IFR Asia LGFV Funding Roundtable 2016: Part 1

IFR ASIA: Welcome to the discussion on China’s local government financing vehicles. Let’s start with a definition: what is an LGFV, and why are they relevant for the capital markets?

IVAN CHUNG, MOODY’S: It’s a very good question, what is the definition of an LGFV? There is no consensus among the market participants or even among regulators in China. To our understanding, it’s a policy entity. They’re doing public works for the government, and the government is supposed to pay for these projects.

The key issue here, particularly before the publication of Document 43 near the end of 2014, is that there’s almost no contractual obligation on the government. Essentially the Chinese budget law meant local governments could not issue bonds, so the LGFVs borrowed on the government’s behalf, but whether the government can use the resources in the budget to help them make repayments is unknown.

Even today there’s still a lot of uncertainty. For example, now provincial governments can issue municipal bonds, but there is less transparency about how the provincial government will allocate the proceeds to LGFVs at the city or county level.

So what’s missing here is the transparency of the government budget. We believe that the government is an integral part of the credit. However, without a contractual agreement or clarity over the budget there’s a big question mark about whether the government can really provide support.

We also see lots of variation among the issuers. The one we just published today, Zhuzhou City Development (Baa3 stable), they have lots of government projects linked to the budget so we can feel confident that they are close to the government. But on many other occasions there’s a big question mark on who can provide support and how they can refinance the debt. That is a big risk to the investor.

IFR ASIA: There’s a CBRC guideline, I think, that says when an LGFV becomes profitable enough it gets reclassified as an SOE. Does that mean LGFVs are basically non-viable entities?

IVAN CHUNG, MOODY’S: By nature they are not profit seeking. Normally the government will cover their costs plus a little bit of margin, so they might be barely profitable. If you use a conventional credit matrix it would be horrible, but if it’s linked to the government’s budget then actually it’s an extension of government policy, and then we would look at it in a different way.

I don’t think the CBRC definition fully reflects all the credit drivers in a LGFV.

IFR ASIA: The key development for us recently has been the explosion in the number of LGFVs that have made it into the capital markets, both onshore and offshore. Keith, how big an opportunity are we talking about here?

KEITH CHAN, HSBC: LGFVs are one of the sectors that we have started looking at given that they have been aggressively issuing US dollar bonds over the past year.

Right now there’s about US$15.5bn of offshore US dollar bonds outstanding. Around US$2bn of that is from private placements and the rest is public issuance, so US$13.5bn–$13.6bn. This year in US dollars there has been more than US$6bn of issuance from China LGFVs, already higher than for the whole of 2015. This is a booming sector, and it’s now about 8% of all investment-grade issuance from China in US dollars, so we’ve spent quite a lot of effort looking into these credits.

We expect the China offshore LGFV space to be US$20bn by June 2017, so that means another US$5bn of issuance before June of next year.

IFR ASIA: What about the local side? Kun, is there a number available for how much has already been issued onshore? Where do you see that going?

KUN SHAN, BNP PARIBAS: The CBRC has a list of around 11,000 LGFVs and it’s updated on a monthly basis. Not all of them can tap the domestic capital market – especially the interbank market, where they will fall short of requirements on ratings, size, these kind of things. Of those, about 1,700 names have issued onshore bonds, and we can see that not all of them can print deals in the international market.

DAVID YIM, STANDARD CHARTERED: For me, not all of those names can bring large deals offshore, but there will be more going forward. A lot of people question the incentive for them to borrow overseas because of the dollar appreciation, especially because the onshore market is very cheap. But a lot of LGFVs come to the offshore market for other purposes. You can see them as special agents for the local government to build a profile with international investors and with the public.

IFR ASIA: Sean, what do you think?

SEAN CHANG, BARINGS: First of all, the target number for new issues is not aggressive. Since we started in 2014 with the first one, others have followed quickly.

I think the local government, whether at the city or provincial level, will have a view on who should go and represent them overseas. Some of them, I agree, are not for commercial reasons, but it means not everybody can come to the market.

It’s not just the top-tier cities or provinces that are coming to the market. We have seen some high-yield names coming to the market now. They may have less flexibility in the onshore market, so they are more willing to accept a higher yield to issue bonds offshore than some of the others from the first-tier cities. That’s why you don’t see that many from Beijing or Shanghai: there is no incentive for them. They have access to liquidity onshore and they don’t need to promote their own city because everybody knows Shanghai and Beijing, right?

That’s why you see second and third-tier cities coming to the offshore market. But I would not say that they’re all coming regularly because most of them only issue US$300m or US$500m, and the company will not be doing enough in the next 12 to 18 months to need a new issue. It’s not like the property sector, where they just keep coming back with two or three issues in a year – at least in the good old days.

IFR ASIA: If it’s a government initiative, is it also about promoting capital market development?

SEAN CHANG, BARINGS: The central government is encouraging companies to tap the overseas capital markets. Whether it’s an LGFV or SOE doesn’t really matter; they just want to see more companies using an overseas platform for funding.

IFR ASIA: Weizhou, perhaps I can ask you about the recent changes on the policy side. What’s changing now?

WEIZHOU YANG, MIZUHO: If we look at this morning’s news, the government’s latest step is to encourage debt-to-equity swaps. I also think in the last year the government has moved to control the LGFV segment because it maybe thinks that shadow banking is becoming an issue, as anything off the balance sheet comes without so much supervision. The government was worried about this issue last year, and we can see that they have changed their policy as a result.

The Chinese economy is slowing down and the government is quite worried about it, so they have had to find some engine to drive the economy. They found two ways. The first is real estate, and we can see the housing bubble this year. The second – and I think maybe the most important in the future – is infrastructure, but they have to find some money to pay for it and the central government is facing a projected deficit of almost 3% of GDP this year, which is the highest in history. So they have to fund infrastructure in another way, and that is one of the reasons why LGFVs are raising so much more money this year. That’s the story on the policy side.

KEITH CHAN, HSBC: You also need to look at the municipal bond market. Last year the total issuance was Rmb3.8trn, and out of that Rmb3.2trn was to swap with existing debt, so there’s only Rmb600bn of new money for actual investment. I think that’s one of the reasons driving the issuance by LGFVs.

The debt swap programme will be finished by the end of 2017 or 2018, so in theory after that local governments will be able to issue municipal bonds to finance infrastructure spending. Then the question will be whether the LGFVs will continue to need financing, because the local governments will be able to issue muni bonds at a lower cost.

That could be a change driving this sector. The LGFVs may eventually become SOEs, as we said, or become other form of public infrastructure financing vehicle. The key here is whether the boom can continue if the municipal bond market is strong enough.

IFR ASIA: Okay, let’s get another view on this. Are fears about LGFV debt less of a concern today than they were two years ago?

IVAN CHUNG, MOODY’S: At the moment the LGFVs enjoy lower interest rates and better liquidity in both the onshore and offshore market compared to two years ago. However the funding environment could change quickly and some inherent risks remain.

In any case, the market has huge potential that deserves our attention. The LGFVs have considerable funding needs to support infrastructure investment in China. From the buy-side perspective, we have to compare the potential default and volatility not just within China but with other parts of the world, and I think it’s still worthwhile to look at this market seriously. We’re talking about less than 1% interest rates in much of the world! This could be exactly where yields are coming from in the next decade and beyond.

At this stage, the LGFV market is not as complicated as, for example, the US when they evolved into CDOs and other structures. Investors just need to do some additional analysis and really look deep into what the ultimate sponsors are.

IFR ASIA: David, I want to ask you what do these structures really look like. They’re not completely guaranteed, are they?

DAVID TSAI, CLIFFORD CHANCE: No, not at this stage. Effectively you either have a guaranteed or direct issuance structure or a keepwell issuance structure in the offshore market. Going back to your first point, about how you define an LGFV, we look at it from a documentation point of view. It’s actually reflected in the legal documentation whereby you see, for example, some linkage to the SASAC (State-owned Assets Supervision and Administration Commission) at the provincial or local level, which has to give approval for this particular vehicle to issue offshore. That means you have to have evidence of direct support from the local government.

That can also be reflected in definitions around a “change of control”. With an SOE, you might allow some movement to accommodate for SOE reforms, perhaps allowing the state to sell down to 50%, but for a local government finance vehicle you would still expect 100% clear state ownership. If the bond documentation makes it clear that investors have a change-of-control put option that would be triggered upon the local government reducing its shareholding stake below 100%, then it is clear there is an element of the local or provincial government’s continuing support. On top of that, from a diligence point of view, it should be clear that the LGFV is not a profit-driven type of organisation; but is a policy driven entity or construction, as people have mentioned.

The final element is the use of proceeds. Unlike other SOEs with overseas investments, it’s generally clear that the bond proceeds that have been raised overseas would have to be remitted back onshore. So if all those elements tie up, for us as offshore international legal counsel, we will generally regard this as an LGFV bond issue.

IFR ASIA: Looking at the list of recent deals, there’s a big difference between some of these issues. So, David, how important is the rating when you’re trying to determine the right price?

DAVID YIM, STANDARD CHARTERED: It is important, because otherwise it’s difficult to look at the relative value of the investment. The financials don’t make a lot of sense because they’re all highly leveraged, so you can’t really look at these like a normal corporate issuer. So in a way you have to rely on an independent agency’s view on how important that particular LGFV is to that particular city or province.

That’s why, so far, we have not seen an unrated LGFV come to the market. There are some guaranteed by banks, but none that are unrated.

IVAN CHUNG, MOODY’S: Yes, to add to David’s view, all the names in the public US dollar market are all rated issuers. We think ratings here are very important from an investor’s perspective, as they help them do the credit risk analysis given the limited transparency in the LGFV sector.

Some investors also try to look into where the onshore LGFV bonds are trading. Pretty much everything onshore is rated at least Double A, but some investors are trying to look for some guidance in the spread between different LGFVs in the onshore market in order to gauge relative value offshore.

IFR ASIA: Sean, how are you assessing them?

SEAN CHANG, BARINGS: A lot of these factors are yet to be highly representative because we haven’t experienced any major default yet. The onshore and the offshore dynamics can be totally different as the foreign investors have a huge universe to invest in, compared to the onshore investors who may be crowding into the same issuers.

From our perspective the market is still developing and it is still relatively small. We look at it as an alternative investment rather than a mainstream type of investment, so we wouldn’t set up a totally different fund specifically targeting this segment, as yet. But I’m sure onshore there are lots of investors who have dedicated funds to invest purely in this particular sector.

For the indices we track LGFVs could be one or a few of the constituents, then we might take this as an index play. But because we are quite total-return-focused, we have to look at something like LGFVs as a non-index investment. We will either hold it or we totally avoid the sector, depending on the market situation.

IFR ASIA: Do you look at how much debt they can support, or is it more about which province or which city is issuing?

SEAN CHANG, BARINGS: I think our approach is slightly different to the credit ratings agencies. When we look at the LGFV we tend to look at it on a standalone basis. At the end of the day, the repayment capabilities of the sponsors and the strength of support from the local governments are important. The documentation is also fundamental in looking at how well protected investors are.

That’s why we tend to prefer those offshore jurisdictions, like issues coming out from Hong Kong or Singapore, because they are quite familiar to investors like us. In domestic China, we’ve only seen bankruptcy laws in place for the past two years. There is no history, and that could worry us.

Of course that would not totally restrict us from investing within the onshore market, if it is worthwhile and enables us to add total return.

IFR ASIA: In the local markets, do these different credits trade at different yields?

KUN SHAN, BNP PARIBAS: That’s an interesting question, because around 35% of the total onshore credit market is related to bonds issued by LFGVs. Before 2008 there were very few LGFV bonds, and the pickup started in 2009 when China rolled out a Rmb4trn stimulus package. I think that means that you cannot really blame the LGFVs for their debt burden, it’s the whole system. That’s why we still think that the government has the responsibility to solve these problems as soon as they see them, and not leave them to fall into bankruptcy.

The key risk is not default risk, because all the LGFV structures are the same and they are all doing the same kind of business. So if something happens to one LGFV the whole system will go wrong, and everybody will sell their bonds. It’s really a liquidity risk.

I still remember when a Yunnan LGFV stopped paying interest on bank loans several years ago. At that moment the LGFV sector in the bond market was shutting down and it was really hard to sell LGFV debt. LGFVs onshore used to trade at really high yields, say 6%-10%. Now it’s a real sweet spot.

In the past there were certain differences in pricing but now I think they are all trading in a similar level. In the onshore market the key investors are not the fund managers, it’s the banks. How the banks do their credit analysis is very different from the fundamental offshore approach. And if an LGFV is in debt, their outstanding loans will be much greater than their bonds. So a bank investor can just call their local branch to check whether it’s a good credit or a bad one.

DAVID YIM, STANDARD CHARTERED: The LGFV market, whether it’s onshore or offshore, is actually fuelled by the investors’ interest in these bonds. In the onshore market they are chasing assets and yield. Offshore, a lot of investors are chasing PRC bonds and there is a lot less real estate issuance in the offshore markets now, so investors can look at this particular sector to replace some of the assets that are not there anymore. That drives the yield down.

Onshore, the differential between AAA or AA is very small because you cannot go too low. But in the offshore market there is still some differential because of the liquidity. You do see some variation between a BB rating and a BBB+.

IFR ASIA: So far we’re talking about liquidity and pricing risks, but what about defaults? Is there no question that an LGFV might be allowed to fail?

KEITH CHAN, HSBC: In this round of stress testing in the onshore bond market, there have been no LGFV defaults at all in the last 12 months. We have central SOEs defaulting, we have POEs, we have local and provincial SOEs, but no LGFV defaults at all.

So to a certain extent the LGFV onshore bonds are becoming safe havens, and are performing well.

IFR ASIA: But if some of these central and local SOEs are allowed to fail, doesn’t that suggest that government support is shrinking?

KUN SHAN, BNP PARIBAS: This is about whether you think China will go for defaults or something softer. I think for LGFVs it’s more likely to be debt restructuring where necessary. The next trend will be applications for debt-to-equity swaps from the central SOEs, and they will try to renegotiate with the banks.

Defaults in the onshore market are new, and this year there have been more cases. While they have happened to SOEs, we believe it’s not been the LGFVs because there are systemic risks. LGFVs are linked to the banks, linked to the government and linked to bond investors – who are also banks. So if you let the LGFV go then the whole system is under threat.

KEITH CHAN, HSBC: That’s why there are some investors who are trying to buy bonds from the low rated LGFVs. If something happens, it doesn’t matter whether you’re A- or BB. Everyone’s affected, so why not go for the highest yield possible. That’s why I think we’re going to see more small issuers coming to the market.

IVAN CHUNG, MOODY’S: The issue here is transformation risk. If an LGFV deviates from its policy function, its expected government support will likely decline. Some LGFVs now engage in commercial activities, and so they are not 100% involved in government projects. There are over 1,000 issuers in the onshore bond market and the profiles are quite varied. Some of them used to be LGFVs but may be raising money for commercial projects such as property development.

Secondly, the debt swap programme is still an unfinished work. The central government has recommended issuing municipal bonds to replace obligations that were issued before end of 2014. But after they are swapped the central government obligation will be gone because all those legacy debts will have been repaid.

The publication of Document 43 also restricts the local government from providing support for indirect debts, meaning that there could be a transformation in the level of systemic support after the debt swap is complete. Of course you can argue that the swap will continue, but still there is a policy risk here.

KEITH CHAN, HSBC: That’s why it’s quite interesting to look at this sector. We use the term LGFV for all these government entities, but if you look at each as an individual they are all very different.

I think we’ll come to a point where investors will pick and choose the ones that they feel more comfortable with. Some actually don’t mind if the LGFV makes a loss, because this shows the support from the government. Others will say it’s better to have some commercial operations so at least it’s profitable.

IFR ASIA: It’s a bizarre idea that actually making money might expose you to more risk, if the LGFV is turned into an SOE.

IVAN CHUNG, MOODY’S: It is not necessarily the case. Some LGFVs have turned to public utilities and are profitable. Such LGFVs are still strategically important if they provide essential services, say water supply, to a large population. They may end up having improved fundamentals and maintaining strong government support.

IFR ASIA: On the legal side, is there anything you can do to reassure investors that the status of these issuers won’t change?

DAVID TSAI, CLIFFORD CHANCE: Ultimately, it boils down to two things. One is the structural point. If the group is confident that their managerial structure won’t change, that their management will remain tied to the municipal or provincial government, then you could reflect that in the “change-of-control” redemption mechanism under the terms and conditions of the bonds. This provides bond investors a means of exiting if the LGFV changes from its policy focus into a more commercial SOE, because that is not what investors had invested in.

The second is that from a disclosure point of view we need to be very careful. If the issuer has any inclination to transform or has an intention to eventually shift gears from being a policy vehicle to a more commercial vehicle then you need to document that in the risk factors for investors. That will deviate from the traditional LGFV story where you are investing in a policy instrument.

DAVID YIM, STANDARD CHARTERED: One positive on the structure is that we also see more LGFV issuers using the direct issuance structure, moving away from the keepwell agreements in the first batch of LGFV deals. That, in a way, gives investors more protection. We have not seen a default yet so we cannot really tell if we can go after the issuers.

IFR ASIA: How confident are you that investors can exercise a change-of-control clause on a government issuer? There has been one I know of in Hong Kong, for China City Construction, where investors still haven’t got their money back.

SEAN CHANG, BARINGS: I have to say our firm was not involved in that particular transaction, but what we’ve understood is that it boils down to how a particular change-of-control definition is drafted. It may not be entirely clear who ultimately needs to be the controlling shareholder.

Where the actual formulation is clear I don’t think there should be any dispute in terms of whether you are entitled to redeem the bonds or not.

IFR ASIA: But even if you trigger it, you’ve got to trust the issuer to pay your money back somehow.

SEAN CHANG, BARINGS: That’s true. From that point of view, the clarity we need to see in due diligence for these kinds of transactions is: “Do you have NDRC approval for this?”

Going back to David’s point, the reason why I think people have moved away from keepwell structures is that all overseas debt issues from a Chinese entity now need to get approval. There is no longer the risk that someone finds a way around the process through a keepwell structure, because the government has now centralised the approval process.

Direct issuance, or at least guaranteed issuance, is much stronger than an offshore issue with a keepwell deed. It means the mainland issuer is at the centre of these transactions, rather than one step removed. On top of that, if you draft the COC clearly I think the trigger points are still there.

KEITH CHAN, HSBC: That example has actually made a lot of investors look at this control clause much more closely. I think for an LGFV the chances of that happening are a lot less than for a China City Construction.