Despite China’s 2014 Budget Law that stated local government financing vehicles (LGFVs) would no longer be recognized as public sector liabilities eligible for government support, no LGFV has defaulted on its publicly traded debt.
That situation is likely to soon change, according to Fitch Ratings in a new report, and could trigger a re-pricing of the market, analysts said. “However, widespread LGFV defaults remain a tail risk, given that the authorities continue to rely on local government investment—supported by LGFVs—to hit economic growth targets and have a broad spectrum of policy tools to limit default contagion.”
The Chinese government has tried to separate LGFVs from public-sector balance sheets as part of a larger effort to contain risks associated with the growth in municipal contingent liabilities, Fitch said. Debt ceilings and debt swaps have been used to convert LGFV obligations into explicit local government debt, but LGFV debt continues to rise strongly. Since the 2014 Budget Law, investors haven’t much changed their view of the likelihood of default for these bonds given the narrow spreads on LGFV securities, as “ … there remains a conflict between these stated central government policies and implicit support of LGFVs in practice at the local level,” Fitch said.
Fitch estimates approximately 5.4% of GDP in LGFV bonds issued domestically since 2015 remain outstanding, with pockets of excessive risk taking and debt hiding likely a part of the mix. Analysts predict that Chinese authorities might soon allow selected defaults on LGFVs that come under stress, particularly lower-tiered ones that consist of property with urban development.
“We would expect a re-pricing of LGFV bonds due to better risk discrimination by creditors and an accelerated replacement of the opaque LGFV mechanism with a genuine municipal bond and loan market,” analysts said. “It is also likely that market liquidity might dry up for some LGFVs, at least temporarily, which could cause problems for some issuers—particularly those that have issued debt with short maturities and are therefore exposed to refinancing risk. Access to foreign borrowing may also become more limited or expensive for some LGFVs.”
Still, the government is in a position to prevent systemic defaults, including the last-ditch use of a fiscal solution, Fitch said.
– Nicholas Stern, managing editor