China's shadow banking curbs cut local borrowers' lifeline
China's crackdown on shadow banking is raising concern among bond investors about local borrowers' ability to make repayments as a record CNY1.8 trillion (€230 billion) of notes come due this year.
Regulators have stepped up efforts to patch loopholes in off-balance sheet financing in the last couple weeks, moves that will effectively block most fundraising channels for local borrowers.
Concern that some local government financing vehicles may not be able to repay debt has helped push up the yield premiums on AAA-rated LGFV notes to near the highest in three years.
China has redoubled efforts to cut excessive borrowing, and has zeroed in on risks from local companies that racked up debt for projects like tubes, bridges and sewers.
The Ministry of Finance also started to tighten scrutiny of public-private partnership projects from the end of last year, making it hard for regional authorities to raise funds from even legitimate sources.
Revelations that several local governments inflated economic data may also hurt investor sentiment as a broader bond market rout already pushes up borrowing costs.
"The focus of deleveraging this year will probably be on local governments," said Li Liuyang, a Shanghai-based analyst at China Merchants Bank. "As some regions start to 'squeeze' the inflated growth data, there’s a higher risk of defaults in their various forms of borrowings, including bonds, asset management plans and wealth management products."
Off balance-sheet financing has been used to complement the limited amounts that municipal governments can raise via bond quotas over the last couple years and has helped fund infrastructure construction.
Amid the recent jitters, sales of LGFV bonds are headed for a second monthly decline. They have plunged to CNY32 billion so far this month from December’s CNY130 billion, data compiled by Bloomberg show.
Four years after the first default in publicly-traded bonds onshore, no LGFV note has suffered that fate. That’s prompted investors to continue pricing in implicit government guarantees.
Any default will likely trigger a re-valuation of the CNY6.2 trillion LGFV debt market, along with the CNY14.7 trillion of municipal bonds, whose issuers are all rated AAA regardless of their fiscal strength.
The Ministry of Finance said last year it will dispel financial institutions’ "hallucination" that the central government will bail out local repayment failures.
In a joint statement with China's insurance regulator on January 18, the ministry said local governments can't use insurers' funds in ways that disguise their true purpose. The banking watchdog prohibited lenders from extending debt financing for regional authorities or insolvent 'zombie companies,' in a notice on January 13.
"The first default is likely to occur following regulatory restrictions on local government guarantees and bailouts," strategists Becky Liu and Jeffrey Zhang at Standard Chartered wrote in a research note last week.
Yunnan State-Owned Capital Operation, which has some functions similar to LGFVs, delayed repayments to a trust product. While the company later managed to return the funds, saying the delay was an agreed arrangement, Merchants Bank’s Li said such cases wouldn’t occur if the region hadn’t had any fiscal strains.
China is set to complete a three-year program in 2018 that allows local authorities to convert debt into municipal notes. Some CNY1.73 trillion of such liabilities will be swapped into municipal notes by the end of August, said Wang Kebing, an official at the Ministry of Finance.
Liaoning province, the Inner Mongolia autonomous region, and Tianjin Municipality have admitted to inflating local economic data. That highlights oversight problems and significant falsifications will lead to revisions on government-related entities' ratings, according to a Fitch report.
"One can’t underestimate the refinancing pressure on LGFVs, as it's become increasingly difficult for non-standardised borrowings and as banks become prudent in lending," said Liang Shichao, an analyst at CIB Economic Research & Consulting. "The latest credit events are damaging investors' trust in LGFVs, at a pace faster than expected."