LGFVs: to default, or not default? Ask Beijing

China’s recent shift towards short-term monetary loosening has failed to arrest a default on a local government debt vehicle in the western province of Xinjiang, renewing concerns over Beijing’s determination to contain systemic risk.

The timing of the default, however, is more surprising. Authorities in Beijing have recently loosened their grip on monetary policy in an attempt to shore up the balance sheets of struggling companies, as a trade war with the US threatens the export-dependent economy.

The National Development and Reform Commission, the country’s top economic planner, said on Wednesday that Beijing was looking to boost investment in infrastructure projects to alleviate financing pressure on local governments, citing the ongoing trade tensions with the US.

"The latest default on the Xinjiang bond will inevitably dent the sentiment in the market," a senior debt banker based in Hong Kong told FinanceAsia. "International investors will probably stay for  longer on the sidelines."

For years, international investors have been concerned that the rampant growth of local government debt is an example of moral hazard; officials see promoting local economies and boosting economic output as key to developing their careers. Spending big on infrastructure is the fastest way of doing so — and officials know they are unlikely to still be in the same place to deal with any long-term problems their borrowing brings.

Investors assume the LGFV bonds, which are often used for local infrastructure investments, are guaranteed by the central government because a failure to service the debt obligation could triggered social unrest.

The default by the Xinjiang company underscores that risk. The Shanghai Clearing House announced on Monday that the company had failed to pay principal and interest on its Rmb500 million, 270-day bond. The company is 92.74% owned by Xinjiang Production and Construction Corporation, while an investment vehicle of the policy lender China Agricultural Development Bank owns the remaining 7.26%.

The latest default raises the question about whether the presumption of state backing, the so-called "implicit guarantee", is still valid in the debt issued by a government related entity.

WILD RIDE

This is at least the fourth case so far this year of a local government-related entity defaulting on debt obligations, although it is the first to come to light involving a bond.

In May, a property firm owned by the Tianjin municipal government defaulted on two trust loans worth a combined Rmb500 million ($72.5 million). Later that month, Xilinhot Geipaishui officially defaulted on loans totalling Rmb4 billion.

That followed a high-profile default by the Yunnan government in January.

A government-linked entity called Yunnan State-Owned Capital Operation technically defaulted on two trust loans totaling Rmb1.5 billion, but the company was ultimately saved by the local government of Yunnan, which provided about Rmb 2billion of new equity to the company.

The string of bond defaults at the local governments comes alongside steady rise in corporate defaults in China. According to a Standard Chartered report in May, nine companies have defaulted on their onshore bonds this year. The value of defaulted bonds was up 32% year on year.

According to S&P’s estimate, Rmb1 trillion of local-government bonds will mature each year between 2018 and 2019, and the remaining Rmb5 trillion will mature after 2020.

"The deleveraging campaign has resulted in a massive negative shockwave to the local governments as they are struggling to raise capital to refinance their outstanding debt," a Beijing-based trader with a Chinese brokerage firm told FinanceAsia.

New issuance of LGFV bonds in 2017 dropped 30% year-on-year to Rmb 1.7 trillion, and net issuance, the sum of new issuance minus maturing debt, in 2017 fell to the lowest level in seven years, according to a report by Guotai Junan in March.

China's recent softening of monetary policy helped LGFVs rebound in secondary trading during July. It also created a ray of light for offshore issuance with a few deals launched offshore, allbeit heavily supported by onshore capital. 

Then the default by Xinjiang Production and Construction Corporation has revived doubts once again. 

As one senior China banker told FinanceAsia: “The default of the Xinjiang bond raises the question of whether the Chinese deliberately let the local government default on its debt, or the local officials at the government of Xinjiang are not reacting promptly to contain the situation.”

The answer should become clear in the government's reaction to the default and it will be critical for investor sentiment. 

WHAT IS AN LGFV?

The Xinjiang debt default also raises another problem investors face with LGFVs: there is really no firm definition of what an LGFV is. Investors and bankers define an LGFV as a funding vehicle associated with a Chinese local government for investment in infrastructure projects.

However “the Xinjiang issuer is more like a state-owned company than an LGFV because based on public disclosures its major business and assets are related to commercial operations like cotton, coke, real estate and pharmaceuticals,” said Ivan Chung, head of Greater China credit research and analysis at Moody’s. “It does not play a key role in public infrastructure investment and development which LGFVs do on behalf of government."

The company has incurred heavy losses since 2014 due to a drop in government subsidies, including in the first quarter of this year, according to the company's statement to the Shanghai Clearing House.

As one Chinese investment banker told FinanceAsia in July: “The LGFV market is just not functioning right now."