The first defaults on public bonds by Chinese local government financing vehicles (LGFVs) are becoming more likely, and will probably trigger a repricing of the market, says Fitch Ratings.
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.
No Chinese LGFV has defaulted to date on its publicly traded debt. Moreover, judging by narrow spreads on LGFV securities, investors have not revised their expectations significantly for government support since the passage of the 2014 Budget Law, which stated that LGFVs are no longer recognized as public-sector liabilities and are not officially eligible for government support.
Subsequent guidance reiterating that LGFV debt is to be evaluated by creditors on market principles has also had little impact on investor perceptions. However, there remains a conflict between these stated central government policies and implicit support of LGFVs in practice at the local level.
Efforts to disentangle LGFVs from public-sector balance sheets have been part of a broader drive by the central authorities to contain risks associated with growth in municipal contingent liabilities.
Debt ceilings and debt swaps to facilitate the conversion of LGFV obligations into explicit local government debt have also been introduced. However, LGFV debt continues to rise strongly.
Fitch estimates that CNY4 trillion (5.4% of GDP) in LGFV bonds issued domestically since the Budget Law came into effect in 2015 remain outstanding, and it is likely that this growth has involved at least pockets of excessive risk taking and debt hiding.
The authorities' next step to address indiscriminate LGFV debt growth and to encourage greater market discipline might be to allow selected defaults on LGFVs that come under stress. There is a precedent for this in the way some Chinese state-owned enterprises have defaulted over the last couple of years, as the central government has sought to impose hard budget constraints and inject greater market discipline in the credit-allocation process.
Selected LGFV defaults would have consequences for the broader LGFV market. For example, we would expect a repricing 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.
Market liquidity might dry up
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.
However, the authorities are in a position to prevent systemic defaults. In particular, the government's pervasive ownership and influence across the financial system provide other tools to limit contagion.
The use of fiscal resources to bail out LGFVs would be a last resort, given recent policy efforts to break perceptions of implicit state support, but credit could be directed toward the LGFV sector if required, which would contain the risk of a market panic.
“We believe only some LGFVs would be likely to default. These would be LGFVs deemed most financially stretched by the authorities, and consist mostly of lower-tier (non-provincial) LGFVs, particularly those that mix commercial with policy activities, such as property with urban development,” says Fitch.
This excludes the vast majority of Fitch-rated LGFVs, which are connected with high-ranking local governments and undertake key policy roles. Fitch rates LGFVs using a notching approach from the relevant local government, and may widen the notching or switch to a bottom-up rating approach if the policy role of the LGFVs is seen to be diluted.