ANALYSIS: The Shady Underbelly of China’s Local Government Bonds

A woman walks past Chinese yuan and U.S. dollar symbols in Hong Kong, on November 28, 2012. Philippe Lopez/AFP via Getty Images

Concerns that problems associated with China’s property development companies could spill over to local government financing vehicles (LGFVs), jeopardizing local government financial stability, are not new to international investors. A lack of transparency and a complex financing environment only heighten those concerns.

The suicide of Yu Lei, a major figure in China’s bond market, however, casts a long shadow over the country’s municipal financing practices and the systematic risks they pose on the world’s second-largest economy.

It also highlights the opaque and dangerous nature of LGFVs, particularly at a time when foreign investors in China are getting increasingly worried about the future of their investments in local credit markets.

Yu was an investment manager who made a fortune and earned the nickname ‘Bond Prince’ through a fundraising practice that is now banned.

However, he was later detained by authorities and betrayed by his business partners. He committed suicide earlier this month at his Shanghai home, according to reports.

Yu, who would have turned 40 this year, amassed a personal fortune exceeding 1 billion yuan ($138.9 million) in just a few years, starting in 2019. He accomplished this primarily by assisting state-backed enterprises (SOEs) in issuing bonds through a process known as “structured issuance,” which has since been prohibited by authorities.

In these issuances, issuers pretend to be financially healthy by buying back their own bonds to secure low-interest rates. Much of China’s municipal financing is based on unstable systems, which Yu exposed through his involvement in structured bond sales. With Yu reportedly involved in transactions totaling 30 billion yuan ($4.2 billion), his case highlights the potential extent of such activities, raising investor concerns about the underlying credit risks associated with LGFV offerings.

Nebulous bond deals are common at the municipal level, with specific investors and underwriters receiving additional fees that distort coupon rates, a Bloomberg report on Tuesday said.

His involvement in such deals for LGFVs revealed China’s municipal finance’s significant hazards, while his death serves as an urgent call for regulatory reforms, according to the report.

Complex Web

LGFVs emerged as a consequence of local governments’ limited ability to raise income taxes and served as a means for them to increase infrastructure spending and revitalize the local economy. Local governments are often the sole or main owners of the LGFV, which provides debt that banks and other financial institutions can use to fund projects such as social housing or roads and bridges.

Returns on these infrastructure projects are typically insufficient to cover debt service expenses and loan repayments, therefore local governments have traditionally sold land to property development corporations to make up the difference.

At the center of the controversy, according to Bloomberg, are the cryptic bond arrangements that are common at the municipal level in China. These arrangements, which are frequently designed to skirt statutory borrowing restrictions, allow a small group of investors and underwriters to pocket additional fees, misrepresenting the real cost of municipal borrowing.

While Yu’s ability to coordinate such transactions facilitated billions in LGFV bond sales, thereby highlighting the systemic vulnerabilities inherent in China’s municipal finance system, the 1 trillion yuan ($140 billion) debt swap scheme and other recent interventions by Beijing in the LGFV bond market have inadvertently exacerbated the risk profile of these bonds.

In August of last year, China enabled local governments to raise around 1 trillion yuan through bond sales to settle the debt of LGFVs and other off-balance-sheet issuers.

This measure ended in a convergence of interest rates, regardless of the issuer’s creditworthiness, obscuring the inherent risks of different LGFV bonds as well as impairing investors’ ability to assess the financial health of LGFVs.

Risks to Municipal Finance

The property sector’s woes have also disrupted LGFV’s funding cycle, selling properties and land to cover debt servicing and repayments, considerably increasing the likelihood of LGFV default.

Although no LGFV has defaulted yet, credit rating agency Fitch Ratings in its January report estimated that the “LGFV sector faces around 232 billion yuan (about $32.68 billion) of maturing offshore US dollar bonds in 2024,” which is “much higher than the CNY161 billion [$22 billion] last year.”

Some LGFVs with weaker credit profiles increased shorter-term loan issuances to reduce total funding costs, meeting the financing cost cap set in some provinces. This additional debt, coupled with restricted flexibility, represents the main risk for LGFVs in 2024. According to Fitch Ratings, it has intensified refinancing pressure on LGFVs over the long term by widening the duration mismatches.

LGFV bonds pose considerable dangers to the stability of China’s municipal financing system under these conditions.

For one, with local authorities facing cash-flow problems due to real estate crises, there are growing concerns about the IMF-estimated $9 trillion LGFV debt market. If these vehicles default or face liquidity issues, it could trigger a credit crunch at the local government level, affecting financial stability and economic growth.

The lack of transparency in LGFVs further erodes investor trust. When investors are unsure about the underlying financial condition of LGFVs, they may be unwilling to invest, resulting in market volatility and potential defaults. Worries regarding state backing for LGFV debt might also result in negative feedback loops involving LGFVs, enterprises, banks, and local governments. If one LGFV has financial difficulties, it might cascade to others, raising systemic hazards.

The stress in LGFVs has already started surfacing as reflected by liquidity constraints in locations such as China’s Guizhou Province.

It was announced last week that the province is selling its bonds to help repay debt issued by its LGFV, which is not just a rare move but also “speaks [of] a policy preference to just shuffle the bad debt around rather than deal with it through bankruptcy and asset reallocation,” Ray E. Farris, the New York-based ex-chief economist of Credit Suisse, wrote on LinkedIn.

The revenues of the private note will be used to repay or refund two bonds offered by a local government-backed vehicle in the region, Guizhou officials said.

Caution for Investors

Structured bond deals, which might involve trillions of yuan, therefore require extensive due diligence by investors, experts say. Similarities in coupon rates and hidden investments in private equity firms are among the warning signs that indicate a more serious problem.

The weakening effectiveness of traditional market indicators, as illustrated by the rebound in LGFV bonds despite their troubled beginnings, confuses the investing picture even further.

Faced with regulatory hurdles, investors traverse a complex investment landscape and the need for openness, due diligence, and a shift toward market-driven credit procedures becomes increasingly clear.

The bond market’s future stability and integrity may be dependent on the CCP regime’s willingness to confront these structural challenges straight on, even if it means facing difficult realities about the financial health of its local governments.