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China debt crunch

China provinces rush to address 'hidden debt'

Fears grow over local government finances after multiyear spending spree

Local government entities have been some of China's biggest borrowers.   © Reuters

HONG KONG -- Chinese local governments are rushing to shore up their finances as fears mount that borrowing by the public sector could become the next crunch point for the country's $50 trillion financial system.

Bond sales by so-called local government financing vehicles (LGFVs), which fund infrastructure from roads to schools and factories, soared 76% to 290 billion yuan ($45 billion) in January, research firm Gavekal Research said. Since late December, provincial governments have also issued bonds that could be used to roll over debt, both on and off balance sheets, totaling 500 billion yuan.

China's 2,000 LGVFs have more than 3 trillion yuan due onshore this year, according to Moody's Investors Service. It is part of a record 10.4 trillion yuan of outstanding bonds after a decade of splurging on assets.

Investors have been more nervous about Chinese public sector borrowers since late last year, after state-owned companies Yongcheng Coal & Electricity and chipmaker Tsinghua Unigroup defaulted, shaking assumptions of an implicit government guarantee.

Local government entities have been some of China's biggest borrowers, making them the object of increasing scrutiny by Beijing as the central government tries to curb risks in the financial sector. The flurry of bond issuance suggests borrowers are trying to make the most of an opportunity to refinance and extend the maturities of as much existing debt as possible ahead of an anticipated clampdown on debt issuance.

"'Extend and pretend' has generally been a successful strategy for local governments," said Wei He, an analyst at Gavekal. "Yet rolling over debt is now getting more complicated. With local fiscal and financial strains rising, and the government's willingness to bail out borrowers limited, it looks inevitable that there will be more bond defaults."

No local government issue has yet defaulted. However local governments' headroom to deal with their debts by themselves is limited. The costs of debt service equaled 90% of all local government revenue last year.

Investors are most concerned with the amount of so-called hidden debt, held by government infrastructure financing vehicles and public-private partnerships. This borrowing is often opaque, does not appear on local governments' official balance sheets and is not recognized by the central government.

Including borrowing by LGFVs, China Chengxin International Credit Rating estimates the hidden debt at 43 trillion yuan ($6.46 trillion) by the end of 2019 -- almost half the size of the economy. Some 60% is held by banks.

The debts are the result of a decadelong spending spree encouraged by authorities to support the economy especially during periods such as the post-global financial crisis, the trade war with the U.S. and the coronavirus pandemic.

Chinese authorities recognized the risk in 2017, but the need to support the economy upended moves to contain it. They are redoubling efforts to acknowledge and reduce the risk from hidden debts as the economy bounces back from the coronavirus pandemic.

A top policy panel attended by President Xi Jinping in December identified curbing risks from local governments' hidden debt as one of the prime policy targets for 2021. Later that month Finance Minister Liu Kun, in a teleconference attended by ministry staffers and local government officials, vowed to "tighten up the management" of local government debt.

That sparked off the fresh round of debt issuance as local governments raced to push out maturities by lengthen their funding profile.

Guo Shuqing, chairman of the China Banking and Insurance Regulatory Commission, told a media conference last week the "process of orderly resolution is ongoing" when it comes to hidden debt.

A closer examination of recent local government debt offerings reveals a change in the wording of prospectuses. The paperwork now said the new bonds would be used to roll over any public sector debts, indicating it could replace hidden debt as well. Previously prospectuses indicated that the proceeds of such bonds would be used to meet on-balance sheet debt.

For instance, Xuzhou Xinsheng Investment Holding, a unit of the city of Xuzhou in the eastern province of Jiangsu, in January raised 2.8 billion yuan in five- and three-year bonds and used it to redeem early a 500 million yuan bond. Nanjing Hexi New Town State-owned Assets Management, an arm of the Nanjing government, last month said it will redeem a 2 billion yuan three-year bond before the due date, using a new bond issued solely for buying back existing debt.

"The recent increase in early redemptions of bonds could be related to the expansion of the trial program to resolve the risks of hidden debt," wrote Liu Yu, chief fixed income analyst at GF Securities. The program was originally designed to allow county-level governments to deal with off-budget debt by issuing new bonds.

However, some provinces that face large redemptions, such as Guizhou and Sichuan, only have limited authority to issue new bonds, given a quota system for borrowing that China imposes on provinces.

Meanwhile credit in the financial system is starting to shrink as regulators remove excess liquidity, which analysts say increases the likelihood of a default.

Terry Gao, head of Asia-Pacific international public finance at Fitch Ratings, said "the possibility is always there" in terms of a first-ever LGFV default this year. "Lower-tier government-related LGFVs may face more headwinds," he said.

Because LGFV debt offers a higher return for investors -- a yield of 5%, compared with 3% for the nation's five-year debt -- some analysts believe there will still be plenty of buyers.

"Investors looking for higher returns may prefer to buy LGFV debt over more risky corporate and state-owned companies," said Ivan Chung, associate managing director for corporate finance at Moody's Investors Service. They continue to believe LGFVs are "more closely" linked to the government and would receive the required backing, he said.

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