Chinese LGVF Bonds
August 13th, 2018
China’s high debt-to-GDP ratio is often discussed as a potential harbinger of a financial crisis. As the Chinese economy expands, subnational governments are taking on an increasingly important role in the accumulation of this debt. There are four formal levels of administration; provincial, prefectural, county and township. Taxation is mainly controlled by the central government though local governments can set property and land taxes. Since the central government constrains the ability of subnational governments to raise capital through taxation, local governments have turned to bonds for funding.
Local government funding vehicles (LGFVs) are companies owned and funded by a local government in order to raise funds for municipal projects. These firms stem from the taxation system in China that allocates the lion’s share of revenue to the national government, and from regulations implemented in 1994 that prevent the government from selling bonds. This strict budgetary regulation was intended to promote sound financial management and prevent local governments from spending themselves into deficits. LGFVs became prominent after the Asian Financial Crisis of 1998 and the Great Financial Crisis of 2008 when central government stimulus packages put the onus on local governments to raise necessary funds. LGFVs are effectively state-owned enterprises (SOEs).
A recent high-profile example of potential LGFV volatility has been provided by Qinghai Provincial Investment Group Co. S&P Global Ratings has put the firm on negative watch; basing this decision on the lack of a clear refinancing plan for Qinghai Provincial’s substantial debt.
The main purpose of LGFV bonds is to raise funds for the construction of urban infrastructure. After the 2008 global financial crisis, local governments embarked on infrastructure sprees. Local governments also recognize the need for high-quality infrastructure in order to undergo rapid economic development. These specific construction bonds, known in Mandarin as ‘chengtouzhai’ (城投债), are backed by local governments but were not placed on the balance sheet until 2015 when new regulations intended to promote fiscal responsibility were implemented. These bonds are issued by LGFVs with names such as “Gansu Provincial Highway Aviation Tourism Investment Group Ltd”. Since local infrastructure projects are generally expected to derive smaller returns than larger, national-scale projects, there is an implicit risk of eventual default present in LGFV bond issuance. Fiscal expenditure has also been shown to have become more inefficient as the economy has grown. The Keynesian fiscal multiplier has been reduced with estimates ranging around 0.5. LGFV bonds suffer from weak fundamentals and the most durable asset held by most LGFVs is land.
Of central importance for investors is the implicit guarantee by the issuing government. The Chinese central government has demonstrated a willingness to provide an implicit guarantee for bank debt. However, this has changed in the past year with People’s Bank of China (PBoC) officials stating that local governments should rein in their debt. The central government favors LGFVs that focus explicitly on public welfare and poverty alleviation.
A study by Chinese economists Laura Xiaolei Liu, Yuanzhen Lyu, and Fan Yu (2017) found that the markets deem these bonds to be local government liabilities. They also find that investors perceive the local government to be the implicit guarantor. Higher government debt was correlated with a higher yield spread. This follows the trend of subnational bonds across the globe often being riskier but yielding higher payoffs. Local politicians have an incentive to control the debt levels in their administrative regions. Since political promotion is not based on elections and is instead largely reliant on economic performance; local balance sheets can be constrained from ballooning out of control. In fact, how prudently an official oversees borrowing in their region has been considered part of official promotion criteria since 2014. Another interesting side effect to this incentive is that defaults on loans are lower when the China Development Bank is the loaner as opposed to commercial banks.
The central government might simply take a hardline approach in the face of mass default and refuse to backstop consistently defaulting local governments. Another scenario could be that the government steps in to guarantee in case of a default but gets to work on reforms that improve local revenue generation. The central government is aware of the risks of ballooning local debt and initiated a debt-swap program in 2015.
Government reform that focuses on correcting local income and expenditure imbalances would also be prudent. A reform that allows a larger residential property tax is said to be in order. This would allow governments to raise consistent revenue from land ownership and not simply from land sales. This would also provide a fiscal cushion in the case of short-term land value depreciation whereby the capital retained from sales would drop significantly. Reforms must also focus on eliminating so-called “zombie firms” or SOEs that do not make profits and rely on subsidies from the government. The central government must restructure or eliminate inefficient SOEs that redirect capital away from productive and innovative firms.
How well LGFV bonds continue to do will continue to hinge upon how stable the national economy is. Household investors are increasingly making up a larger share of bond purchasers in China and are often marketed as safe ways to park retirement savings. Foreign investors are increasingly attracted to Chinese capital markets as they open up to foreign investment. It would be wise to heed government pronouncements and observe the willingness to provide an implicit guarantee for LGFV bonds. The government has recently unveiled a package of proposed economic policy reforms on July 23rd that seems to reinforce the guarantee for LGFV bonds. It will be interesting to see how these reforms pan out while China’s economy undergoes a structural readjustment as the government attempts to rein in ballooning debt.