Monday, August 29, 2011

Potential Risks About China LGFV debts

In our earlier article: Inside LGFV debts in China, we explained how China’s national public debt to GDP ratio can still be acceptable and why the China LGFVs (Local Government Financing Vehicles) debt problem has been getting serious recently. Now in this article, we want to explore more about the potential risks of LGFVs and what we expect to happen in the near future, as below:

(1) Since the Chinese central government has never made clear any national body or party should bear any public responsibility for permitting the continuous growth of local government debts, Chinese local governments still have every incentive to maintain or increase their current debt leveraging ratios. In the absence of bearing any public responsibility, Chinese officials of different local governments race against each other to borrow even more money to fund their huge projects for faster GDP growth before they rotate to their higher-level positions in the next term. At he same time, different Chinese banks also race against each other to pour credits into their LGFV borrowers as they all depend on new loans to avoid older loans become non-performing. We can say that the real risk of LGFV debts should mainly come from this absence of public responsibility.

(2) Another risk of LGFV debts should come from the existing GDP growth formula of China local governments. As long as the China local governments keep spending in fixed asset investment and they keep funding their fixed asset investment through LGFVs, the existing GDP growth formula is in fact largely supported by LGFVs. Unless this growth formula is going to be changed, the size of debt-financing through LGFVs will undoubtedly continue to grow. Now we have to consider it as a structural economic problem and recognize that China national GDP growth will be unlikely to grow in the current high speed without LGFVs (Local Government Financing Vehicles).

(3) In recent years, China local governments rely just too much on real estate related revenue, such as land selling, especially for local governments below the county-level. The total revenue from selling lands in the top five mainland cities already reached RMB 533 billion last year, an increase by nearly 70% over 2009. Taking Beijing and Shanghai as examples, their local revenues were respectively RMB 235 billion and RMB 287 billion in total last year, and it is estimated that their income from selling lands alone contributed over 50% of their total revenues. The excessive reliance on the mainland real estate market now poses the biggest risk to the possible default of China LGFV debts.

(4) Since the national macroeconomic regulating policy in real estate market has recently been intensified, it is reasonable to expect that the real estate related revenues of China local governments will decline. In addition, the weak real estate market should also reduce the overall solvency of the local governments as they mostly use land or housing as collaterals for their public debts.

(5) Mainland media once reported in end-May that CBRC (China Banking Regulatory Commission) planned to rectify the debt problems of LGFVs in the next three months, and will involve an amount up to 2-3 trillion Renminbi RMB (or called CNY, yuan), of which losses will be absorbed by the Chinese central government and the mainland banking sector. That means large state-owned banks have to bear part of the losses, and they basically have no choice but have to support the policy of the Chinese central government. After all, although the Chinese state-owned commercial banks are now named "commercial" banks, obviously they are still not operating just like the other western commercial banks. The LGFV problem did touch nerves of investors again, as they have worried about the deterioration of LGFV debts might lead to an increase in non-performing loans (NPLs) ratio of Chinese local banks and impose a negative impact on their profitability.

(6) In the next three years, many LGFV debts will enter a repay period. The market worries that the financial strength of some weaker local governments can affect solvency of their LGFV debts. In fact, the actual ability of LGFVs to repay their debts will hinge mostly on the local macro-economic factors. Those weaker local governments can honor their debt repayment only if the local economy can continue to grow stably, the local government tax revenues can continue to expand steadily, and the profitability of their projects can continue to be kept eventually.

(7) Although Shanghai municipal authorities did deny a media report about a debt default case for one of its LGFVs engaged in the development of highways and real estate, it still cannot cool down the worries of the market. It is because, if the media report about debt collaterals was true, and the Shanghai LGFV really had deferred its debt repayments by extending maturity into longer-term debts with governmental fixed-asset collaterals that could never be sold for debt compensation, it is, by definition, still a default. We expect this kind of default will continue to happen nationally in China, just like the Yunnan case occurred earlier, even though the Yunnan local government eventually averted its default.

(8) In April, the Chinese "big 4" state-owned banks still said that their risk exposure to local government debts is under control. The "big 4" are namely the Industrial and Commercial Bank of China (ICBC stock codes: 601398.SH, 1398.HK), Bank of China (BOC stock codes: 601988.SH, 3988.HK), the Agricultural Bank of China (ABC stock codes: 601288.SH, 1288.HK), and also the China Construction Bank Corp. (CCB stock codes: 601939.SH, 939.HK). Although these banks currently have LGFV non-performing loans (NPLs) ratios of nearly or less than 1%, about 90% of the loans mainly fund for public infrastructure projects and carry a tenor of over 5 years, and hence will surely mature later and become troublesome in the future. LGFVs thus will have potential risks with direct impact and pressure on domestic banking sector soon, though the China Banking Regulatory Commission (CBRC) has not yet confirmed any consolidation problems for the LGFV debts in the short-term. The market now estimates that if one of two trillion (in RMB) have to be set aside for bad loans, the domestic Chinese banking industry's overall NPLs (non-performing loans) ratio will substantially rise to over 6% from the existing level of 1% in average. If such estimation becomes true, losses from those NPLs will probably wipe out at least a few years of profits generated from the domestic banks.

Finally yet importantly, as long as China GDP growth formula remains unchanged and LGFV debts remain a hidden problem for the national Chinese banks, investors are advised to properly evaluate the risks before enlarging their investment in the mainland banking sector.


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