08/11/17

China's Policy Makers Warn on Debt, But Bond Buyers Shrug

(Bloomberg) -- What happens when you say you’ve taken away a safety net, but nobody believes you?

That’s essentially what’s going on in one corner of China’s bond market, with the implication being that someone needs to get hurt before the message hits home. The issue relates to local government financing vehicles, or LGFVs, which boomed a decade ago when China’s Communist leadership let provincial and municipal authorities ramp up borrowing to fund all sorts of infrastructure and property development.

National policy makers nowadays have prioritized reducing risk in the financial system, and part of that involves telling local authorities to let LGFVs stand on their own, without the backing of the state. Some have listened -- for example, Moody’s Investors Service and Fitch Ratings have said debt repayment failures are becoming more likely.

Who’s not listening? Bond buyers. The yield premium on LGFV five-year notes rated AA -- a typical grade -- over government securities has dropped 61 basis points from a June high, to 163 basis points, according to data compiled by ChinaBond. That means they’ve broadly kept pace with the rest of the corporate-debt market, outperforming during a time when government bonds have tumbled, sending yields to three-year highs.

“The market has grown used to negative headlines on LGFV bonds,” says Meng Xiangjuan, head of fixed-income research at SWS Research Co. in Shanghai. “The fact that they have yet to see any real defaults on LGFV bonds is underpinning the outperformance of the sector,” she says.

The yield premiums shrank even after an April warning from Beijing that local governments should untangle themselves from LGFV bonds that total almost $1 trillion. Regional administrations were told not to bear any financial obligations of LGFVs. Central bank Governor Zhou Xiaochuan emphasized just last month that complicated relationships among various levels of regional governments are creating price distortions for their debt.

Such caution hasn’t reined in issuance -- LGFVs, which help finance roads, bridges and sewers, managed to sell 634 billion yuan ($97 billion) of bonds in the third quarter, the most since the first three months of 2016, according to data compiled by Bloomberg.

“Investors still count on guarantees from the local governments” said Wang Yifeng, a Beijing-based analyst at China Minsheng Banking Corp.’s research institute. That’s because “there’s yet to be any systematic crisis in the LGFV sector,” Wang said.

Beijing is trying to walk a fine line between boosting the role of credit risk in the setting of borrowing costs, and a wholesale collapse in LGFVs that would reawaken fears of a hard landing for the economy. Ivan Chung, head of greater China credit research at Moody’s, sees regulation on LGFV debt tightening over time, with local governments making up the bulk of issuance and the financing vehicles only executing some infrastructure projects.

The stakes for avoiding collapse are high: LGFVs must repay 879 billion yuan of bonds in 2018 both onshore and offshore, according to data compiled by Bloomberg.

“Deleveraging is at the top of Xi’s agenda and LGFVs are part of it,” said Chi Lo, greater China senior economist at BNP Paribas Asset Management in Hong Kong, referring to President Xi Jinping, who reiterated the need to reduce financial risks at last month’s Communist Party congress. “If the issue isn’t solved, the capital mis-allocation problem will remain, and the excess capacity problem won’t go away.”