Following several years of administrative curbs on their financing and operating activities, China's local government financing vehicles (LGFVs) are back. Their operations are accelerating because they play outsized roles in helping spark economic momentum as China begins to normalize following the COVID-19 lockdown. LGFVs are also back in the domestic bond markets, raising record-high funds.

S&P Global Ratings believes that longer term, reform initiatives will resume, and the LGFV model will be gradually phased out, because it creates off-budget, or "hidden" debt for their local government owners. China is increasingly issuing government bonds to fund infrastructure investments and improving the transparency of government financing practices. However, in a post-COVID China, key LGFVs will be important to efforts to execute stimulus policies.

The role of LGFVs in the infrastructure boom to assist post-epidemic recovery also points to government support--which undergirds the creditworthiness of companies in the sector. In our view, new borrowings by LGFVs are less likely to increase government "hidden" debt as previously, and the policy direction to delink off-budget activities of LGFVs from their local government owners will continue over time. However, the capacity to support LGFVs is becoming more divergent. Some lower-tier governments face deteriorating fiscal positions.

We address investors' questions on recent rating actions in the sector, government support, refinancing risk, and the general credit outlook for the LGFV sector.

Frequently Asked Questions

What led you to revise your rating outlooks to negative for some LGFVs?

The primary drivers were weakening credit profiles of their local government owners. Weaker local governments have limited buffers to absorb the double whammy of declining fiscal revenue and rising debt due to COVID-19. This, in our view, is the situation facing Chongqing Nan'An district, Liuzhou city in Guangxi province, and Yangzhou city in Jiangsu province--the owners of the LGFVs whose outlooks we recently revised to negative.

Table 1

Are special-purpose bonds helping to mitigate the strain from COVID-19?

In the first quarter of 2020, China's national general budget revenue dropped 14.3% over the same period last year. For local governments, the aggregate decline was 12.3%. Major tax sources shared between central and local governments plummeted---such as value added tax (VAT), and corporate income tax. At the same time, revenue classified as "governmental funds" shrunk 12% year on year; these funds come mainly from land sale proceeds and contribute significantly to total revenue of local governments.

Chart 1

We estimate that China's real GDP growth will shrink to just 1.2% in 2020, its lowest level since 1977. Local government budget deficits are set to widen on the back of the economic fallout. This together with countercyclical measures to increase infrastructure investments could accelerate local governments' debt accumulation (see "Economic Research: Up Next: The Complicated Transition From COVID-19 Lockdown," published on RatingsDirect on April 16, 2020).

We expect local governments to lift infrastructure investment to help offset the drag of sluggish demand. Their financial capacity to shoulder this burden has been boosted by three separate increases in the 2020 quota for special-purpose bond (SPB) issuance. The pre-approved quotas allow for cumulative new issuance up to Chinese renminbi (RMB) 2.29 trillion (about US$322 billion) for 2020, compared with the full-year quota of RMB2.15 trillion in 2019. The final amount will be announced at the upcoming national congress, which were postponed to May (from March) due to COVID-19. We believe the quota could rise further, adding to the debt load of China's local and regional governments. By the end of 2019, China reported total local government debt of RMB21.3 trillion, accumulated mainly through government bond issuance.

Chart 2

Chart 3

As we have seen in past years when the Chinese economy slows, increased infrastructure spending is a tool that the government uses to jumpstart growth. While China has been re-positioning itself to a more consumption driven growth model, we view the current investment-driven initiative as China's response to restore economic growth hammered by the unprecedented slowdown due to the COVID-19 pandemic. LGFVs play an important role as platforms for executing traditional projects. There is also a continued push to develop more high tech "infrastructure" such as 5G networks, which may rely more on social capital than state-owned companies like LGFVs.

Will government support to LGFVs wane amid the COVID-19 fallout?

Yes and no. On one hand, strained fiscal coffers could undermine direct financial support from local governments. This could manifest in delays or reduction of operating subsidies and capital injections to financing vehicles, and receivables could become harder to collect from local governments over the coming 12-18 months.

We expect policy risk to linger for LGFVs, especially when China's economy returns to normalcy and deleveraging is back on the agenda of the central government. In our view, the central government still aims to grandfather out the implicit guarantees of LGFVs by their local government owners. Authorities also will seek to keep a lid on off-budget borrowing by local governments. Since 2018, new off-budget borrowings are strictly prohibited from being counted as government obligations, and we believe the transition of LGFVs away from linkage with their government owners will continue.

We believe major LGFVs remain important to executing key initiatives by local governments. Amid the viral outbreak, some LGFVs engaged in special tasks, such as procuring medical supplies, implementing quarantine measures, facilitating work resumption, and offering rental or fee concessions for tenants in industrial parks they operate. In addition, local governments may use LGFVs to lead or participate in potential bailouts for fellow state-owned enterprises (SOEs) or local banks in financial distress (see "Gansu Highway's Proposed Bank Rescue To Strain Its Cash Flow," April 22, 2020).

Infrastructure will play an important role in restoring China's ravaged economy, given likely lingering weakness in consumption and exports, as well as manufacturing and property investment. We expect infrastructure investments to grow by about 8%-10% this year, compared with just 3.8% in both 2018 and 2019. While lockdowns dragged down infrastructure investments in the first two months, spending quickly returned to positive territory in March. Infrastructure investments should remain brisk for the rest of the year, supported by a strong policy push and more available and less-costly funding.

Chart 4

The enlarged issuance of local government SPBs will drive the infrastructure growth in 2020 and thus, to a certain extent, replace the financing role of LGFVs. These bonds reflect the efforts of China to make local government borrowings more transparent and continue the crackdown of off-balance-sheet borrowings. That said, key LGFVs will continue to lead some traditional infrastructure projects, such as regional railways, subways, and upgrades of urban public facilities. In these areas, the proceeds from SPB may contribute only part of the financing.

To support China's infrastructure spending, will LGFVs leverage go up?

Yes, although over time the government is still committed to a deleveraging of the LGFV sector. Since 2019, LGFVs have taken advantage of benign domestic credit conditions to tap the onshore bond markets. At the same time, local government issuance of SPBs may amplify the borrowings of major LGFVs, mainly through those large or critical players that tend to have more borrowing capacity and credit market access.

While only governments can issue SPBs (which are roughly similar to municipal bonds), some of these obligations can still effectively end up on the balance sheets of LGFVs. The bonds can only be issued for qualified projects, so if an LGFV is mandated to carry out the project, the SPB obligation can be transferred to the LGFVs balance sheet. We expect SPB project companies will further lever up through borrowing from banks or issuing bonds, though those will be legally non-recourse to the LGFV's parent government.

Local governments are required to apply the SPB proceeds primarily to infrastructure projects. Most urban renewal and land development projects, accounting for over 60% use of SPB proceeds in 2019, are excluded from qualified projects this year (unless they are financing existing projects) to leave room for infrastructure. Local governments have also been given more flexibility in the use of these proceeds, including to use up to a quarter of the funds to be deployed as equity in those projects. This can attract co-investors and allow a substantial leveraging-up of local government investment.

Chart 5

SPB projects are designed to be self-financed and rely on project-level cash flows to service debt repayment. Project debt especially those outside SPB proceeds, should have no recourse to the government, implying governments are not liable for such new borrowings. It is worth noting that most infrastructure projects have low returns in China, including projects such as toll roads, metro lines, railroads, hospitals and schools, waste water treatment, urban facilities upgrade and industrial parks. As is the case with greenfield infrastructure projects in many places, there is degree of uncertainty as to long-term performance. However, the risks are usually only apparent over time following the completion of construction, which can take a number of years.

Adding to the need to finance increased capital spending, stronger LGFVs are also scrambling to issue domestic debt while the cost of such funding is getting cheaper. Government stimulus measures after the COVID-19 outbreak have boosted onshore bond markets and guided down risk-free rates. LGFV onshore bonds rated 'AAA' and 'AA+' by China domestic rating agencies have registered record issuance in the first four months of 2020. In the same period, 'AA' rated bonds also saw their highest issuance since 2017.

We expect the LGFV sector, especially larger issuers or those from economically developed regions, to accelerate borrowing in the onshore bond market in 2020. Some proceeds will also be applied to replacing costly alternative financings.

SPB issuance was first introduced in 2015 partly to replace the financing function of LGFVs. The recent increased issuance of SPB is a reaction by China government to the current low growth environment. We believe that SPB growth rates will normalize when China starts to recover from the sudden slowdown. Over time, the LGFV model will be gradually phased out or find themselves focusing more on commercial activities.

We expect weaker LGFVs, mainly those owned by lower-tier local governments or those with high debt levels and weak fiscal power, may lever up less due to their limited borrowing capacity as well as less acceptance by credit markets.

Chart 6

How will LGFV refinancing risk be managed in 2020?

This is a risk that has been postponed rather than eradicated for most LGFVs. Many LGFVs are taking advantage of easier financing conditions and lowering their debt costs and pushing out maturities. However, some weaker financing vehicles may be less able to access the markets and therefore refinancing risk will remain for these entities.

LGFVs rely heavily on China's state-owned banks and capital markets to refinance maturing debt. Easier monetary conditions since last year have encouraged debt fundraising. So have lender preferences for LGFVs in an environment of rising corporate defaults, especially for private-sector firms. In 2019, according to data provider Wind, LGFV net bond issuance (the balance of new issuance and bonds maturing) totaled RMB1.1 trillion, a 115% jump from 2018. In the first four months of 2020, net issuance of all LGFVs hit RMB966 billion in the onshore market, the highest period on record.

Part of the surge in domestic debt is related to LGFVs taking advantage of favorable markets to replace costly outstanding debt, especially alternative financings such as trust loans and financial lease. This has been the case with Jiangsu province, which has the largest amount of outstanding LGFV debt.

However, these fundraising activities will steepen future maturity walls. Some RMB1.82 trillion of onshore LGFV bonds will come due from May through the end of 2020; this includes "effective maturities," or RMB416 billion of bonds with put options that are exercisable this year and RMB108 billion that the issuers can call back. Some RMB2.54 trillion is due in 2021, and RMB2.27 trillion in 2022. Capital structures are negatively affected because about 31% of new bonds issued since January 2020 have maturity shorter than one year, compared with 19% in 2016.

Chart 7

Credit easing is not indiscriminate. Weaker LGFV borrowers continue to see wider credit spreads and restrained access to long-term funding in the bond market. Hence they also tend to do more "structural issuance" through buying their own bonds in disguised ways. This would help boost issuance and distort price to reflect better on issuers which are less favored by investors.

Weaker LGFVs also have capital structures with a higher percentage of short-term maturities. In addition, they typically borrow more trust loans/financial lease, loans from local commercial banks, and through private placement notes. Not only is this funding often costlier, these channels can abruptly dry up amid periodic policy backlashes on riskier financing practices.

Chart 8

Is nonpayment risk reduced?

No, the ability to service debt remains challenging for weaker LGFVs. Although LGFV debt issuance has sped up again since 2019, fueled by a buoyant onshore bond market, credit divergence remains acute and weaker LGFVs have to pay high costs to get financing. We also note that policymakers have encouraged restructuring of credit terms for debt obligations of distressed borrowers, especially for alternative financing means.

Chart 9

With little transparency, missed payments by LGFVs in trust loans or other wealth management products have occurred in regions where local governments, especially the lower-tier ones, are under fiscal strain and high debt load. This includes Guizhou, Inner Mongolia, Yunnan, Sichuan, and some provinces in northeast China.

We believe more distressed LGFVs will potentially miss payments or not pay back debt due at maturity. This is despite our anticipation that bondholders may consent to the restructuring or the exchange offer. In addition, credit distress in the market for private-placement notes, which has poor disclosure, could transmit to public traded bond markets:

• In November 2019, an Inner Mongolia LGFV, Hohhot Economic and Technological Development Zone Investment Development Group Co. Ltd., defaulted on its private placement notes by failing to meet payments to investors who exercised their put options.
• In September 2019, loss-making LGFV Jilin Transportation Investment Group Co. Ltd. exercised the option to extend the maturity at the 300-basis point step-up rate, making it the first issuer of "perpetual bonds" in China not redeeming the bonds to liquidity stress.

More recently, Chinese regulators have been open to exchange offers in the onshore market, and even hailed this as a financial innovation, which can help the weaker borrowers to avoid "defaults" through negotiation with lenders. In April 2020, with the green light of regulators, a Dalian-based LGFV -- Wafangdian Coastal Project Development Co. Ltd.--"settled" the repayment of maturing private placement notes by exchanging them for newly issued notes. This may be the first case of exchange offer in the LGFV sector in the onshore market, and, in our view, is unlikely to be the last.

What's the credit outlook for LGFVs?

Our credit outlook on the LGFV sector is biased towards the negative. Currently, about one-quarter of the LGFVs we rate have negative outlooks, primarily driven by the weakening credit profiles of local government owners. The COVID-19 fallout erodes the buffers of local governments against worsening budgetary performance and rising government debt. The pandemic might also constrain their capacities to use other possible means to bail out distressed LGFVs.

We believe the government support to LGFVs will wane in the longer term. The central government is steadfast in its goal to curb off-budget borrowing of local governments. Increasing issuance of government bonds is gradually replacing the role of LGFVs in financing infrastructure backed by local government implicit undertaking.

The pressure to change is mounting in the LGFV sector. Transitions to more commercial operations and mergers among local LGFVs will be ongoing to help maintain market positions and financing capacities. Government policy changes are also pushing LGFVs to move away from alternative financing, such as trust loans, whose high costs and volatility have plagued weaker LGFVs, to a greater use of bank and bond market financings.

In the near term, LGFVs still benefit from abundant liquidity in the onshore market, declining funding costs, and the perception of strong continued support. However, when market liquidity dries up again and credit divergence further worsens, we may see more distressed LGFVs falling through the cracks quickly. In fact, local governments may have more tolerance to SOE defaults, given the precedence of recent defaults by Tianjin's Tewoo Group Co. Ltd. and Qinghai Provincial Investment Group Co. Ltd.

Related Research

• Guangxi Liuzhou Dongcheng Outlook Revised To Negative On Wobbling Government Creditworthiness; 'BB' Rating Affirmed, April 28, 2020
• LGFVs Yangzhou Urban And YETDZ Outlooks Revised To Negative On Weakening Government Financial Capacity; Ratings Affirmed, April 24,2020
• Gansu Highway's Proposed Bank Rescue To Strain Its Cash Flow, April 22, 2020
• Economic Research: Up Next: The Complicated Transition From COVID-19 Lockdown, April 16, 2020
• The Refinancing Clock Is Ticking Louder For China's Issuers , April 16, 2020
• Credit Costs For China's Banks Could Rise By US$224 Billion In 2020, April 8, 2020
• Chongqing Nan'an Urban Construction Outlook Revised To Negative; 'BBB' Ratings Affirmed, April 1, 2020
• Pandemic Upends Finances Of China's Weak Local Governments, March 27, 2020