by Lianting Tu, and Judy Chen

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