New Risks Loom for China Local Debt, This Time in Dollars

(Bloomberg) -- Just when it looked like Chinese local government financing troubles were a thing of the past, a new risk is looming.

The vehicles that grew to gargantuan size during the previous Communist leadership team's all-out drive for growth have been steadily addressed by current President Xi Jinping's lieutenants, largely through a Beijing-led bond swap program. Now, units set up by local authorities to fund construction projects are selling debt outside the country -- in dollars.

While issuance is still small, it's surging. A record $12.3 billion in such dollar bonds was sold last year, with more on tap in 2017, making local financing vehicles a rival for property developers as top Chinese issuers of U.S. currency debt. The obvious problem: the funding vehicles don't typically have dollar revenue to draw on for debt servicing, which raises repayment dangers if China's yuan keeps depreciating -- a risk highlighted by the potential for accelerated Federal Reserve tightening.

"Plans to roll over or refinance when the bonds mature may be too optimistic," said Christopher Lee, a Hong Kong-based managing director of corporate ratings at S&P Global Ratings. "The funding window could close any time if the market volatility rises, or dollar rates surge, or there are unexpected credit events."

S&P predicts the local government financing vehicles will sell 20 percent to 30 percent more of dollar bonds in 2017. “As the tenors of the bonds are mostly three years, the real test will come in 2018, when the first wave of LGFVs are due for repayment,” said Lee.

Yuan Dangers

While currency forecasters on average see the yuan dropping less than 4 percent this year, according to a Bloomberg survey, the prospect for Federal Reserve rate hikes, along with capital outflows from China, are risks that hang over the exchange rate.

For the potential challenge the currency is facing, click here.

Another potential complication for China's local authorities is the move by central government policy makers to rein in leverage on the domestic front. That priority, which has driven the People's Bank of China to boost money-market interest rates in recent months, may be affirmed in the annual gathering of the National People's Congress that kicks off March 5, according to Morgan Stanley economists including Robin Xing and Jenny Zheng.

China's Ministry of Finance has used restrictive language lately with regard to LGFVs, which ran up 1.9 trillion yuan ($276 billion) of local bonds last year, bringing their total outstanding debt to 5.6 trillion yuan. The ministry said last month that local governments shouldn't provide guarantees for financing vehicle debt.

Tighter Times

Local conditions are tightening: yield premiums on five-year notes issued by LGFVs over comparable sovereign debt have risen to the highest since July 2015. And issuers have found it harder to sell on the home front -- leading to a second straight month of maturities outstripping corporate bond sales in January, only the second time that's happened in 15 years.

“The tightening environment in the onshore market is likely to drive more LGFVs to the offshore dollar bond market this year,” said Angus To, deputy head of research at ICBC International Research Ltd. in Hong Kong.

The yuan's decline itself has increased the appeal for China-based investors of buying dollar debt, through wealth management products -- something that's given local government financing vehicles a ready source of demand.

Yet emerging risks are prompting some fund managers, including domestic ones, to turn away from the market, with Lu Congfan at HFT Investment Management Co. saying they have little exposure and Darryl Flint, founder and chief investment manager at Double Haven Capital HK Ltd., considering shorting the notes. 

Recent Issue

One LGFV that's issued recently is Qinghai Provincial Investment Group Co., which sold three-year dollar notes at 7.25 percent in February. The entity is based in a western Chinese region with one of the lowest per-capita gross domestic products, and invests in power, raw materials and real estate development. As of 2015, the latest available data compiled by Bloomberg, its earnings were below its interest expense. The company declined to respond to a request for comment about foreign-exchange risks stemming from its dollar bond.

Fitch Ratings has called on investors to consider the rising dollar debt load of LGFVs as an additional liability for local authorities, even if they haven't pledged guarantees for them.

On the flip side, the pattern in China in recent years of gradually removing blanket support for bonds linked with the state -- a process that's seen a rise in defaults -- translates to risk for bondholders.

“LGFVs are essentially state-owned companies with local governments as shareholders, so if SOEs can default, it's unreasonable to say LGFVs won't,” said Shan Kun, head of China markets strategy at BNP Paribas SA. in Shanghai.

--With assistance from Ling Zeng

To contact Bloomberg News staff for this story: Helen Sun in Shanghai at hsun30@bloomberg.net.

To contact the editors responsible for this story: Richard Frost at rfrost4@bloomberg.net, Christopher Anstey, Robin Ganguly

With assistance from Helen Sun