Is LGFVs Debt a Problem ?
Local financing
government vehicles are funded and operated by local government authorities to
fund infrastructure or other development projects, such vehicles were
established by the local municipalities through the injection of land, equity
and different sorts of capital instruments like bonds, commercial papers, etc. These
type of financing vehicles became famous when after the 2008 financial crises
the Chinese regional governments started funding infrastructure projects by taking
on bank loans through the off-balance sheet Local Government Financing Vehicles
(LGFVs).
Chengtou are LGFVs specifically established to
fund mega projects requiring a lot of capital and these were created mainly as
a part of China’s stimulus package against the global financial crises of 2008.
Since the Chinese government took a proactive strategy by devolving around 2.2
trillion yuan to local authorities so that they can undertake extensive
urbanization to increase employment in the economy, the Chinese central bank
encouraged the local governments to borrow externally by establishing the
LFGVs.
In China, there
are mainly two types of LFGVs which are classified as follows:
·
Quintessential: These are indispensable tunnels for the local
governments to access the bond markets as debt raised by such vehicles doesn’t
show on the government’s balance sheet. Such types of LGFVs are given monopoly
power for undertaking regional development projects by the local authorities
such as expressways, affordable housing, logistics supply chain development,
etc.
·
Hybrid: Such LGFVs tend to have diversified
holdings as they can invest in both public housing projects as well as
commercial projects which adds more revenue streams. Given the recent economic
developments in China, the business models of local government bodies have
become highly vulnerable to financial default. They can sometimes operate as
State Owned Enterprises (SOE) which usually deal with debt obligations on their
own rather than depending on implicit sovereign guarantees.
But in recent
years the debt of LFGVs has been rising making them financially unviable to
continue their operations given the current instability in the Chinese economy
post-Covid-19 restrictions. As per an annual report by Rhodium Group, the
overall cash positions of around 2,892 local government financing vehicles saw
a decline relative to rising interest and debt costs, the total debt of the
survey firms rose to 54 trillion yuan in 2022 from 50 trillion yuan in 2021.
Poor Earnings
of LGFVs:
As the LGFVs are mostly owned by provincial governments they become instruments to gain political support or allocate resources toward policy goals such as supporting local highway projects or real estate markets. Income streams from infrastructure-related projects are the primary source of revenue for such vehicles, most of these returns are not received in cash but in the form of receivables due to which these vehicles tend to have weaker cash flows.
Since a number of LGFVs have entered into partnerships with private real estate companies in the past the present precarious situation in the Chinese property market will definitely affect the earnings of these government-financing vehicles mainly due to the widening shortfall between the revenue and expenses. Also, LGFVs use large portion of the debt raised to pay off their daily operating expenses such as management of land inventory, employee payrolls, and other working capital needs. As per the Chinese Central Bank around 80% to 90% of their spending is met by external funding in 2020. But relying on such type of funding creates new debt for already burdened LGFV thus creating a lot of pressure on their operating cashflows which reduces their ability to access further credit from new resources apart from the government's implicit guarantee and this cycle keeps on going. The graph below shows the various sources of cash flows which are indicative of retrograding of LGFVs earning productivity.
The burden of
refinancing
Given the
various economic challenges that China is facing such as turmoil in the
property sector, dwindling exports, and a slump in land sales have increased
the responsibilities of LGFVs which have the main objective of ensuring
regional economic stability. But as we have seen the LGFVs aren’t able to earn
much relative to their operating expenses, so these government funding vehicles
have become heavily dependent on local government support.
The recent crises in the Chinese real estate sector where construction companies aren’t able to pay off their debt have affected the revenue streams of local governments for whom selling land parcels formed a major part of their income, as a result, LGFV-affiliated firms are being asked to purchase vast amounts of land so as to ensure macroeconomic stability by providing resources to cash-strapped regional enterprises. As per Financial Times, land acquisition by LGFVs rose to 57 billion US dollars in 2022 which artificially inflates the price of the property which isn’t sustainable as the Chinese real sector is still under stress with the bankruptcy of Evergrande in 2021 when it defaulted on most of its bonds along with a 39% fall in sales in 2021, a report by property consultant CRIC showed that sales of top 100 developers have fallen by 33% in July 2023. As per the Rhodium group report in 2019, 78.7% of LGFV bonds were used to refinance maturing debt or to swap other debt instruments of these quasi-government financial vehicles which was around 19.3% in 2013. This shows most of the newly issued LGFV bonds are used to pay off the old debt thus further adding to the fiscal burden of the local government thus restricting their infrastructure investment spending.
The above shows
an increase in number of LGFV bond used to repay the old debt of financial
vehicles. Also, the market forces are affecting the reputation of LGFVs as the
central government decided to stop giving direct support to ailing enterprises
especially those in deprived regions forcing such LGFVs to raise bonds at
higher prices thus raising the refinancing pressure on local/regional
governments.
Can LGFVs
lead to financial distress?
Since LGFVs in
China raise funds from both interbank markets and the public exchanges, along
with established indirect interlinkages with the corporate sector. Since LGFVs
offer financial support to local non-financial firms, property markets, and
regional municipalities by infusing capital mainly in the form of equity-related
products and as per a 2020 report from IMF, nearly 1000 firms had both direct
or indirect claims in the form of equity-like instruments on LGFVs which can
lead to problems since these LGFVs have amassed huge debt burdens which worsens
the scenario given the cash-strapped nature of
the local governments, as the Chinese government has been running record high
fiscal deficit, the Chinese government debt to GDP ratio has increased to
around 76.9% which raises an eye on the government’s ability to repay its debt.
So, lending to LGFVs has become a highly risky business avenue as their
earnings capacity has been degraded due to excessive debt and decreasing
efficiency.
But the Investment
linkage data from Capital IQ shows that around 5000 firms have either debt or
equity exposure to local government financing firms out of which 58 are banks
and 112 are securities companies. Also, Chinese banks recently have been
undertaking a lot of loan restructuring of LGFVs debt which offers a lot of
ease to the liquidity position of weaker financing vehicles thus delaying the
inevitable default on their bonds, such schemes usually involve maturity
extensions or discounted interest rates which negatively affects the
profitability of the banks.
The stimulus
loan hangover effect described as in
The above graph shows
that MCDs issued by the local government has been steadily increasing whereas
the bank loans as a percentage of GDP has been falling
The Wind Finance
Concept Index is downward trending which implies that the market capitalization
of top companies in the banking, construction, and shadow banking sectors has
been degrading mainly due to the perceived risks of a dilapidated property
sector and excessive local government debt.
The fall in the
index can be a signal that if a widespread default of LGFVs take place then it
would definitely result in a financial meltdown of the Chinese markets. Since
LGFVs have increased their dependence on regional banks for funding as there
happens to be connections between local governments and regional banks as a
result such banks keep on funding the non-performing assets of the weaker LGFVs
which reduces their profitability making them financially unviable and
increasing the risk of inducing bank runs.
Influence of local Governments and their different characteristics
The less
developed regions within China are bound to be affected more since these areas
are highly affected by the post-covid restrictions resulting in reduced tax
revenues for such regional governments. As per
The probability
of the local government’s implicit debt is an important factor in calculating
an LGFV’s bond pricing and this further depends on the level of the government
which acts as a guarantor. And even if the bonds are covered in the fiscal
budgets of central governments the credit risks of such LGFV bonds would be
highly linked to the financial conditions of the local governments.
The debt swapping program in which provincial
governments are allowed to issue bonds or other
financial instruments to any other regional governments
to swap LGFV debts with higher interest rates, helps to transfer proportions of
LGFV debts onto the balance sheet of the governments. It is believed that the
government’s influence beyond the market mechanism affects the bond pricing, for
example, the implicit guarantee enables the LGFVs to raise funds at a cost
45.67% lower than those instruments issued by non-state enterprises with
similar credit risk profiles.
In a Marco-polo report,
it was clearly stated that different provinces have diverging repayment
capabilities as the diagram shows the risk of different regions.
The regions
which are above the line are safer in terms of financial health whereas those
which are below the line indicates a higher risk of default. The metrics
included in the graph were calculated by MarcoPolo by analysing financial
reports of around 2,500 LGFVs for the past 10 years.
Given the fact
that LGFVs themselves are not able to earn enough to cover their interest
payments combined with the fact that most financing vehicles lack experience in
project development and aren’t able to generate enough income streams plus the
newly purchased land usually lies as idle inventory. As mentioned, the LGFVs
borrow heavily from the banks to fund these purchases of land parcels, since
private developers are exiting the debt-laden realty sector. This has resulted
in the high involvement of the government in the financial markets of the
Chinese economy as a result LGFVs have become black holes for the country’s
financial system with their surging debt loads and weakening revenues starting
to alarm investors.
The fundamentals and financial conditions of LGFVs have been declining in quality due to the above-mentioned reasons but still such financial vehicles continue their operations by raising debt at cheaper rates due to the implicit government guarantee adding to their already existing stock of borrowed funds. Various schemes undertaken by local governments such as refinancing of debt, and swapping of LGFVs bonds are some of the tools that help the quasi-government vehicles to renegotiate the implicit debt thus creating incentives to add more debt, for example, around 100-billion-yuan worth of Swap bonds were issued in Q1 of 2019 by the Chinese government. Also, recently the Chinese Central Bank is believed to have started funding certain LGFVs in smaller cities through the China Development Bank (CDB) so as to increase liquidity for the cash-strained LGFVs
The bar graph is
a testimony to the increase in debt obligations of LGFVs which makes matters
worse when one realises that a large portion of this debt is maturing soon,
along with deteriorating fiscal revenues of local governments. As a result, the
government introduced a scheme to inject state-owned assets such as hotels,
mining rights, tourist sites, etc. into these LGFVs instead of extending
implicit guarantees. The aim of this scheme was to help the LGFVs become
self-sufficient by giving them an opportunity to explore new business avenues.
And since LGFVs
are critical for regional development as they help in bringing money,
technology and resources to the populace plus offer employment opportunities by
asking for staff workers, providing financial resources to regional business
firms which creates demand for trained workers, thus offering liquidity and
financial stability to the regional financial system.
So, if the government refuses to fund the LGFVs it would have drastic macro-economic consequences on the Chinese economy. This means that LGFVs can keep on accumulating debt even if they have been missing interest payments owed to banks and other enterprises, which we can observe from the following.
Comments
Post a Comment