Local government financing vehicles—the bright spot in China credit
Despite market volatility and weakness in Asia’s credit markets, especially the sharp downturn in China’s property sector, the investment-grade China local government financing vehicle¹ segment in the offshore market has delivered relatively resilient performance and recorded a significant increase in net issuance year to date. We highlight the positive drivers behind this bright spot in China’s credit space.
In view of the recent challenging environment in fixed income (characterized by surging global rates and the prolonged downturn in Asian credits led by the volatile Chinese property sector), investors may be actively searching the region for attractive investment options.
Local government financing vehicles in China (LGFVs), which number around 10,000 in almost every region, may not be as well known or well accepted as other asset classes. In previous years, the opaqueness of some issuers, along with concerns over a mounting maturity wall, may have kept some investors away.
We believe, however, that global investors should take a fresh look at LGFVs for several reasons. Those in the investment-grade (IG) space have demonstrated resilient performance so far in 2022 amid a difficult economic environment. In addition, it’s the only corporate issuer to record a year-over-year net issuance increase. Finally, we believe the asset class should benefit from several near-term policy tailwinds moving forward.
China’s IG LGFV sector registered a total return of -2.90% and an excess return of 1.16% year to date over U.S. Treasuries, making it the best-performing segment in the China IG complex. The sector’s spread has also tightened by more than 40 basis points year to date, close to levels last seen in late 2017 and early 2018.²
China IG credit performance by segment (YTD)
Source: Barclays Research, May 12, 2022. SOE refers to state-owned enterprise. YTD refers to year to date. QTD refers to quarter to date. MTD refers to month to date.
Looking ahead to the second half of 2022 and beyond, we expect the IG LGFV sector’s performance to continue. This could be supported by solid demand from Chinese investors who are attracted by the yield differentials between the onshore and offshore markets, and low supply from state-owned enterprises (SOEs).
Significant increase in net-issuance
Among the IG corporate issuers in China, IG LGFV is a market segment that recorded a year-over-year increase in net issuance: US$12 billion in the first four months of 2022 versus US$3 billion in the same period last year. This sharply contrasts with IG-rated privately owned enterprises (POEs) that saw US$1 billion of net redemption in the first four months of 2022 as compared with US$12 billion of net issuance in the same period last year.³
At the same time, net issuance in the Asian U.S. dollar bond market fell by 91% to US$7 billion in the first four months of 2022, with mainland China recording US$11 billion of net redemptions—in sharp contrast to net issuance of US$30 billion in the first four months of 2021.
Local governments are more reliant on LGFVs and more supportive policies are expected
Overall, the economic and policy backdrop for the IG LGFV sector also remains supportive. A reduction in LGFV revenue from land sales should be mitigated by stronger support from financial institutions, larger central-government transfers, better earnings from increased infrastructure spending, and the accelerated issuance of local government special bonds. That said, we believe the mandate to control local government off-balance-sheet debt⁴ will remain as some of the debts are too large and strategic to fail.
Local government fiscal revenue is expected to be lower
We think the consolidated fiscal income of local governments for 2022 is likely to fall. For 2022, the collective forecast⁵ of 31 provincial governments is a 3% growth in consolidated fiscal income (5% growth for general budgetary revenue, 18% growth for transfer payments from central government,⁶ and a 10% decline for government fund income). This estimate was made before the Shanghai lockdown and, as such, is probably optimistic.
Local government revenue sources in 2022
Source: HSBC, December 2021.
Lower land sales will pressure local government fiscal profiles
Restrictions on property-developer financing and the enforcement of stricter auction rules had already weakened a key source of income for local governments last year, triggering a decline in land-sale revenue in more than half of China's provinces in 2021.
Revenue growth from land sales conducted by local governments will likely remain sluggish in 2022 (our base case is for a 20% year-over-year fall in income from land sales).⁷ This will reduce an essential source of local governments’ income, compelling them to rely more on central government transfers and raise additional debt to finance countercyclical infrastructure spending. Some local governments may need to rely more on LGFVs for financing infrastructure investments while having fewer resources to support them. Besides, lower revenue from land sales will significantly affect regions with less diversified economies and those with a greater reliance on fixed-asset investment. It will also hit areas experiencing ongoing population outflows as a result of the reduced demand for urban land.⁸
Expect more supportive policies for LGFVs
We believe the shortfall of fiscal revenue due to weaker land sales and zero-COVID policies could be filled by:
- Financing support from national and local financial institutions
- A cut in fiscal spending, or even sales of government assets
- A further step up in transfer payment from central government, potentially through another special China government bond issuance
- Additional infrastructure spending, partially through the accelerated issuance of local government special bonds, which could increase tax revenue for local governments
As a result of difficult economic conditions, initiatives to deleverage LGFVs are likely to be put on hold for the rest of the year to ensure that 2022 GDP targets are met.
A boost in infrastructure spending could benefit LGFVs
Although China’s growth slowed down to 4.8% in the first quarter of this year (vs. the 2022 GDP growth target of around 5.5%), infrastructure investment accelerated to 8.5% during the same period (vs. 0.4% in 2021). We expect infrastructure-related budget spending and credit to grow by double digits in 2022 through accelerated issuance of local government special bonds, pushing infrastructure investment growth to over 10.0%.
In the past, the risk/reward trade-off for LGFVs may have seemed less attractive relative to other alternatives in the China credit universe; however, on the back of a rapidly shifting domestic economic environment, a resilient year-to-date performance, and supportive policy tailwinds, investors could find opportunities within the segment, which has become increasingly important.
Appendix: background on Local Government Financing Vehicles
What are LGFVs?
LGFVs were initially established to provide funding for local infrastructure upgrades and prepare parcels of land for sale to property developers. They subsequently expanded into other areas of business related to urban development such as transportation, utilities, and social housing. LGFVs have ventured into more commercial companies in recent years, including trading, property development, industrials, and finance. As of today, approximately 3,000 local governments issue RMB bonds; among them, 166 issue U.S. dollar bonds in the offshore market.
How much debt do LGFVs have?
According to their financial reports, LGFV bond issuers had about RMB$45 trillion of interest-bearing debt outstanding as of 2020. This is equivalent to 41% of China’s GDP in 2020, up from 33% in 2016. As of December 2021, LGFVs had RMB$12.6 trillion of bonds outstanding, equivalent to 52% of China’s RMB corporate bonds, up from 35% in 2016. Furthermore, LGFVs now have a sizable presence in the Asian U.S. dollar-bond market within the IG, high-yield, and non-rated segments, with US$67 billion outstanding as of March 7, 2022. This was issued by 166 key LGFV U.S. dollar-bond issuers (about 6% Asian U.S. dollar bonds and 13% China U.S. dollar bonds).
Source: HSBC Research, March 2022.
1 Initially, local governments in China weren’t permitted to issue debt in their own name, so they created LGFVs to raise funds from the market on their behalf. 2 Barclays Research, May 12, 2022. Spreads are over U.S. Treasuries. 3 On the other hand, high-yield LGFVs experienced a net redemption of US$421 million in the first four months of 2022 versus a net redemption of US$313 million in the same period last year. 4 Some of the debt raised by LGFVs are kept off the balance sheets of local authorities, but they carry an implicit government guarantee of repayment. 5 Local governments disclose their fiscal revenue forecasts for each year. 6 According to the 2022 Government Work Report, transfer payments from the central government to local authorities will jump by 18% this year to RMB$9.8 trillion. This is one of the largest year-over-year increases in the past decade. 7 A total of 31 provincial governments have budgeted for RMB$7.7 trillion of land sale income in 2022, down 11% year over year. Among the provinces that generate the most revenue from land sales, Zhejiang estimates a 23% decline from 2021, Jiangsu expects land sales to fall 19%, while Guangdong projects a flat year. 8 Relatively more developed provinces in coastal China and provincial capitals will see a smaller impact because their local governments have a wider range of fiscal revenue to draw upon. The most vulnerable provinces are Mongolia, Shanxi, Gansu, Heilongjiang, Jilin, and Liaoning.
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