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.

From the above diagram, we can conclude that if there are a large number of defaults by LGFVs then it can ruin the Chinese financial sector since the contagion in the Chentgou bond market can easily spread to other segments of the financial markets since the LGFV sector is the largest sector in China’s bond market accounting for around 40-50% of non-government bonds market. Th

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 (Zhuo Chen, 2018) shows that those provinces where LGFVs were funded excessively by bank loans tend to issue more municipal corporate bonds, trust bonds, etc. to refinance these bank loans at the maturity date. This shows that the composition of the government debt shifted from bank loans to non-bank loans which means that LGFV business operations constitute a significant proportion of the Chinese shadow banking sector.

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 (Laura Xiaolei Liu, 2021) LGFV’s bond credit spread is positively related to the local government’s implicit debt, and this relation changes with the modifications in fiscal and macroeconomic policies. The regional government’s fiscal deficit also affects the LGFV’s ability to attract funds from investors.

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.

 Growing Debt of LGFV

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.

 Conclusion

LGFVs had been definitely instrumental in promoting China’s economic growth in the past but at present, the ever-increasing debt levels of these local government bodies pose a threat to China’s economy due to the reasons discussed in the article. The government should enact policies to restrain the growth of debt levels of these financial institutions which were created with the main purpose of promoting economic growth.