IFR ASIA: Ivan, how do you account for all of this when you’re looking at a rating?
IVAN CHUNG, MOODY’S: Whatever happens our analysis focuses on the issuer’s ability and willingness to meet their debt obligations. Many LGFVs are linked to the government. Having said that, we need to do more analysis on the local government’s ability to provide support. Under the Chinese structure, the local government get 30% of tax revenues and the central government gets 70%, but the local government still covers 70% of expenditure. That means the local government’s finances mostly depend on the transfer payments from the higher-tier governments. The provincial government depends on the central government, and the city depends on the province.
When we do the analysis we look at the tier of government. The upper tier is the 36 municipal governments (including their capitals) that can issue bonds, which includes the 27 provincial governments that have a direct link to the central government, as well as the key cities like Beijing and Shanghai. Fiscally they will report directly to the central government, so we believe there is strong support from the central government.
Then we see whether this support extends to the issuing entity. That depends on whether they are doing essential public services, such as utilities, and whether their funding support is clearly included in the budget. Otherwise the support will be weak.
It’s more complicated if the issuer is from a lower tier government, because most of the time they are weak on a standalone basis. So we need to see whether a higher tier of government can provide support. We lack transparency here because there are maybe 100 cities in the province and it’s not clear how one city can be more important than the others. So for the lower tier governments, in general, we have more reservations and we need more transparency.
Then the important thing is how this translates to support for the LGFV. Even an issuer with profitable operations can still maintain a high level of support if they are doing things like utilities or other types of profitable public services. However, if they are moving towards commercial operations, theoretically, their profitability will improve the standalone credit quality, but the support from government will be lessened.
IFR ASIA: What about the recent defaults from some of these local SOEs? Does that make you reassess those expectations of support?
IVAN CHUNG, MOODY’S: Generally we see that the change in government support is in sectors facing overcapacity or those where a default would be less likely to trigger systemic problems.
I need to highlight that it’s evolving. Five years ago everybody thought that any SOE default would trigger a systemic risk, but now people are used to it. The same thing may or may not happen with LGFVs five years down the road.
IFR ASIA: Perhaps it would be interesting to get a macro view on how much support China will be able to give some of these entities. If China’s economy is slowing, what does that mean for some of the more highly stressed local governments?
WEIZHOU YANG, MIZUHO: I think the Chinese government will maintain its support for issuers, but there are questions in the longer term, because as we can see one local SOE, Guangxi Nonferrous Metals, has already filed for bankruptcy, just last month.
We expect that maybe the Chinese government will introduce more market mechanisms and do some SOE reforms. But the key point for next year is the 19th National People’s Congress, when the top party leadership will change. Before that, I think the Chinese government will do anything to prevent any financial crisis or social instability.
LGFVs, as Ivan just said, are linked to the budget, linked to the government and linked to investors. China won’t let so many LGFVs go bankrupt in the short term so as to guarantee the stability.
IFR ASIA: Keith, how do you manage the longer-term risks? Five years ago we probably wouldn’t have said that steel companies were going to go bust in China!
KEITH CHAN, HSBC: I think most investors in Chinese US dollar credit are placing more emphasis on a bottom-up approach. So although we have LGFVs in different sectors there are still certain groups of LGFVs that tend to receive a stronger investor following. You have the metro railway issuers, for example, who need to be compensated by the government on a regular basis. Investors are generally more comfortable with those issuers given they either have a monopoly position or clear government support.
In general, we recommend that investors look into names that have a strong standalone business, a monopoly position in city gas distribution or water supply, for instance.
IFR ASIA: Do you think China could make an example of some provinces that have borrowed irresponsibly? Could they have to restructure their debt instead of getting help from the central government?
KEITH CHAN, HSBC: I think that comes down to Ivan’s point right at the start of the discussion on the definition of an LGFV. If it’s government debt, in black and white, there shouldn’t be any concern – no matter whether you are a fourth-tier city or a province.
It’s not like the US system, where you could have Detroit defaulting on its debt without triggering a default for the US government. That’s not the case for China. In our opinion it’s more the definition of an LGFV that is the tricky point. Is this particular entity counted as part of the government’s debt? There is no question about the government’s viability. It’s more about the specific issuer or company and whether they should be part of the government finances. That’s the trickiest part.
DAVID YIM, STANDARD CHARTERED: The fact that all these issuers, at whatever level, have to register with the NDRC to issue offshore debt gives the investor a certain type of comfort. If you are just too small, or not really representing a particular city or province, then you would probably not be given this registration.
SEAN CHANG, BARINGS: The reason I mentioned NDRC was also because when you apply to issue foreign debt you do need to specify the use of proceeds. If that’s approved then the NDRC’s approval will also be sent to SAFE, which will allow the remittance of proceeds, redemption and so forth across the border. There is some unity in the approval process, so if the investors trigger a change-of-control put, for example, there shouldn’t be any restriction on the repayment of the principal.
I think David’s point is right, in that the NDRC will look very carefully at your ability to repay when you apply to register a foreign issue. You do need to show balance sheet provisions and so forth, so that’s helpful.
IVAN CHUNG, MOODY’S: But I don’t think that translates to an explicit guarantee from a particular government department. It’s only a regulator who needs to ensure that they’ve done their due diligence on certain criteria. I think the key is whether this debt is linked to the local government budget. A lot of LGFV issuers rely on land sales for repayment, which is outside the regular budget.
Secondly, we need transparency on government finances, because what’s disclosed to the market is at the provincial level but it doesn’t say whether a particular LGFV debt is part of the government debt. In some cases they have a contractual agreement with the government, so it would become part of the budget. Otherwise they could be more exposed to property market risk.
KUN SHAN, BNP PARIBAS: For this question, first of all we need to look at the leverage ratio in China. Overall now it’s 250% of GDP, and we think it will increase smoothly. But the problem is the composition of this leverage. China is dealing with a highly leveraged state-owned sector, with over 160% of GDP, but household and government leverage is still low.
I think household leverage will decline due to the cooling measures now in place. The next thing is that the leverage will switch from the corporate sector to the government, so it’s moving from the implicit to the explicit.
We are quite positive on local governments going forward. I think the debt swap programme is a masterpiece because in the past this has created problems with shadow banking. LGFVs in the past didn’t care whether they pay 8% or 10% for their borrowings. After this debt swap we’re down to 4%, which is a big benefit to the local government.
The next big reform will be the fiscal and tax system, which dates back to 1994. Through this tax sharing system, the central government got a larger share of tax revenues, and they decided the portion of tax refunds and transfer payments to local governments. But local governments have a huge responsibility for infrastructure investment, thus land sales and additional borrowing via LGFVs are alternative sources of funding. Most of the local governments’ cash flows come from a tax rebate from the central government and land sales. This can be changed and will now be in the reform plan.
IFR ASIA: The tax system will be changed?
KUN SHAN, BNP PARIBAS: Yes. That means that the local government will enjoy more tax, local tax. A lot of people are now questioning the local governments’ reliance on land sales, and I think China is investigating what kind of tax can replace that revenue. Potentially it’s a corporate tax, and also a resources tax in sectors like coal mining. This can be part of the local government revenue in the future.
IFR ASIA: You call the debt swap a master stroke. But the first round was not particularly well received, was it? Is the municipal format becoming more market-based now?
KUN SHAN, BNP PARIBAS: Initially several banks did not accept the new municipal bonds because they had enjoyed yields of 7% or more for three or four year bonds with implicit guarantees. Now they have lower yields at 10 years, and the banks are not really happy about that. That’s why the PBOC and State Council gave them some concession, for instance allowing the new notes to qualify for repo and reducing the risk weighting for banks to 20% compared to 100% on LGFV bonds.
Initially there was no trading at all in the muni market. But now we finally see some trading activity as it offers a certain pick up compared to central government bonds. Next year there will be a Rmb7trn swap programme again, so that means the overall muni market will be equivalent to the size of the Chinese government bonds. A lot of the Chinese banks have to do some trading to build their portfolios.
China has Rmb26.3trn of wealth management products compared to Rmb150trn of bank loans. As Chinese banks take a hit from shrinking margins they will have to shift from the loan business to the investment banking business. Most of that investment will be going to the bond market.
IFR ASIA: As the LGFV market grows, are investors going to get spoiled for choice?
SEAN CHANG, BARINGS: Yes and no. I think if investors are not so sophisticated, if they don’t know anything about the investment then they should avoid it totally. If you just go with the crowd, this could still be a good investment but at the end of the day you don’t know what your protections are. You don’t know your legal position, and without any liquidity in the market then you can’t exit easily.
KUN SHAN, BNP PARIBAS: In the onshore market we don’t have proper hedging tools, so that means that all the investors head in a similar direction. If they buy they buy at the same time, but if they sell there is nobody to buy. There are no hedge funds that want to buy risky credits.
The key problem onshore now is not the size of the market, because it’s already the third largest bond market in the world. The problem in China now is the lack of market-making.
SEAN CHANG, BARINGS: Yes. You heard Ivan mention Document 43, but there is no proper legal system yet as to how these LGFVs should be classified. We’ve spoken about the definition, and there are some loose legal documents, but we haven’t yet heard from the standing committee of the state council on how these entities should be treated. I think that’s confused a lot of people.
IFR ASIA: How does the LGFV market fit in with broader reforms as China looks to create a credit culture? If everything trades at the same price onshore, then what does that mean for the offshore market?
DAVID YIM, STANDARD CHARTERED: Two years ago it was actually very attractive for a lot of these PRC companies to tap into the overseas market, because the cost of funding onshore was very high. There was no concern about renminbi depreciation, so it was a one-way bet.
That’s now reversed, because liquidity onshore is so strong and pricing has been squeezed so much. That’s why there are some issuers who looked at the offshore market have stopped, as there is no funding advantage.
IFR ASIA: So why do it then?
DAVID YIM, STANDARD CHARTERED: There are some who will tap the market for different reasons, to diversify their funding, or to promote that particular city.
DAVID TSAI, CLIFFORD CHANCE: Some of the issuers that we’ve encountered have overriding policy reasons why they want to issue overseas. For example, that particular city or municipality may have set up a free trade zone and is using a particular LGFV to raise their profile in the international market.
In that case, they may want to include the free trade zone in the disclosure for the bond issue. It’s a way of advertising the new zone to the wider investment community. That’s one impetus for certain kinds of issuers.
KEITH CHAN, HSBC: Whether it’s an LGFV or any other SOE, the offshore bond is only going to contribute a very small percentage of funding. Even for some of the biggest PRC issuers that sell offshore bonds every year, they’re only raising 5% or less of what they need every year.
The offshore market is only a supplement. It will never replace what they need from the onshore bond or loan market.
IFR ASIA: What happens as the onshore market opens up and more overseas investors gain access? Whether you buy in dollars or in onshore renminbi becomes a real option.
KUN SHAN, BNP PARIBAS: That is the future, right? When the market infrastructure, regulation, accounting standards and everything else work then investors can just pick and choose between an onshore or offshore instrument. At the moment, the onshore market is already open to foreign investors but participation is still tiny. If they don’t have people on the ground they have no way of determining the right price, because everything is Triple A. You just don’t know what you’re getting into.
SEAN CHANG, BARINGS: The onshore market is not easy to access, but with the mutual access programme you can now tap into the interbank bond market and we are starting to see differentiation between issuers.
The whole market is hugely underweight China, despite concerns over liquidity and credit risks. Lots of institutional investors, pension funds and insurance companies are underweight China in a big way. A lot of that is because China still has capital controls so it’s not easy to take funds in and out.
Back to your question about why these issuers come to the offshore market, I think it’s also in the country’s interest to promote Chinese credit overseas. They’re not thinking about one cycle – when the renminbi begins strengthening again it will be more reasonable for to issue in other currencies.
IFR ASIA: I’ve heard it said that LGFVs are effectively unregulated PPPs – public private partnerships. Is there a chance that China will develop something a bit more formal?
SEAN CHANG, BARINGS: I think PPP growth is going to be a global trend as governments look to infrastructure to generate growth. China has an advantage because they’ve saved a lot and they are able to provide funding for all these projects. For the bond market the measure to look at is how long these timeframes are. For short-dated financings the loan market might be more appropriate.
KUN SHAN, BNP PARIBAS: There’s definitely interest from the private sector, but the public sector is finding it difficult to catch up. If you talk to investors on the private side sometimes the returns they get on a PPP project has fallen short, and there is a risk because the government can change their policies and that affects their returns. You need a better system to push this kind of thing.
The key for China is you cannot keep relying on infrastructure investment to drive GDP growth. The margins are declining.
IFR ASIA: Before we close, let’s get some predictions. What’s going to happen to the LGFV market next year?
KEITH CHAN, HSBC: I think issuance will be continue to be strong. In the offshore universe right now there’s around 30 names, but the geographic breakdown is quite different from onshore. We’re yet to see any issuance from Yunnan province in the offshore market, for example.
So we suspect a way to look into the pipeline is that we look into the breakdown of the LGFV bonds in the onshore space, we will probably see more different provinces or cities trying to come to the offshore bond market for funding.
SEAN CHANG, BARINGS: Infrastructure is going to be one of the main themes for next year. Given that the Asian Infrastructure Investment Bank has already been created, I have no doubt that China will continue to look to infrastructure to drive growth. We are still quite optimistic and view China as one of the biggest opportunities in the coming year.
WEIZHOU YANG, MIZUHO: Next year the LGFV programme will expand as the Chinese economy is now going through some major structural reforms. LGFV bonds will be an important way of supporting local development and stimulating economic growth.
KUN SHAN, BNP PARIBAS: In the US dollar market I think it’s a very technical story. There is really strong demand from onshore investors for dollar bonds because they expect the renminbi to depreciate. Next year, if people still believe the depreciation story, then more and more Chinese money will fly into dollars.
But the big problem for dollar bonds from the LGFV sector is pricing, because it’s not that cheap anymore. If most of the bonds are held by Chinese investors, what happens when they come to sell? These are the things that I’m concerned about.
IVAN CHUNG, MOODY’S: I think we will continue to see issuance increase, given that it’s from a small base and the NDRC registration process has been simplified . Funding costs and diversification of investors are the main drivers.
I expect we will see more high-yield issuers from lower tier governments, and in a longer term also more from higher-tier governments like provinces, who may see some pricing advantage in going to the offshore market.
IFR ASIA: What’s the lowest rating you’ve given on an LGFV so far?
IVAN CHUNG, MOODY’S: We have four LGFV published ratings and all are investment-grade, and you can imagine that many issuers are still concerned about whether they get investment grade or not and decided not to disclose their ratings if they are not investment grade, but progressively you will see lower-rated names become interested.
DAVID YIM, STANDARD CHARTERED: Definitely there will be more LGFV issuers coming to the offshore market. There will be more from the second and third-tier cities, which may have real funding needs and find the offshore funding cost attractive, or others from the first-tier cities which just want to raise their profile and/or diversify their funding channels.
The ones I think the investors really, really want are those from the top-tier cities, mainly engaged in transportation or utility related operations. At the moment, these ones may have little reason to go offshore because the liquidity from the onshore markets is so strong. Unless that trend is reversed it will be difficult to convince those top names to come to the offshore market unless they have some offshore projects.
DAVID TSAI, CLIFFORD CHANCE: As legal counsel, we do get some sense of how these issuers feel about the offshore market, about disclosure and so forth. Right now there is a bit of a wait-and-see approach. Some issuers are not so keen to dip their toe in the water until another peer has done so. That said, I do agree with the panel that there will be more coming.
IFR ASIA: Legally, is the structure and the format set in stone now?
DAVID TSAI, CLIFFORD CHANCE: Yes, we believe it’s largely set now, especially with the NDRC approval process and SAFE permitting cross-border guarantees for direct issuance, these measures will provide the LGVFs with more interface directly with offshore investors for offshore bond issuances.
IFR ASIA: Ladies and gentlemen, thank you very much for your time.
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