September 27, 2023

China’s dark debt corner is facing funding tightness

(Bloomberg) — The $9 trillion in Chinese local government bonds that helped the rest of the world out of the 2008 financial crisis pose a growing risk this time around.

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The bonds financed an economic boom in China more than a decade ago, when local authorities borrowed heavily to invest in everything from roads to subways. But one of China’s largest state investors advised asset managers who oversee its money to sell some of its debt, Bloomberg News recently reported, adding pressure to the securities.

It has left authorities with the tricky balancing act of defusing a huge risk to the country’s lenders without causing defaults and destabilizing the financial system. Any implosion of bonds from local government financing vehicles would ripple through the local banking system, further depressing overall growth in the world’s second-largest economy.

Goldman Sachs estimates that 34 trillion yuan ($4.75 trillion) of local government debt is on the balance sheets of banks it covers. The potential headwinds to growth would hit an economy whose post-pandemic recovery is already relatively lukewarm.

The heightened risk is highlighted by the increase in the average coupon on LGFV yuan bonds from 3.94% last year to 4.39% in the first six months of the year, despite China easing monetary policy is.

‘far-reaching impact’

“The direct impact of LGFV’s default would be borne almost entirely by domestic investors, but the indirect impact should be far-reaching,” said Brock Silvers, director of private equity firm Kaiyuan Capital. “If China’s recession eventually extends or deepens because the old playbook has finally expired, the impact of LGFV’s debauchery will be felt on a global economic scale.”

The latest developments are increasing the hurdles for tense local governments in China. A nationwide real estate slump saw their revenues from land sales plummet while government spending skyrocketed during the pandemic.

In a survey released last month, investors across Asia said rising levels of municipal loans were the region’s biggest financial risk this year. One of the concerns is that the money raised by the LGFVs has been used for projects that typically don’t generate enough returns to cover their debts, leaving many dependent on refinancing or government injections to stay afloat.

Adding to the difficulties is that many LGFVs have been essentially excluded from the Free Trade Zone bond market following recent guidance from the People’s Bank of China, a major blow to the vehicles as they were the most common issuers of those securities.

Tight grip

The guidelines show that Beijing “continues to keep tight control over local debt risks and does not want a funding channel without regulatory oversight,” said Sherry Zhao, senior director of international public finance at Fitch Ratings.

It also leaves issuers from poorer provinces in particular with fewer financing options at a time when investors are souring their risks. As a result, they face higher borrowing costs, while the average maturity of onshore LGFV bond issuance falls to its lowest level since the data series began in 1999, adding further pressure on regulators to defuse the problems.

“As you get closer and closer to the center of Chinese government guarantees, LGFVs are right on that frontier,” said Logan Wright, head of China Markets Research at Rhodium Group LLC in New York. “They’re important because if you’re questioning commitment to LGFVs, what more are you asking the government’s credibility to defend?”

Week overview

  • According to Bloomberg Intelligence, some of the largest regional banks in the US may need to issue $168 billion in bonds at the level of their holding companies to meet the Fed’s plan to increase capital requirements for lenders.

  • US leveraged bond prices rose to their highest level since August as buyers turn to the secondary market, while new issuance remains relatively subdued.

  • A refinancing transaction of sorts is reviving in the $1.3 trillion market for collateralised loan obligations, a sign that the industry is healing as concerns about rising inflation and a potential recession recede.

  • BC Partners and a group of Keter Group BV creditors have agreed on a deal to extend the term of the garden furniture maker’s debts, giving the private equity firm time to sell and repay the company.

  • Concerns about debt payments and tight finances at Vedanta Resources Ltd. of billionaire Anil Agarwal are once again taking center stage, underlined by losses on some of the commodities giant’s bonds.

  • At least two Sino-Ocean dollar holders said they received no interest on July 13, the first of nearly $380 million in bond obligations this quarter for the in-focus Chinese developer.

  • Private equity firm Carlyle Group would be inclined to buy portfolio company Praesidiad Group Ltd. to a group of creditors as part of a debt restructuring.

En route

  • Blackstone Inc. takes on Max Besong, global head of collateralized securities lending trading at JPMorgan Securities, according to those in the know.

  • Boutique investment banks and law firms in Brazil are hiring as demand for debt restructuring advice soars in Latin America’s largest economy. Moelis & Co. has hired three people this year for its Sao Paulo office, which has a total of about 20 employees. And Houlihan Lokey Inc. hired banker Bruno Baratta from Lazard Ltd. to start an office in Sao Paulo where he builds an initial team of about 10 people.

  • Omar Chaudhry, who headed trading of collateralized loan obligations at BNP Paribas SA, recently left the French lender, according to those in the know.

  • Fidelity Investments has hired Adam Russell as a fixed income trader in Canada, according to acquaintances.

–With help from Wei Zhou, Taryana Odayar and Dan Wilchins.

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