Since the beginning of March when we first explained why QE (or at least some manner of “unconventional” monetary policy) may be inevitable in China, we’ve tracked developments around the country’s local government debt refi effort closely. For those in need of a refresher, we've documented the program from inception to implementation and beyond in exhaustive detail in the following posts:
- China's Latest Spinning Plate: 10 Trillion In Local Government Debt
- China Floats QE Trial Balloon, PBoC May Launch LTROs
- Failed Chinese Local Bond Offering Leads To PBOC Easing Confusion
- China Officially Launches Critical Local Government Debt Swap — But Is The PBoC Really Just Issuing Treasury Bonds?
- China Creates Perpetual Leverage Machine After Dropping Debt Directive
- Confusion Reigns At PBoC As Multi-Trillion Yuan Bailout Threatens To Undermine Rate Cuts
While we won't endeavor to recap the entire series of events here, note that the entire effort comes down to one simple thing: China's local governments have managed to accumulated a debt pile worth 35% of GDP via off-balance sheet, high-cost loans which are now being swapped for low interest muni bonds in an effort to reduce debt servicing costs and extend WAM. This is part of a wider effort on China's part to deleverage an economy laboring under $28 trillion in debt. This deleveraging effort goes far beyond local government debt, as Beijing is now moving to allow for more corporate defaults as the country moves to liberalize its financial markets.
There's a critical link between local governments' off-balance sheet financing (the loans that China is now working to restructure) and China's financial system as a whole. The LGFVs (the vehicles local governments used to skirt official borrowing limits) are guaranteed by provincial governments, as are some critical state owned enterprises. In turn, LGVFs and SOEs have guaranteed the debt of private enterprises. This state of affairs, combined with the central government's willingness to allow for more defaults, sets up the potential for a destabilizing knock-on effect that could trigger the beginning of a long-delayed NPL cycle at Chinese banks and send tremors through the system. SocGen has more:
As the growth deceleration intensifies and financial market liberalisation accelerates, denying the debt problem is becoming an increasingly unviable strategy. The Chinese government may be able to keep papering over the debt problem by continuing to offer implicit credit guarantees to everyone for another year or two. However, developments in the past year suggest that top policymakers are now willing to face up to the problem and work on a deleveraging plan. One recent announcement in this direction came from Premier Li, who told a roomful of international and domestic media in March this year that allowing credit events to occur and leaving them to the market to work out will be necessary to address the moral hazard problem.
Market pricing of interest rates is at the core of interest rate liberalisation, which policymakers are keen to push through. That is simply impossible without the existence of risk. Besides installing a deposit insurance scheme, which implicitly admits the possibility of bank restructuring, onshore bond defaults have started to emerge alongside the acceleration of interest rate liberalisation. By the time of this publication, we have counted four credit events in the onshore secondary bond market, including one SOE, and close to a dozen private placement bond defaults (Table 1). While in a few default cases (e.g. Chaori and Zhongsen) investors were eventually paid, the occurrence of these credit events have kick- started risk revaluation in the bond market (Chart 7). We think that, due to its signalling effects, the bond market will continue to be a cautious test ground for the government.
The fiscal reform will also bring more credit risk to the fore. The fiscal reform has started to limit local governments’ ability to extend credit guarantees at a time of slowing domestic growth and tightening global liquidity. Local governments have played a critical role along the credit risk chain. They extend credit guarantees to LGFVs, local SOEs and even some private companies that are deemed local champions, and it is also a common practice for LGFVs and local SOEs to provide credit guarantees to small and medium-size private enterprises. As this critical domino chain of local governments in China’s credit risk situation begins to wobble, there could be significant ramifications for broad financial market stability. Such a chain reaction seems to have begun: SOEs and LGFVs are the guarantors in a majority of private placement bond default cases but have failed to provide credit protection as promised (Table 1).
Apart from reform, the pressure exerted by the multi-year growth deceleration is already weighing on commercial banks, whose NPLs have doubled since 2012 (Chart 8), indicating that private sector debt restructuring has begun and that the process so far is rightly being left to market mechanisms. Consequently, for the first time Chinese loan officers are prioritising containing credit risk over growing loan books, and this has gotten in the way of the transmission of monetary policy easing.
For reference, here's what SocGen had to say after reviewing several LGFV bond covenants:
- Leverage of LGFVs is generally high, with the average D/E ratio close to 200% and the median at around 150%.
- Profitability is very low, with ROA at only 2%. Nearly 80% of LGFVs in the sample have negative cash flows. Since LGFVs are mostly operating in the infrastructure space, the lack of short-term return is partially understandable.
- Debt-servicing capacity is simply dismal. The effective interest rate of these LGFVs is already very low, at less than 2.5%, probably implying a big share of non-interest bearing debt (e.g. accounts payable). Even so, half of the LGFVs still have an interest rate coverage ratio of less than one, which generally points to a situation of financial stress. The corresponding debt-at-risk accounts for close to 60% of total debt in the sample.
Admittedly, all of this is terribly convoluted, and indeed, that's precisely the point. China has gone to great lengths to mask its enormous debt problem by spreading credit risk across a dizzying variety of financing vehicles that are carried off-balance sheet and, in the case of China's banking sector, outside of traditional loans. Now, Beijing is attempting to untangle the mess. The only question is whether it's possible to delverage the system before it collapses under the weight of its own complexity.