China’s local government financing vehicles (LGFVs) are a baffling construct. They emerged in the wake of the global financial crisis, as Beijing sought ways to inject life into provincial cities.
In other countries, these off-budget organizations, which help local officials raise money to splash out on big projects – usually infrastructure – would by now have been wound up.
But China is not built that way.
They hung around, growing ever-more bloated with debt. At the end of 2021, total LGFV debt was Rmb54.4 trillion ($7.82 trillion), reckons data provider Wind, more than double the level of six years ago. They have Rmb4.5 trillion in outstanding debt due in the year to the end of June 2023, or 46% of all maturing debt issued by domestic non-financial firms.
Most, to put it kindly, aren’t in great shape. Moody’s analysts said on August 24 it would take “several years” for LGFVs to get to the point where “self-generated cash flow can service their debt”. In a survey published on July 22, Rhodium Group pointed to a “sharp rise in debt” alongside “deteriorating cash flows to service those debts” – all set against a backdrop of falling tax revenues and land sales, exacerbated by a sluggish economy.
When and not if the defaults start, investors will seek the nearest available exit. That’s a big problem
Yet even that isn’t enough to deter onshore investors from snapping up their bonds as fast as they are printed, despite primary market coupons falling to record lows.
According to data from Dealogic, LGFV debt issuance in all currencies in the current year to September 8 was $134.7 billion, the second highest on record. And it isn’t the volumes that impress so much as the size of order books: take the Rmb500 million bond printed in June, which bagged Rmb30 billion in bids.
There are reasons for this. A lack of ready-made investment alternatives is one. Another is the expectation that Beijing will again expect LGFVs to kick-start the economy by funding a new bumper crop of big-ticket building projects.
Then there’s the fact that investors see them as being safe. Notes Rhodium Group: “With property developers defaulting left and right, LGFVs are the only issuers still offering decent returns without any history of defaults.”
But for how long? They exist not to generate returns but to serve the state. A 1.7% return on assets in 2019 fell to 1.6% in 2020 and to 1.5% in 2021. This highly specific asset class must continually raise fresh capital just to service rising debt: the annual gap between net operating cash flow and interest payments is reckoned to be Rmb2 trillion.
Rhodium analysts argue that deteriorating fundamentals make a default on LGFV bonds “inevitable” and an event likely to “drive a wave of defaults when it eventually occurs”. They compare it to the events of 2017-2018, when a wave of onshore corporate bond defaults fired the starting gun on the property sector’s slow-moving crisis.
Avalanche
So where is the rock that will start the LGFV avalanche? Almost certainly in one of China’s poor inland regions. In July, Guizhou, identified by MacroPolo – the Paulson Institute’s think tank – as the second-most debt-stressed mainland province after Qinghai, said it was seeking to restructure and seek 20-year extensions on all its non-bond debt.
When and not if the defaults start, investors will seek the nearest available exit. That’s a big problem, for a painfully indebted asset class that depends on the capital markets to keep itself afloat, and that’s critical to keeping the nation’s financial machinery ticking.
City-wide Covid lockdowns that crush the spirit, a cratered property sector, an economy staggering if not quite yet on its knees – it has been a tough year for China. If investors flee LGFVs, things could get a lot worse.
