Tuesday, August 16, 2011

What is Inside LGFV loans in China

As you may know, the problem of LGFV loans is not something new in China. So what is LGFV actually? By definition, LGFVs (Local Government Financing Vehicles), also called LGFPs (Local Government Financing Platforms), are financing instruments just like SIVs (Special Investment Vehicles) in western banks. Various local governments in China establish LGFVs mainly for funding their development projects such as airports and highways. They usually use the state-owned resources and assets (including land, equity, government fees, bonds etc) as collaterals to set up companies for meeting basic lending requirements in terms of assets and cash flows so that they can borrow loans indirectly from banks.

According to the current PRC algorithm law (Chapter 4, Article 28) effective 1 January 1995, unless otherwise agreed by law or by the China State Council, Chinese local governments are prohibited to fund themselves by issuing municipal bonds. The Chinese central government imposes this kind of restriction on borrowing to ensure the money can be used in viable projects. As the existing law does not allow financing through municipal bonds or borrow loans directly from banks, alternative financing instruments are therefore necessary for Chinese local governments to cope with their huge development expenditures and, LGFV is obviously one of the most useful one.

If you were long-time investor in China, you might not really fear about the LGFV problem as it has already existed in China for many years. So what makes the LGFV debt problem appear to be getting worse recently? The main reasons are:

(1) By the second half of 2008, when global economy was facing a financial tsunami, Chinese central government decided to formulate an economic stimulus plan worth RMB 4 trillion to sustain its goal of at least +8% growth in GDP. The Chinese local governments had to follow this policy direction, and also formulated a series of measures involving many infrastructure projects to promote local economic development. However, since the local governments could not fund themselves by issuing municipal bonds, they had to borrow money from local banks through other methods like LGFVs (Local Government Financing Vehicles).

(2) In March 2009, PBoC (People's Bank of China) and the CBRC (China Banking Regulatory Commission) jointly issued a guidance of "Further Strengthen the Credit Structure Adjustment to Promote Steady and Relatively Fast Economic Development" that actually supported the formation of LGFVs.

(3) For similar reason, the mainland banks were also actively supporting national key projects and infrastructure, so the number of LGFVs did increase rapidly since 2009. The problem is getting bigger as the Chinese banks continue to grant loans to LGFVs (Local Government Financing Vehicles) regardless their real ability to repay debts.

It is hard to estimate the actual scale or amount of LGFV loans, as different data sources in China show basically different figures. Some economists may even have no confidence in any of these figures at all. So what is really inside? According to data from the "2010 China Regional Financial Performance Report" released by the PBoC monetary policy analysis group in early June, the number of LGFVs exceeded 10K at the end of last year, over 25% more than number of LGFVs in end-2008, and around 70% of them are county-level LGFVs (Local Government Financing Vehicles). The report also pointed out that the amount of LGFV loans was less than 30% of the total loans in the country last year. Based on the fact that total loans hit RMB 47.92 trillion last year, the amount of LGFV loans should be less than RMB 14.38 trillion, around 36% of the whole China GDP in the year. This maximum amount of LGFV loans estimated by the PBoC statistical data, however, was much higher than the RMB 9.09 trillion reported from the CBRC statistics or the RMB 4.97 trillion reported from the China NAO (National Audit Office).

We have to say that these different data sources do have a common weakness: they do not have a standardized LGFV loan classification (or even definition). As a result, it should be reasonable to believe that some of these data sources can just underestimate the actual size of LGFV loans. After analyzing all these data sources and their different LGFV loan classifications or definitions, we, Mr China, estimate the size of LGFV loans should be around RMB 9 trillion by end-2010. Adding together with other non-LGFV type local government debts, the total size of local government debts should be RMB 11.3 trillion in 2010. With the Chinese central government debts of around RMB 6.7 trillion in 2010, the overall Chinese government (central + local) debts could reach RMB 18 trillion in 2010, around 45% of its GDP (China 2010 GDP was RMB 39.8 trillion). By the above calculations, China's national debt ratio is far better than the European Union (EU) allowable standard of 60% and should still be considered as a manageable level.

However, even though it is not a problem in quantity, we still believe that what the main concern about LGFV problem should be quality. Yesterday a news reported that 30% of LGFV loans (around RMB 2.8 trillion) has sufficient cash flows and can be converted to normal company-type (non-LGFV type) debts. Come on, only possibly 30% from LGFVs (Local Government Financing Vehicles) can now be considered as quality loans, how about the rest 70%?

Next article(s): Potential Risks of Chinese LGFV debts
Possible Solutions for Chinese LGFV Debt Problem


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