24 October 2018

China May Have $5.8 Trillion in Hidden Debt With ‘Titanic’ Risks

By Eric Lam

China’s local governments may have accumulated 40 trillion yuan ($5.8 trillion) of off-balance sheet debt, or even more, suggesting further defaults are in store, according to S&P Global Ratings. “The potential amount of debt is an iceberg with titanic credit risks,” S&P credit analysts led by Gloria Lu wrote in a report Tuesday. Much of the build-up relates to local government financing vehicles, which don’t necessarily have the full financial backing of local governments themselves.

Missed bond repayments in 2018 have already surpassed previous highs

With the national economy slowing, and a Beijing-set quota for issuance of local-government bonds not being enough to fund infrastructure projects to support regional growth, authorities across the country have resorted to LGFVs to raise financing, according to S&P. That’s left LGFVs “walking a tightrope” between deleveraging and transforming their businesses into more typical state-owned enterprises, the S&P analysts said.

Rising vulnerabilities among LGFVs occur against a backdrop of a record pace of defaults this year in China, which has sought to roll back a decades-old practice of implicit guarantees for debt.

The most vulnerable LGFVs include the following, in S&P’s analysis:

Those tied to weaker prefectural, city or district-level governments with lax supervision over state-owned enterprises.

Those focused on commercial activities -- thus having diminishing importance to local governments.

Those with significant refinancing risks thanks to large short-term debt or reliance on borrowing from the shadow-banking sector.

The focus on funding to sustain growth at the local level echoes a broader shift in the central government, which last year was focused on reducing leverage in the financial system. That phase is essentially over, thanks in part to an escalating trade war with the U.S., according to Citigroup Inc. analysts.

“The markets are right, in our view, to feel more concerned about the sustainability of China’s debt and the increased financial risks,” said Liu Li-Gang, chief China economist at Citigroup in Hong Kong. He also saw “renewed pressure” on the yuan.

Even with the central government’s shift toward stimulus, however, S&P sees Beijing determined to “bring discipline to the financing practices of local governments and their LGFVs.” That ultimately may mean local authorities aren’t fully able to keep LGFVs afloat, however, and the bottom line is “the default risk of LGFVs is increasing.”

— With assistance by Tongjian Dong, and Lianting Tu

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